Documents: 28/04/2004 - Lord Penrose's Report on Equitable Life - EMAG's Comments
Lord Penrose's Report on Equitable Life - EMAG's Comments
INTRODUCTION
Lord Penrose's report upon Equitable Life runs to over 800 pages. It covers many years of the Society's history, investigates highly technical issues and will take a long time to digest fully. This summary has been prepared to inform EMAG's members of its main contents.
The purpose of Lord Penrose's report is to tell the story of Equitable Life's demise and to draw lessons for the future. It was not Lord Penrose's job to attribute blame, rule upon mal-administration or recommend compensation.
WHAT WENT WRONG?
a) Equitable took on a risk it could not afford
Lord Penrose found that from 1975 to 1988 Equitable Life issued pension policies, which effectively guaranteed the holder an annuity upon retirement based upon interest rates of about 7%, even if actual rates proved to be lower, (the guaranteed annuity rate or GAR). Relevant interest rates fell from about 16% in 1982 to about 4% in 1998 and first fell below the critical guaranteed rate in 1993. In 1998 the cost of this guarantee was estimated at £1,500 million.
He found that the executive management had long been aware that falling interest rates could be very costly and an approach to deal with the problem was formulated as early as 1983; (the differential terminal bonus policy). This was implemented 10 years later and gave the retiring policyholder either the policy value the Society had indicated to him (including terminal bonuses) or an annuity at the guaranteed rate upon only the contractual part of his policy value (excluding terminal bonuses). In crude terms, if he opted for the guarantee, his terminal bonus was cut to pay for it.
Retiring GAR policyholders thought the guaranteed annuity rate should apply to the full uncut value of their policies and in July 2000 the House of Lords agreed. Lord Penrose was not asked to comment on the House of Lords decision. However, he does say that the Society's publications and communications with policyholders until 1996 gave rise to the reasonable expectation that total policy proceeds at maturity would be computed irrespective of whether or not the guarantee was claimed.
The Society made no charge for this guarantee and made no provision in its regulatory returns or financial accounts until long after the cost had materialised as a result of falling interest rates.
In 1988 the directors had the opportunity to start a new bonus series for the new non-GAR Personal Pension Plans, but decided against. Lord Penrose says 'This exposed those joining the fund [the non-GARs] to the potential cost of the guarantees and was not adequately disclosed. The Board appear to have taken the decision not to start a new bonus series without adequate consideration of the relevant factors.'
Although the House of Lord's decision was the incident that sparked the Society's downfall, Lord Penrose takes the view that it was by no means the only factor. He says 'Superficially claims of £1.5 billion should not have brought down a Society with funds of £32 billion. A movement in liabilities of about 5%, though a significant injury, perhaps, should not have rendered the Society moribund.' (Paragraph 113 Chapter 2)
b) Equitable declared bonuses out of thin air
The report found that
- from the late 1980s onwards the directors over-allocated terminal bonuses, which meant that the aggregate of policy values indicated to policyholders exceeded the assets of the with profit fund
- the executive management regularly computed the relationship between assets and policy values ('the Office Valuation')
- this realistic financial position was progressively weakened as policy claims withdrew funds in excess of prudently calculated policy values
- by the end of 2000, the position reached could only be dealt with by radical re-alignment of policy values, as happened in July 2001.
The Report summaries the realistic financial position as shown by the office valuation as follows:
| Year |
Assets |
Aggregate
Policy
Values |
Unfunded
Policyvalue
Position |
Unfunded
as a %
of Assets |
| |
£ million |
£ million |
£ million |
|
| 1989 |
4,921 |
5,166 |
(245) |
-5% |
| 1990 |
4,902 |
6,277 |
(1,375) |
-28% |
| 1991 |
6,266 |
7,805 |
(1,539) |
-25% |
| 1992 |
7,915 |
9,214 |
(1,299) |
-16% |
| 1993 |
10,880 |
11,065 |
(185) |
-2% |
| 1994 |
10,817 |
12,956 |
(2,139) |
-20% |
| 1995 |
13,366 |
14,962 |
(1,596) |
-12% |
| 1996 |
15,699 |
17,424 |
(1,725) |
-11% |
| 1997 |
19,240 |
20,598 |
(1,358) |
-7% |
| 1998 |
21,367 |
23,567 |
(2,200) |
-10% |
| 1999 |
26,139 |
26,873 |
(734) |
-3% |
| 2000 |
25,843 |
28,900 |
(3,057) |
-12% |
The above figures only include a substantial allowance for GAR costs in 2000. The office valuation confirms the validity of the conclusions reached in the report EMAG commissioned from Chartered Accountants Burgess Hodgson, which was published in March 2003.
Lord Penrose report strongly supports their conclusion that 'the effect of this 'over-bonusing' was that:
- about half of terminal bonuses was not represented by assets
- the 'past performance' record of Equitable Life policies was enhanced by profits, which had not been made
- new (and existing) policyholders were encouraged to invest based upon this 'past performance'
- excessive payments were made to leaving policyholders throughout the decade [Lord Penrose estimates the cost of this at £1,800 million]
- Equitable Life's finances were chronically weak
- There was nothing in the 'smoothing kitty' when the stock market fell in 2000-03. Indeed the smoothing kitty was 'overdrawn'.' [Lord Penrose reports by £3,057 million]
The report rejects attempts by the Society and the FSA to justify the above financial picture as part of a 'smoothing policy'. It says that Equitable Life did not have a 'consistently expressed and coherently followed smoothing policy'. (Chapter 19 Paragraph 240)
c) Equitable 'massaged' the numbers it gave to regulators
Each year insurance companies are required to present their calculation of their assets and liabilities to the regulators to demonstrate their 'solvency'. These highly technical calculations are in addition to the financial accounts and run to hundred of pages. They make no provision for terminal bonuses.
Lord Penrose discloses that Equitable Life's actuaries bolstered the Society's apparent solvency by the consistent adoption of the least prudent valuation basis, plus a series of practices of 'dubious actuarial merit'. These included
- valuing future liabilities at an inappropriate rate of interest. This typically understated those liabilities in the period 1990-1996 by about £500 million
- valuing a financial re-insurance policy at over £800 million in the years 1998-2000
- carrying forward selling costs, estimated in 2000 at £900 million
- increasing reliance on 'future profits' allowances (from £250 million in 1994 to £1,000 million in 2000)
- taking on a 'subordinated loan' of £346 million in 1997 which did not count as a liability
Lord Penrose concluded that excessive bonuses and dubious valuation practices were a 'major contributory factor to the weakness that required a substantial reduction in policy values in July 2001.' (Paragraph 56 Chapter 19)
WHOSE FAULT WAS IT?
Although it is not Lord Penrose's job to attribute blame, he does conclude 'principally, the Society was author of its own misfortunes.' He is particularly critical of the actuary directors Messrs Ranson, Headdon and Nash.
WHY DID NO ONE NOTICE WHAT WAS GOING ON?
One of the issues identified by Lord Penrose was the absence of recognisable standards set by the actuarial profession. In particular it failed to develop any coherent principles or rules of practice by which to test objectively the approach of an Appointed Actuary, to deal with policyholders' reasonable expectations, either as regards the GAR problem or the relationship between assets and policy values (including terminal bonuses) indicated to policyholders. He reports that 'The profession resisted prescription. The individual judgment of the appointed actuary prevailed.' Such guidance as there was 'offered no standards of performance that might reflect generally accepted principles or rules of conduct such as one might have expected of a professional body.' In short, actuarial standards did not adequately cover either GAR or over-bonusing
Another of the alleged safeguards of the regulatory structure was the duty of each Insurance company 'Appointed Actuary' to ensure 'that [its] long-term business is operated on sound financial lines'. Lord Penrose reports (with obvious distaste) that at Equitable Life the Appointed Actuary was often the same person as the Chief Executive. Barry Sherlock was the first appointed actuary and held office from 1974 until 1982 during which time he was also chief executive. Roy Ranson took over as appointed actuary in January 1982 and went on to hold both offices from 1990 until 1997.
As regards the non-executive directors, Lord Penrose says they were '
- Ill-equipped to manage a life office by training or experience;
- Totally dependent on actuarial advice;
- Ill-prepared to take necessary decisions in any event because of the fragmented approach adopted to instructing them; and
- Incompetent to assess the advice objectively and challenge the actuaries even if they had questions about the material supplied'
(Paragraph 90 Chapter 19).
As for the auditors, Lord Penrose says that it was 'not within the terms of reference [of his enquiry] to form or express any views on the performance by the auditors of their contractual or professional duties.' He does however comment that 'without adequate accounting standards relating to liabilities, including contingent liabilities [i.e. terminal bonuses], audit has been inhibited from effective reporting on life offices' financial statements as a whole'.
WHAT DID THE REGULATORS DO?
a) The system
The report discloses a dysfunctional regulatory system. During the critical period from 1987 to 1998, prudential regulation was the responsibility of the Department of Trade and Industry ('DTI'). However the vital job of scrutinising companies' returns was subcontracted to the Government Actuary's Department ('GAD').
Lord Penrose takes the view that the 'DTI insurance division was ill-equipped to participate in the regulatory process' and 'for all practical purposes, scrutiny of the actuarial functioning of life offices was in the hands of GAD until the reorganisation under FSA was in place'. (Chapter 19 paragraph 158). In Chapter 16 paragraph 262 Lord Penrose provides an example of how the regulator/GAD relationship operated in practice. He says 'HM Treasury [who took over from DTI in 1999] appear to have been content to allow GAD to conduct the dialogue with the Society [about the 1996 asset deficit] without active Treasury participation. He continues 'It is difficult to avoid the view that regulation was falling between two stools, the major player in discussions having no regulatory power, and the empowered regulator having little part in the processes that would have instructed regulatory action.'
The regulators' incapacity also meant that GAD in practice took actions/decisions that were probably outside its remit. For example, in 1991 the Society informed the DTI that Roy Ranson would succeed Barry Sherlock on the latter's retirement as Chief Executive. Since Ranson was already Appointed Actuary he would then hold two conflicting roles, a situation the DTI was keen to avoid. Ranson objected to their view. GAD intervened to defuse the situation. Lord Penrose found that largely because of GAD's intervention 'DTI had lost the opportunity to impose effective discipline on the Society in this matter, and never thereafter had the authority required to bring about a change.'
As another example, Lord Penrose reports that in June 1991 Ranson supplied important internal papers to the GAD actuary (Pickford) on a 'confidential' basis. These showed how the Society had dealt with the previous year's stock market fall, which reduced the fund value by 10.4% by voting a total bonus of 12%. This brought the shortfall of assets as compared to policy values up to its all time record of 28%, a situation from which the Society never recovered. This vital information was not passed on to the DTI as regulator. Lord Penrose found that Pickford 'was in error in allowing a private understanding with Ranson to cloud his duties to regulators.'
In short, the concept of empowering the DTI to regulate, with 'advice' from GAD did not work in practice. The DTI did not have the expertise and the GAD did not have the muscle.
b) Solvency Returns and practices of 'dubious actuarial merit'
Lord Penrose concluded 'The regulators also failed to give sufficient consideration to the fact that a number of the various measures used to bolster the Society's solvency position were predicated on the emergence of future surplus. In the case of the reinsurance agreement, it is not clear on what basis the Society was permitted to take the credit against its potential annuity guarantee liability that it did [£800+ million].'
In short, the regulators allowed Equitable to get away with practices that they should have put a stop to, in particular the re-insurance agreement, which was virtually a sham.
c) Policyholders' Reasonable Expectations ('PRE')
The report concluded that the regulatory returns and measures of solvency applied by the regulators did not keep pace with developments in the industry, in particular the trend towards un-guaranteed terminal bonuses. 'Thus regulatory solvency became an increasingly irrelevant measure of the realistic financial position of the Society.' Nevertheless, Lord Penrose reports that the regulators clung to the traditional solvency tests, which ignored terminal bonuses and took a half-hearted approach to enforcing PRE which included them.
He found that the regulators had both the power and the responsibility to police PRE. They knew this was part of their job but simply did not do it. He says 'The regulators acted as if they had power to investigate PRE with a view to taking action, and I believe that they were right to do so. They never got round to taking such action, but that is a different matter.' (Chapter 15 paragraph 18)
The report reveals that the GAD was aware of the Society's asset deficit from 1992, occasionally considered its impact upon PRE, but took no action. In Chapter 16 Paragraph 206 the report comments on GAD's attempt in November 1996 to address the asset shortfall. 'There seems to have been a failure by the regulators to ask for and analyse such further figures or documents as would have enabled them to make a proper assessment of problems that were then being discussed with the company'.
d) GAD's overall performance
Lord Penrose concludes 'GAD did not appear to have challenged sufficiently the opinions and assumptions underlying actuarial valuation. Although GAD brought in a more detailed style of scrutiny in the early 1990s, the standards of scrutiny still impress me as complacent, lacking challenge, and hesitant in criticism and in following up on any criticism made. This was, indirectly, reflected in a lack of robustness in the regulatory process.' (Chapter 19 Paragraph 160)
e) Conclusion
The regulation of Equitable Life 'failed policyholders'. (Chapter 20 Paragraph 83)
THE GOVERNMENT'S RESPONSE
The government's refusal to provide compensation to Equitable Life policyholders in respect of this serial regulatory failure was explained by Financial Secretary Ruth Kelly MP on 8th March
'Many people have drawn parallels between Equitable and Barlow Clowes. It has been put to us that as the then Government provided redress in the Barlow Clowes case, we should do so with respect to Equitable, but there are major differences between the two cases. Barlow Clowes had ceased trading; Equitable is still trading. In the case of Barlow Clowes, there was a finding of maladministration; for Equitable, there has been no such finding. At the time of Barlow Clowes, there was no compensation scheme; now there is the Financial Services Compensation Scheme. Those who continue to argue that what happened for Barlow Clowes should also happen in the case of Equitable Life have got to take into account both the existence of a compensation scheme and no finding of maladministration.'
This explanation does not stand up to much examination.
Why should cessation of trade be a necessary prerequisite to compensation? 1,000,000 people trying to provide for their own retirement have lost upwards of £3,000 million, whilst government regulators looked on. Surely this is more important than the technicality of Equitable Life's continuing to trade? Equitable has not issued any new policies for 3 years. Lord Penrose accurately described it as 'moribund'.
The existence of the Financial Services Compensation Scheme is a red herring. It will only come into play if the Society goes into liquidation, an event it may well avoid, by continuing to cut bonuses. Even then the FSCS capacity is untested. The cost of its compensation is to be met by the insurance industry, which we expect to resist paying for the failure of Equitable Life. The FSCS would not in any case address the losses of those who have left Equitable Life, perhaps 500,000 people.
Lord Penrose was not instructed to address the subject of mal-administration. Ruth Kelly relies upon the Parliamentary Ombudsman's report on 'Mr P', which has been totally undermined by Lord Penrose's disclosures.
The PO (Ann Abraham) only considered the period from 1st January 1999 to 8th December 2000, whereas Lord Penrose shows that the damage was done during the previous decade. She ignored (or did not discover) the asset deficit and the practices of dubious actuarial merit, which Lord Penrose identifies as major contributory factors in the Society's demise. She only considered the situation of someone who invested in 2000, just before the House of Lords' decision. Lord Penrose shows a clear case to answer in respect of all Equitable investors during the 1990s. She accepted the Society's line that it operated a proper smoothing policy, a line totally rejected after detailed examination by Lord Penrose. She claims that GAD is excluded from her jurisdiction. Lord Penrose finds fault with GAD throughout his report. A finding of no mal-administration is meaningless without examination of the Government Actuary's Department during the whole of the 1990s.
Ms Kelly also claims that compensation cannot be paid where the 'fault' lies with the system rather than the operation of that system. She said 'I think that the House should reflect carefully on the fact that it is a question of the laws that Parliament enacted and the context in which Ministers resolved how those laws should be implemented that Lord Penrose criticises, rather than the discrete actions of the regulator.' (Hansard - 24th March 2004)
This is a gross distortion of what Lord Penrose's report actually says. Certainly he was critical of the system created by politicians. But he also shows numerous examples of failures in the way that system was operated by officials, some of which are mentioned above.
WHERE DO WE GO FROM HERE?
It is clear that Gordon Brown, a champion of compensation for investors in Barlow Clowes when he was Shadow Chancellor, has changed his views dramatically. He refuses to address the Equitable Life issue at all and deputes to the unfortunate Ms Kelly the job of selling his new line, a line rightly described by one (Labour) MP as 'callous'. Labour MPs (with a handful of honourable exceptions) have been whipped into line and the Government will rely upon its majority to avoid Parliamentary embarrassment.
So is that the end of the matter? No, not at all. The Parliamentary Ombudsman has still to decide whether to withdraw her initial report and examine the issues raised by Lord Penrose. EMAG's request for judicial review of her first report, particularly the exclusion of GAD from scrutiny is due to be heard at the end of April. During May Equitable Life policyholders will consider a resolution to authorise the Society to contribute £2 million to EMAG's fighting fund. EMAG believes that Lord Penrose's and Ruth Kelly's criticism of the way in which the British Government implemented European Directives upon insurance regulation opens a new route to compensation through Europe, where Gordon Brown's authority is by no means paramount.
CONCLUSION
Lord Penrose report shows:
- that in addition to losing in the House of Lords, Equitable Life's downfall was attributable to declaring bonuses out of profits it had not earned and engineering its solvency returns
- that the primary responsibility lay with Equitable's executive directors
- that the actuarial profession produced no real guidance on either the GAR or over-bonusing issues
- that by allowing Roy Ranson to be both Appointed Actuary and Chief Executive the DTI/GAD surrendered an important safeguard
- that the non-executive directors were ill-equipped and ill-prepared for the job
- that the auditors were inhibited by the absence of recognisable standards
- that the regulatory system was misconceived, with neither of the parties (DTI/GAD) having both the power and the expertise to do a proper job
- that as a result of the empowered regulator (the DTI/Treasury) lacking proper expertise, the GAD filled the gap and sometimes exceeded its authority
- that the regulator/GAD combination failed at an operational level over an extended period to deal effectively with either the GAR or over-bonusing issues, through complacency, hesitancy and lack of robustness.
EMAG congratulates Lord Penrose on the thoroughness of his investigation and in the main accepts his conclusions.
Additional Reading
In December 2003 EMAG published its own Alternative Penrose Report. This provides (in 26 pages) a more detailed analysis of what happened at Equitable Life. It comes to much the same conclusions as Lord Penrose and presents very similar numbers (compiled from published data). It is available free from www.emag.org.uk
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