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The Actuary The magazine of the Institute & Faculty of Actuaries
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Prudential regulation?

The Parliamentary Ombudsman’s report on the Prudential Regulation of Equitable Life was published at the beginning of July. It disappointed those policyholders who hoped that the regulators would have to share responsibility for their plight. The report provoked a strong letter of protest in The Times from a former parliamentary commissioner for standards, Sir Gordon Downey. He complained that the ombudsman had taken the view that prudential supervision was primarily a matter of ensuring solvency describing this as a ‘bizarre interpretation’ when the regulator had ample powers to control the business companies could undertake.

Representative complaints
A ‘Mr P’ brought the specific complaint under investigation. He contended that the Financial Services Authority (FSA) had failed to take action which would have allowed him to take fully informed decisions. As a result Mr P, encouraged by Equitable Life, bought a policy in June 2000 which he would not have bought had he known the true position of the company. The ombudsman took this case as representative of all the hundreds of others presented to her about the prudential regulation of Equitable Life.
As incoming ombudsman in November 2002, Ann Abraham decided to maintain her predecessor’s decision that the period investigated would be from 1 January 1999, when the FSA took over prudential regulation, to 8 December 2000, when Equitable Life closed to new business. This covers the period when Equitable Life’s problems were becoming increasingly visible, but when it was still actively seeking new business. It is the same period covered by the Baird Report, the internal report commissioned by the FSA into the FSA’s and the Personal Investment Authority’s (PIA) discharge of their functions. This report has been submitted by the Treasury as evidence to the Penrose Inquiry. It was because Baird identified some shortcomings on the part of the prudential regulators that the previous ombudsman launched the investigation.

Constraints on investigations
Ann Abraham carefully sets out the limits to her remit: she may investigate only those actions taken by bodies listed in the relevant schedule of the Parliamentary Commissioner Act. The FSA was in this category only because it was acting on behalf of the Treasury, while the PIA and the Government Actuary’s Department (GAD) are excluded. Throughout the period the PIA was responsible for the conduct of business regulation, although it was using FSA staff in the FSA’s offices for the purpose.
The ombudsman’s other constraint is the definition of ‘maladministration’ which, in relation to discretionary decisions, is that the process by which they are reached is faulty or that the result is outside the bounds of reasonable discretion.

Contents of the report
The ombudsman’s staff obtained papers from both the Treasury and the FSA. She was able to construct a detailed day-by-day account of activity within the regulatory bodies that occupies 59 closely printed pages of her report (appendix C). It is clear that there was no lack of activity on the part of the regulators as regards internal meetings, notes, and detailed consideration of the position. Her description of the key parts of this activity also forms the first part of her report.
Interviews were conducted with members of the staff of the FSA, the GAD, and the Treasury, and these are recorded in some detail. The only outsider involved in her work was ‘a specialist in actuarial matters’ recommended by the Faculty and Institute and there is no indication of what this person’s contribution was.

Ombudsman’s findings
The ombudsman’s findings are presented in respect of three periods:
1 from 1 January 1999 to the Court of Appeal judgment;
2 from the Court of Appeal judgment to the House of Lords judgment; and
3 from the House of Lords judgment to the date Equitable Life closed to new business.
For each period she addresses a number of separate matters, and presents a conclusion for each.
For example, in the first period she deals with: regulatory solvency; future profits implicit item; differential terminal bonus policy and policyholders’ reasonable expectations; did the FSA miss any significant factors?; was there anything further the prudential regulator should have done? In each case she concludes there was no maladministration, using a variety of phrases such as: ‘I do not consider that the FSA’s judgment in this respect was wholly unreasonable.’

The regulatory view of the Equitable Life
As I see it, the trouble with this piecemeal approach is that it gives a picture of regulators saying to each other that each decision they took was within their remit, or within established practice, and of the ombudsman’s accepting this as the standard by which to judge them. This is consistent with Baird, who detected a culture with little appetite to examine the wider implications of an issue. The regulators were responsible for a major life insurer on which hundreds of thousands of ordinary people were relying for their retirement. In August 1999 the regulators saw Equitable Life as:
– A high financial risk because of the level of benefits guaranteed, the relatively low free asset position, and the difficulty it would have in raising external finance.
– Vulnerable to a significant and sustained fall in equity prices the FTSE 100 index was around 6,200 at the time.
– Having an attitude tending towards ‘arrogant superiority’, which could blind it to the financial risks of guaranteeing high benefit levels.
– Needing to reduce the levels of reversionary bonuses to reduce risk (by December Equitable Life proposed to pause before making further reductions to see if yields would improve).
– Having a high exposure to guaranteed annuity rates (GAR), for which the reserve of £1.5bn was half-covered by a reinsurance treaty that would be mutually restructured if claims exceeded £100m at any 31 December. This reinsurance could also be cancelled retroactively if Equitable Life changed its practice on terminal bonuses, including losing the court case.
– Assuming in its statutory accounts that equities would continue to rise to produce surpluses by the time GAR contracts matured.
– Awaiting the resolution of a mis-selling claim concerning pension withdrawal schemes. It later emerged that the PIA was thinking of a public reprimand, a fine of about £0.5m, and a review costing about £41m in redress and administrative costs.
We have to recognise that being a prudential regulator is a job resulting in no thanks for getting it right and huge criticism for getting it wrong. Even so, there is an unanswered question: to what extent should the regulators have recognised that this was an unprecedented situation requiring unprecedented action?

Policyholders’ reasonable expectations
The exclusion of the conduct of business division from Ann Abraham’s remit is a cause of concern, as there are signs in the report that some matters fell between the two divisions. However, in the period after the House of Lords judgment, the prudential regulator was taking a prime role. It is clear from the report that a major consideration at the time was to avoid intervening in any way that might have jeopardised a sale. Equitable Life was advertising for new business, although there was no doubt in the regulator’s mind that it would have had to close if the sale fell through. The prudential regulator’s draft reply to complaints referred to continuing solvency and the maintenance of minimum solvency margins, and it told Equitable Life it was taking a fairly robust line with people who approached them.
Policyholders’ reasonable expectations seem to have been disregarded. The head of prudential supervision told the ombudsman’s staff ‘new policyholders could be compensated if they sustained loss as a result of joining on the basis of misleading information’. Would this have come from Equitable Life’s already inadequate funds? The report gives a clear statement of the prudential regulator’s brief; there is nothing to say that policyholders’ reasonable expectations can be disregarded for the greater good.
To my mind, allowing new business to continue in this period was the most questionable part of the regulator’s work. It was so convinced that a sale was likely, with a substantial injection of funds, that other considerations were disregarded. It seemed strange to me that anyone would want to pay for goods as badly damaged as Equitable Life then was. I suppose one can imagine chief executives thinking of the glory that might ensue from rescuing something as important and historic as Equitable Life.
However, it took potential bidders only a few months to discover that the problems were much worse than they had expected, especially the right of GAR policyholders to make top-up payments. Why was this position not clear to the regulator, with all the experience and information at its disposal? In her final comments on the complaint, the ombudsman says she would have expected potential investors such as Mr P to have sought independent advice. Since any independent financial adviser would have received the same robust answers from the prudential regulator, this comment does not stand up to scrutiny.

Historical overpayments
One other vital issue missing from the ombudsman’s report is that of overpayments to maturing policyholders. The first report of an outside appointed actuary revealed that policy values were in excess of asset values as at 31 December 2000. Later, the independent actuary’s report showed that the excess at that date was about 10%. Papers presented to the Court of Appeal demonstrated a similar excess at each of the previous five year-ends. The excess was under 5% in only one year and over 10% in two years. To my mind the upwards smoothing out of non-existent reserves is comparable to buying a new car in the belief that next week’s lottery will bring a big prize. The fact that the GAD was aware of the point as early as 1997 is shown by the Baird report. Why did the prudential regulator not prevent Equitable Life from weakening the prospects of continuing policyholders in this way?

Waiting for Penrose
From this short account of a 103-page report it will be apparent that I am uneasy about the result. Has Ann Abraham been too ready to accept the justifications given by regulatory officials for their actions, bearing in mind that the only outside person consulted was the actuary mentioned earlier? The report lists 23 material recommendations for change in FSA procedures coming out of the Baird report. The fact that so many alterations are necessary does not seem to have shaken the ombudsman’s belief that there had been no maladministration. The Penrose Inquiry is not subject to the same limitations on its remit, and its findings are eagerly awaited.

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