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The Actuary The magazine of the Institute & Faculty of Actuaries

The Equitable court case

We have recently had the fascinating experience of acting as expert witnesses in the Equitable’s much-publicised case. We know that there is a widespread interest in the issues it raises, and thought that it would be helpful to write an article setting out the actuarial aspects of the case. We have not sought to summarise the arguments from a legal point of view. We leave that to the lawyers!
No company has worked harder to achieve policyholder value than the Equitable. Its unambiguous orientation based on ‘no shareholders and no middlemen’ has proved to be one of the ingredients in its proposition to its customers which has made it arguably the most successful life office in the UK over the last 20 years. What a shame therefore to see it at loggerheads with a group of its policyholders, and in court with a representative policyholder to clarify the position regarding guaranteed annuity options.

The essence of the disagreement
The argument was basically a simple one. Equitable’s case was that it had a wide discretion over the way in which bonuses were to be decided, on what principles, and in what circumstances. It had used this discretion since the end of 1993 to declare two levels of terminal bonuses on its substantial portfolio of pre-1988 self-employed and executive pensions business.
The policyholders argued that they had the right to have the guaranteed annuity rates (GARs), as set out in the policy document, applied to the whole of the cash value of their policies, that is, including the terminal bonus at the higher rate. By implication, they disputed the Equitable’s two-tier terminal bonus system.

Equitable’s with-profits pensions policies, both for the self-employed and for executives, are not unusual. There is a premium rate guarantee during the period from premium payment until retirement. This rate has varied over the years. For some time, for example, it was 3.5%. There is an annual reversionary bonus in the usual way, and a final terminal bonus. One aspect which does serve to confuse matters somewhat is the fact that the policies are written for pensions, and the annual bonuses are declared as pension. However, most of the policyholder communication was in cash form, the pension amounts being converted to cash using the GARs set out in the policy. These GARs are on generous terms, being £97.20 per £1,000 cash until the mid-1970s and then £117.20 for a male at 65, quarterly in advance without any guarantee.
What was accepted was that these GARs applied to the guaranteed amounts in the policy, that is, the original amount guaranteed by the premium rates together with the accumulated annual bonuses.
Policyholders’ reasonable expectations
As we all know, the concept of policyholders’ reasonable expectations (PRE) is an important one. We also know that it is not defined in the legislation that uses the expression (the 1982 Insurance Companies Act). Nor has it been seriously tested in court. In some ways the Equitable case was such a test. Although there was much argument about whether it was reasonable, there was no doubt that some policyholders certainly expected the GARs to apply to the full terminal bonus and that, on the other hand, the company regarded PRE as synonymous with asset shares. It was interesting to note that Jonathan Sumption, the policyholder’s QC, did not make much direct use of PRE. It was certainly implicit in his arguments, but it would be a gross oversimplification to see the case as consisting of PRE saying one thing, the company doing another, and the court being asked to decide who is right. But there is an important message from the case for life office managements. The concept of PRE is a vital one. Offices owe it to their policyholders to explain what they can and cannot expect. Perhaps there has been a tendency in the industry generally to avoid saying some things starkly to policyholders, especially if there is a negative connotation. The lesson is that it is better to be up-front and early in communication matters.
The consequences of the failure to explain must have been one of the aspects that was hurtful to the Equitable’s case. As The Times, perhaps rather unkindly, expressed it:
it emerged that for up to five years the company tried to conceal its decision to cut maturity bonuses for policyholders taking a guaranteed annuity in retirement
No doubt it was the last thing the Equitable’s management or its board intended or wanted to happen, but sadly that is the effect of the events as they have turned out.

Market practice
There was another set of arguments that revolved around the issue of the degree of relevance of market practice. Most, not all, of the large with-profits offices, and probably most with-profits offices generally, currently apply their guarantees to the whole of the proceeds of the policy, ie including the terminal bonus. Or, to put it another way, there is only one rate of terminal bonus, not a lower one if the guaranteed pension is taken. To the extent that it was not clear to policyholders what the Equitable’s practice was, there is a natural tendency for general industry practice to fill the vacuum. Had the Equitable explained what it intended to do when the situation first developed and when the amounts involved were small (which was as far back as 1993), then the actions of competitors would not have been as relevant. There might have been some reaction along the lines of ‘that’s not what I expected’, but it is likely that it would have been much less justified or vociferous.

The bonus declaration process
At first sight Article 65 of the Equitable’s articles of association seems clear enough. It says in part:
The Directors shall apportion the amount of such declared surplus by way of bonus among the holders of the participating policies on such principles, and by such methods, as they may from time to time determine.
The amount of any bonus which may be declared or paid shall be matters within the absolute discretion of the Directors, whose decision thereon a shall be final and conclusive.
Taken on their own these powers are unambiguous. But, when taken in conjunction with the quite usual provision that bonus decisions could not be delegated by the board, it was not so clear. Another issue was did the ‘related bonus’ (a term used in the policy documentation) include the terminal bonus? If it did, the GARs would apply to the terminal bonus as well.
The exact details of the somewhat involved arguments are not really the most important issue for our profession. Rather, the message is to make absolutely sure that the whole process of bonus allocation is legally watertight. That process is not just the board’s powers, it also includes the way in which the process is carried out, so it includes what happens at board meetings, what is included in the board papers, and how it is minuted. It also encompasses the way in which the bonus decisions are implemented at a policy level, how any interim bonus is given, and crucially in the case of the Equitable the way in which terminal bonus is dealt with.
Obviously, the company’s literature as a whole was central. A good deal of attention was paid to the policy document, but the bonus notices, prospectuses, quotations, and illustrations were also highly relevant. The lesson emerging was that literature that was specific to the policyholder carried greater weight than general statements. Some of the documents, such as some bonus notices, were not especially helpful in that they did not specifically deal with the GAR issue. Some of the illustrations were particularly unhelpful to the Equitable’s case, even though they had not been used for many years, (probably because they were superseded by LAUTRO-style quotations). Some of them would have remained in the possession of policyholders, and the lack of a replacement statement left an impression that was unchanged.

The judgments
Sir Richard Scott was clear in his judgment in supporting the Equitable. At the risk of oversimplifying (the judgment runs to more than 35 pages), paragraph 97 states:
However, a reasonable expectation does not become a contractual right. PRE was no more than one of the factors to be taken into account by the Directors. Its effective weight in the balance would depend upon all the other relevant factors taken into account. And the balance was, and is, one for the Directors, not the court, to strike.
The appeal went the other way on a 21 split. Lord Woolf gave as his first reason in a list of nine:
The differential bonus significantly detracts from or undermines the benefit of GAR given by the Policy. The assumption on which the Policy was based was that when current annuity rates fall below the GAR the annuity which the policy-holder should receive would be higher than if there was no GAR.
The House of Lords agreed with the Court of Appeal, the decision being 50. In another long document the major judgment of Lord Steyn was as follows. First, he ruled on the meaning of a ‘related bonus’ in the policy wording in the policyholders’ favour but then continued:
While I accept this description of the position under the policy, it does not conclude the matter in favour of GAR policyholders. After all, participating policyholders become members of the Society. Their policies must be read subject to the powers and decisions of the directors in respect of the declaration and payment of final bonuses.
In other words, the directors’ action in declaring bonuses other than as set out in the policy was only illegal if the result did not meet PRE. It is on meeting PRE that Lord Steyn’s judgment is most critical. He continued:
In this context the self-evident commercial object of the inclusion of guaranteed rates in the policy is to protect the policyholder against a fall in market annuity rates by ensuring that if the fall occurs he will be better off than he would have been with market rates. It cannot be seriously doubted that the provision for guaranteed annuity rates was a good selling point in the marketing by the Society of the GAR policies. It is also obvious that it would have been a significant attraction for purchasers of GAR policies.
So, although not in the language that we normally associate with PRE, the drive of the Lords’ logic is that PRE should be interpreted as it might be by the man in the street and not, as some of us and Sir Richard Scott thought, by professionals in the full knowledge of the financial position of the company.

The lessons
The lessons for the life industry and our profession will take a while to be fully understood. At the time of writing it is understood the FSA is to ask all offices to explain the implications for them. In the meantime, what is clear is that companies will have to:
– make sure that policyholders have any issues explained clearly to them, in good time, and on a personalised basis, especially issues with negative aspects; and
– make sure that the whole of the bonus allocation process is legally watertight.