This letter sets out our response to the findings of the Inquiry as they relate to the work of the FSA.
In brief:
- We welcome the support given by Lord Penrose to the extensive programme of reform of life insurance regulation that is already under way and is described further below.
- He has made a number of important observations - we are able to comment briefly on some below, while others will require further work.
- The Equitable's continuing regulation will need to take account of several key points made by Lord Penrose.
- Our handling of the regulation of Equitable Life since the FSA took over responsibility for its prudential regulation in January 1999 has already been the subject of the Baird Report published in October 2001 and the report of the Parliamentary Commissioner for Administration (PCA) published in July 2003.
- The Baird report concluded that, for existing policyholders, the "die was cast" by January 1999 and Lord Penrose's analysis supports this conclusion. In response to Baird, we said that, with the benefit of hindsight, it was clear that a number of issues could have been better handled, and that we would take those lessons to heart. That is what we have done, in modernising the regime that we inherited and in making the day-to-day supervision of insurance companies more proactive and risk-based. The PCA Report, while agreeing with hindsight that some things could have been done better, found no maladministration by the FSA.
- In terms of his specific criticisms of us, Lord Penrose considers that, when we allowed the Equitable to put itself up for sale, we did not properly explore all the possible options for the protection of new policyholders. We agree that this is an area for improvement should similar situations arise in the future. We still, however, think that we reached the right decision in this case. The prospective benefit to its 1 million existing policyholders of a sale of the Equitable was bound to outweigh the prospective detriment to the 6,000 new policyholders who joined after the House of Lords verdict.
- Lord Penrose also comments on the question of reinsurance. He considers that the FSA allowed too high a value to be given to the reinsurance treaty and did not take proper account of the fact that the reinsurance treaty would fall away if the Equitable lost the Hyman court case in certain ways. The FSA was aware of the impact of that case on the reinsurance treaty and that the treaty could be renegotiated, as indeed it was, in the event of Equitable losing the litigation. We also made it clear to Equitable that it had to take account of the risk that the reinsurance treaty might be cancelled when considering its financial position and bonus policy. But we accept that the previous regime needed to be overhauled and it has been. The rules are now much stricter both about the kinds of arrangement that may be taken into account for solvency purposes and the credit that can be taken.
- Lord Penrose also suggests that the treatment of the reinsurance treaty was not permissible under the legislation at the time. We have sought fresh advice on this, and are satisfied - as we were at that time - that both European and domestic legislation permitted contracts of this nature to be given a value in calculating the solvency of insurers.
- We are well advanced with a modernisation programme, the main objective of which is to provide policyholders with greater protection and to improve consumer confidence in the life insurance industry more generally. We are doing this by introducing policies which recognise the characteristics of life insurance products, the risks insurers run and the information needs of consumers and their advisers, and by making the day-to-day supervision of insurance companies much more proactive and risk-based. We do not seek to eliminate all risk from the savings industry, but we do believe it essential that companies have the hard financial resources necessary to back the promises they make to their policyholders. Lord Penrose considers the FSA's programme at various points in his Report. He notes that it "…has sought to anticipate many of the lessons drawn by the inquiry" and that the work so far "…has reflected a major comprehensive reassessment of the requirements of an efficient regulatory system for the insurance sector".
- We take Lord Penrose as encouraging us in the clearest terms to get on with delivering the modernisation programme and applying it effectively.
The main elements of the modernisation are detailed in Appendix E to the Report, but can be summarised as:
- moving to realistic accounting and reporting for with-profits business, which will require capital to be held against the discretionary terminal bonus expectations of policyholders;
- increasing transparency and fairness of with-profits funds, including the introduction of Principles and Practices of Financial Management (PPFM). These require insurance companies to detail how they set annual and final bonus rates; smooth profits through the bonus system; manage their investment portfolios; and manage their inherited estates. We are currently consulting on treating with-profits policyholders fairly, including greater protection for consumers in closed funds;
- phasing out reliance on "future profits" and, for the period before they are finally phased out, tightening the criteria against which requests for these are assessed;
- reforming audit arrangements and the appointed actuary system;
- bringing together the prudential and conduct of business regulation of life insurance companies; and
- boosting the resources (numbers and skill range) dedicated to insurance regulation. We have already, since 1999, roughly doubled the resources devoted to life insurance regulation, most of the increase coming since December 2001.
- This programme is dealing with the main issues Lord Penrose identifies, although he has raised two important additional issues which we will now examine: (1) the interpretation of the term "Policyholders Reasonable Expectations" (PRE) as part of our consultation on "treating customers fairly"; and (2) dealing with ineffective boards. In this context, we look forward to assisting Paul Myners with his study of mutual life offices.
The Society's Bonus Practices and the implications for our continuing regulation of Equitable Life
- In these chapters, Lord Penrose analyses the impact of Equitable's accounting, valuation and bonus practices on its financial condition over many years. A central feature of the Report is that the Equitable declared and allocated rates of terminal bonus which resulted in policy values exceeding asset values.
- On Lord Penrose's analysis, the Equitable allowed aggregate policy values consistently to exceed asset values, from at least 1989 until the cuts in policy values in July 2001. This contributed to its weak financial condition and made it difficult for the Equitable to absorb the cost of the guaranteed annuity options, finally crystallised by the decision of the House of Lords in July 2000. Lord Penrose concludes that the Equitable's declared policy of operating without an estate, its approach to paying bonus on maturing policies and the absence of a clearly determined smoothing policy resulted in it paying out more than was justified by the value of the with-profits fund. Lord Penrose suggests that the implications of these practices, and resulting weakness, were ultimately reflected, in part, in the scale and incidence of the cuts in policy values of 16% made by the new management in July 2001.
- The regulatory issues raised by this analysis are mostly concerned with an insurer's responsibility for the financial management of with-profits funds. As Lord Penrose acknowledges, they are addressed by the FSA's new standards and principles for with-profit funds which form part of the modernisation programme described above.
- In his analysis of the Equitable's position, Lord Penrose is careful to make clear that examining questions as to the scope of what may have been relevant legal duties, whether they were breached and who, if anyone, deserves redress, formed no part of his inquiry. Indeed, he makes clear that the issues on which he comments can be settled definitively only by resolution in the courts or by some other adjudicator.
- We have considered whether there are new facts or analysis in the Report which cause the FSA to reconsider its view on the continuing solvency of the Equitable, in particular whether the Report's findings might provide a basis for further claims against the Equitable which ought to be taken into account in making judgments as to its solvency. We have sought information from the Equitable's new management. Those who have seen limited extracts from the Report on behalf of the Equitable consider that those extracts (which relate to the approach to bonuses) do not provide the basis for additional claims which would undermine its solvency. On the basis of our present knowledge, we have no basis to override that view.
- Now that the Equitable and its advisers will be able to see the whole Report, we will be putting further questions to them about the potential for its findings to provide a basis for further claims and have asked them to produce an overall assessment of its implications for the Equitable's future strategy. We will also continue with our detailed work to reach our own conclusions. We shall also continue to monitor closely the ongoing position of the fund, in the interests of policyholders.
- The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; the protection of consumers; and fighting financial crime.
- The FSA aims to maintain efficient, orderly and clean financial markets and help retail consumers achieve a fair deal.
