29 March '03 - Letter to the Financial Times by Alex Henney of EMAG

There is a widespread misconception that Equitable Life was brought low by the decision of the House of Lords in July 2000 to outlaw its practice of awarding lower terminal bonuses to policyholders who exercised their right to a guaranteed annuity option (GAO).

The main causes of the debacle were much deeper, and lay in managerial ambitions and actuarial incompetence by the previous board coupled with gross regulatory failure by the government.

Under the Insurance Companies Act 1982, the government was responsible for protecting "policyholders' reasonable expectations". Before mid 1988, most pension policies issued by Equitable included GAOs, many of which had been issued at moderately high rates when annuity rates were very high. From the mid 1980s annuity rates dropped, and there was an increasing risk of the guarantees biting.

The methodology for assessing the necessary level of reserving had been developed by then, and indeed was applied to some other forms of policies that incorporated guarantees. It was not, however, applied to pension policies. Why not? Because the government did not require it.

If the Government Actuary's Department had been awake, not only would it have required reserving by the end of the 1980s, it would have required Equitable to take measures to protect the interests of policyholders without GAOs.

Equitable is a mutual, and used to pride itself on not having a "free estate" (i.e. surplus assets that are not committed to supporting policies). So, if the open market annuity rates fell below the guaranteed rates, part of the cost would fall on policyholders who did not have GAOs. This was definitely not part of their expectations when they took out their policies after 1988.

The regulator slept on and did not act to require life companies to reserve for GAO's until 1998, when there were £35bn worth of policies with guarantees on their books. Then, although the government talked boldly of requiring Equitable to take out a "robust reinsurance policy" to meet its solvency margin (the required excess of assets over policy values), it allowed Equitable to indulge in various financial tricks to massage the margin. The regulator was consistently reluctant to say boo to The Equitable goose.

The next strand of the story is that although Equitable was financially weak, the government acquiesced in its ambition to grow by well above average (five times in value) across the 1990s, and allowed it to run a partial Ponzi fund. A report by accountants Burgess and Hodgson found that from at least 1990 the policy values were generally in excess of the assets. Although reporting high returns was good for marketing growth, those who left the fund took more than their asset share at the expense of remaining and new policyholders.

The music stopped after the Lords' decision, when policyholders fled and policy values were savagely hit. In 1998 the new Financial Services Authority (FSA) took over responsibility for conduct of business regulation. It did nothing to investigate, let alone protect policyholders.

In 1998-99, after Equitable was attracting media criticism over its handling of GAO policies, FSA files contain a minute asking "whether there is anything we should be doing in order to fulfil our regulatory obligations or at least justify our stance". Another asks: "Is there at least enough for a meeting?" Yet another asks: "Is there anything we should be doing on this? I knew we were going to about a year ago (my delay)."

The FSA's performance was nothing short of disgraceful. It assumed responsibility for the prudential regulation of life assurers at the beginning of 1999, so it had a year-and-a-half to get its act together for any possible Lords decision. But did it? Of course not.

Just before the decision it told Equitable it "would not rush to take remedial action". It then allowed Equitable to stay open for new business because it did not understand how weak the fund was (the Government Actuary's Department did not complete its scrutiny report for 1999 until November 2000, four months after the Lords' decision). It did not spot that other companies were not going to bale out Equitable policyholders by paying billions for the "badwill" of Equitable.

The FSA's decision allowed investors to join a fund that was fragile and uncertain. People were investing their money on the implicit prospectus that, if The Equitable can find a buyer, then they may have reasonable expectations. If not, they will be in a mess.

The episode exposed in extreme form the inherent conflict in the FSA's objectives between preserving market confidence - which will be its overriding priority and will generally prevail - and protecting customers.

The FSA's next failure was to sit on its hands and not try to mitigate the obviously flawed nature of the Lords' decision. The case was not well put, and one of the judges has commented: "If the case had been put differently, and we had known the true facts, the outcome might have been different."

Instead of action the FSA signed up to the new Equitable board's flawed compromise, which stuffed the policyholders who did not have GAOs. After a decade of regulatory inaction, the FSA could not even get that right. Annuitants and policyholders without GAOs therefore paid dearly.

Although policyholders pay for regulation, the government and the FSA have done nothing for the overwhelming majority of policyholders of The Equitable. EMAG is dedicated to holding the government to account, and believe it should compensate us for a decade of regulatory failures.

Alex Henney is the chairman of the Equitable Members Action Group.