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Equitable Members Action Group Limited, a company limited by guarantee, number 5471535 registered in the UK

Media Stories: 15/11/2003 - Rodney Allen on FSA's mistaken interpretation

15 November '03 - Comment by EMAG Committee Member Rodney Allen

FSA has blundered over Lords' ruling on Equitable
By Rodney Allen

Reproduced by the Financial Times; Nov 15, 2003

The Penrose inquiry into the Equitable Life disaster will deliver the final word, when it eventually reports, on the failures of government departments that regulated the society before the Financial Services Authority took over in 1999. But it ought also to comment on the FSA's response to the House of Lords' decision on Equitable in July 2000.

I have spent much time studying the arguments behind this decision, and I am convinced that the FSA interpreted the Lords' decision much more broadly than was warranted. As far as I know, this argument has never been publicly debated.

The FSA concluded that the Lords' so-called "ring-fencing" decision meant that a differential bonus system could not be employed to offset the cost of guaranteed annuity rate (GAR) claims. This meant that policyholders without a GAR contract clause had to subsidise those who had one. Sir Howard Davies, then chairman and chief executive of the FSA, told the Commons Treasury committee in February 2001 that the Lords' decision had "overturned the quite fundamental principle of the way which returns are calculated". Davies added: "Everybody is now having to live with it - and not just Equitable Life; other companies, too - and it is having redistributional consequences in other parts of the market and we are having to live with those."

Equitable Life, along with many other life insurance companies, issued pension policies with a clause giving an option to receive a guaranteed annuity rate based on the value of the related pension fund when policies matured. This guarantee could lead to pension providers funding an annuity in excess of the value of the related pension fund.

In 1993, for the first time, open market annuity rates fell below the GAR level, for which Equitable Life had made no provision. It decided to fund the cost by arbitrarily reducing terminal bonuses, believing it had the authority to do so. The society might have handled the issue in accordance with insurance industry practice by creating reserves, but this would have been administratively and commercially inconvenient.

The society gave GAR policyholders the choice of taking a GAR and a reduced terminal bonus, or a full terminal bonus and relinquishing the GAR. This negated the GAR clause advantage. GAR policyholders objected because they believed it conflicted with their policy contracts.

The society took the issue to court. The Court of Appeal found against it on two major arguments. First, the GAR contract clause made no provision for an arbitrary reduction in the terminal bonus when a GAR was taken. Second, the GAR clause was intended to provide an annuity in excess of asset fund value - the policyholder's fair share of the society's assets - when the open market annuity rate fell below the GAR rate. The society's method prevented this.

One judge in the Court of Appeal proposed that, while the society could not offer differential terminal bonuses depending on whether a GAR was taken or not, it could adjust the terminal bonus of GAR policyholders to meet the GAR cost. Otherwise, policyholders without the GAR clause would be subsidising GAR policyholder claims. The Lords rejected this proposal because it would have negated the protection apparently provided by the GAR clause against a fall in annuity rates.

This was interpreted by the society as a ban on any system of differential bonuses to offset the GAR cost. The long-term cost of meeting Equitable Life GAR policyholder claims was estimated at a minimum of £1.5bn, and perhaps considerably more. This contributed to the failure to sell the society and its closure for new business.

The upper house was criticised for deciding the case contrary to the insurance industry principle that potential beneficiaries collectively fund the cost of specific cover to meet individual claims. Adherence to this principle is essential if policies with different terms are to be sold, such as policies without a GAR clause issued by Equitable Life after 1988. But this criticism is unwarranted. The real problem is that the FSA and others failed to realise that the court decision referred to terminal bonuses alone.

The court was asked only to consider methods of adjusting terminal bonuses to meet the cost of GAR claims. From the viewpoint of insurance industry principles, this approach is looking through the wrong end of the telescope. If the society had presented a proper differential bonus system where reversionary or discretionary bonuses paid to GAR policyholders during the policy lifetime were calculated after creating reserves to meet future individual GAR claims, there could have been no legitimate objection.

Such a system would have conformed fully with the GAR contract clause, and since individual policyholder asset shares would have been adjusted in advance, the GAR clause would offer positive value, that is greater than asset share, when open-market annuity rates fell below the GAR. The difference would be met by dedicated reserves.

The court never considered such a rational approach. It is possible that it was unaware that such a solution existed. Nevertheless, the Law Lords' responsibility was limited to dealing with the issues before them. The court told the society what it had done was wrong, not what it might have done in the past or could do in the future.

I suggest that the FSA bears a heavy burden of responsibility for the damage inflicted by its poor interpretation of the Lords' decision.

Admittedly, rectifying the wrong approach adopted by Equitable Life since 1993 would have been complicated, and non-GAR policyholders might have had to accept some of the cost of meeting GAR claims.

An equitable settlement should have reduced potential GAR claims to a manageable level and possibly allowed the society to be sold. The FSA had power under Section 45 of the 1982 Insurance Company Act to intervene. It did not do so.