EQUITABLE LIFE MEMBERS

EQUITABLE LIFE:  PENROSE AND BEYOND

- ANATOMY OF A FRAUD 

A paper by Dr. Michael Nassim

Last Updated: Friday, February 11, 2005 09:58 AM

Level 1: Summary.

·          The Equitable was founded in 1762, and until 1973 ran on established and prudent lines. Mainly based in London and the South East, it over the years earned an enviable reputation for the careful management of its inherited estate of reserves, which were passed down through successive generations of policyholders.  From 1957-88 new policies contained a Guaranteed Annuity Rate (GAR) option at maturity.

·          In 1969 pension regulations were changed, such that the Society stood to lose its institutional FSSU (Federated Superannuation Scheme for Universities) business.  It began a compensatory sales drive. How it wooed new institutional customers remains unknown, but events were to show this was pivotal.

·          As the Society grew its corporate governance and administrative base were modernised and extended. The central executive function at Aylesbury became progressively more important, and by the mid ‘80’s 5 of the Society’s 12 Directors were executives who included actuaries and marketeers. Unhappily these changes extended personal ambitions, and the executive became powerful, largely autonomous, and not properly answerable to the Board and members. It also stoutly defended the right to police its own activities.  Ultimately this was disastrous.

·          The sales drive was seriously affected by the 1973 oil crisis, which caused a market crash followed by prolonged and severe inflation which led into a sustained bull market. An unprecedented compensatory rise in interest rates followed.  Over its course Appointed Actuary Barry Sherlock and his deputy Roy Ranson used the estate as well as appreciation and earnings to fund bonus allocations and boost the Society’s competitive performance record.

·          That year an un-guaranteed terminal bonus adjustment was introduced, and as a matter of policy it became the dominant bonus form.  Fatally, the actuaries from then on repeatedly advised the Board that terminal bonus was cheap to service because it did not require statutory reserving. Since this could only be true if the Society was prepared to renege on terminal bonus, it was a lethal seed of bad faith.

·          By 1983 virtually all the estate was consumed, and the remaining funds were taken up by unconsolidated terminal bonus. The with-profits fund was now a null fund. To support new solvency requirements under the 1982 Insurance Companies act, all remaining capital appreciation was brought onto the books.  Sherlock was replaced by Ranson as Appointed Actuary, but remained General Manager until 1991.  Meanwhile inflation was slowing and interest rates were falling, such that the GAR could be valuable.  A “senior management team” privately formulated a differential terminal bonus policy (DTBP) to claw back terminal bonus retrospectively to fund the GAR.  The DTBP was in bad faith, and its non-disclosure was potentially if not then actually fraudulent.

·          In 1986 the Financial Services Act introduced more stringent disclosure requirements for financial products. And by 1987 at the latest the Society had allocated more bonus to support sales than there were funds to cover them.  The entire estate and a sum in excess of all appreciation and earnings over the period 1973-87 had been distributed.  In order to boost longer-term performance figures and to pre-empt historical difficulties over sharing out proceeds from the estate, most had been given selectively to longer serving GAR policyholders.  And because of the GAR/DTBP position, the null fund had degenerated further into a “with-liabilities” fund.  From now on it risked becoming dependent on future premium income and snowballing sales.

·          The following year more flexible managed pensions were due, and the Society could discontinue its onerous GAR policies.  The senior management team mixed the new policies with the old in the same fund, nominally in order to continue using the unrepeatably boosted performance figures.  From then on the Society traded on a false basis.  They did not advise the board that this produced inequities, nor did they reveal the DTBP.  The DTBP and GAR, under circumstances of over-allocation and falling interest rates, established the with-profits fund as a with-liabilities one, and especially for the new non-GAR policyholders.

·          There was, however, by any reasonable standard an absolute requirement to disclose the DTBP and inequities of benefit and guarantee to non-executive members of the Board at this fateful point- and to minute the discussion. But equally, no competent non-executive director would have approved carrying over of the liabilities into an extended fund.  Not only was this in continuing bad faith, but also the Society was finally embarked on a fraudulent course.

·          If the non-executive directors were not informed, then branch offices, sales representatives and members could not be and were not either.  Commission-earning sales staff operated in a state of “incentivised ignorance”, and as they began to recruit new policyholders the fraud became established.  By 2001, 930,000 new policyholders had been drawn to the lure of the Society’s spurious performance figures.

·          In fact the Society could not fully end GAR policies in 1988, because corporate and institutional scheme Trustees insisted on continuing them for a further five years.  Effectively it blocked the DTBP for the same period, during which retiring GAR members could continue to crystallise their gains with impunity.  This was a serious and hazardous inequity, which newer private members unknowingly funded. 

·          Other reasons why the relationship between the Society, its directors and officers, institutional and corporate clients and their advisers are an ongoing and material issue include:

o        The ability to exploit w-p fund and policy peculiarities with expert/inside knowledge.

o        Conflicts of interest:  GAD had recommended the Society for Civil Service pensions.

o        Need for new scheme business and cordial relations with influential outsiders.

o        Favourable exit terms for scheme members prior to the Compromise.

o        No impact assessment of these matters by Lord Penrose and the regulators.

·          In 1989 and ‘90 Ranson and his assistant Christopher Headdon delivered a paper entitled “With Profits Without Mystery” (WPWM).  It was a post hoc rationalisation for disappearance of the estate and periodic over-allocation, and purported to justify using all the unconsolidated terminal bonus allocations to back the guaranteed portions of policies and finance the business in the absence of any free reserves. It necessarily exposed the Society to running on a negative technical solvency gap, despite which the authors maintained that the Society’s custom was to pay the terminal bonus element in full as it fell due, such that it was of little importance whether bonus was guaranteed or not.  But since the Society was already over-allocated and falling interest rates meant that the covert DTBP terminal bonus claw-back would sooner or later become necessary, this exposition was part and parcel with pre-existing and fraudulent bad faith. 

·          Unsurprisingly, the WPWM paper consisted of interdependent sophistries which are antithetical denials of all the Society’s past lessons.  Actuarial discussants picked most of them up, and notably commented on excessive, unsafe and inequitable mutual insurance in a pooled fund with no free reserves.  They also said it was inequitable to mortgage the past against the future, and that unequal guarantees should be properly explained and charged for. These things, they publicly maintained, were duties of information under the 1986 Financial Services Act and actuarial guidelines.  Ranson, now Appointed Actuary and an executive director since 1985, paid lip service to some of these observations, but neither he nor Headdon subsequently acted on them. Prudence and Equity had now officially abandoned their oldest nest to cuckoo Fraud.

·          Despite whatever whispers there now were in actuarial circles, prudential regulators and the Government Actuary’s department did not react.  In 1987 Insurance Directorate Actuary George Newton had drawn particular attention to the need for prudential and conduct of business regulators to monitor the abilities of companies in Equitable-style predicaments to satisfy policyholders’ reasonable expectations.  The omission to follow it up was to say the least unfortunate. 

·          With all reserves gone and over-allocation now chronic, how else could performance figures be boosted?  The answer lay in technical devices which eroded statutory reserves, and rising new business premium income from which to pay existing members (Inappropriate “gross premium” valuation methods diverted more premium flow for this purpose).  The new liability thus entailed could be deferred, and allowances which anticipated continuance of premium income such as new business loans and a Zillmer adjustment were implemented from 1991 onwards.

·          These actions effectively turned the “with undisclosed liabilities” fund into a Ponzi  scheme which relied on future income.  Because the latter was levered off the now dominant un-guaranteed part of policyholders’ funds it was permissible by the letter if not the spirit of existing regulations, which were immediately enforceable only for guaranteed bonuses.  And Zillmer adjustments were inappropriate because the majority of the Society’s income was derived from recurrent single premium income business which could -and did- subsequently dry up.

·          Interest rates were continuing to fall, and despite further extension of over-allocation the increasing GAR uptake rate was now a dangerous liability.  The DTBP was deployed at the earliest practical moment, which was the end of 1993. It was later modified when it was realised that the value of the GAR might exceed all of a policyholder’s terminal bonus. Reneging on guaranteed bonus to help plug the gap would de facto mean insolvency, and to avoid it the excess was made payable by ongoing members.  This surfaced in Board resolutions of remarkable obscurity, and Ranson mentioned the DTBP informally en passant to the prudential regulators.  Events were to show that the non-executive directors, members and the regulators only slowly realised the significance of what had happened.

·          Retiring GAR policyholders now encountered the retrospectively imposed DTBP, and as time went on they increased in anger and number. By 1998 the Society was obliged to fund the Hyman test case on the legality of the DTBP, which it explained to members in a measured and reassuring tone.  The consequences of the DTBP increasingly preoccupied the Board, and some of the non-executives unsuccessfully attempted to probe the executives on the adequacy of solvency margins.

·          Also in 1997 the worsening position was covered by a subordinated loan of indefinite duration at 8% per annum, i.e. junk bond rates.  £350 million was thereby secured, but servicing it also depended on earnings such that only half of it counted towards regulatory solvency.  And its dubious advantages were wiped out by Chancellor Brown’s new tax on pension fund earnings, which Ranson estimated to worsen solvency by £500 million. Ranson now retired; Headdon and actuary Alan Nash respectively assumed his roles of Appointed Actuary and Managing Director in succession to Sherlock.

·          Assuming the Society won Hyman, the DTBP could be imposed and the absolute insolvency margin of the GAR segment of the with-profits fund was between £15-50 million.  But if the Society lost it was liable for up to £3 billion if all retiring GAR policyholders took their option, which declining interest rates had now made worthwhile.  In the Society’s precarious state this was impossible, and so attempts were made to re-insure the risk.

·          The next moves were highly regrettable: full re-insurance was too expensive, and so Headdon entered into a show treaty which he privately lessened by means of a side-letter agreement.  And as lately as Feb 2000 Nash informed policyholders that losing Hyman would cost no more than £50 million, i.e. what the Society would pay only if it won, and had been officially held on the books as such.

·          In July 2000 the House of Lords ultimately found for Hyman against the Society, whereupon the situation unravelled rapidly.  On Dec 8^th 2000 Nash resigned as MD; Headdon resigned as MD and Appointed Actuary on March 1^st 2001.  Though the GAR uptake rate was now running at over 90%, the Society elected to value it using the overall historical uptake rate of 50% to arrive at a figure of £1.6 billion.  Next the Society cut all policy values by 16% % overall, i.e. not merely terminal bonus.  Since the contemporary value of the fund was around £32-3 billion, this represented a drop of £4.5-4.8 billion and was for good reasons a lot more than the cost of the GAR liability alone.  This was discernible at the time, and raised uncomfortable suspicions.

·          Suspicions were well-founded: besides the £1.6 billion GAR liability, £950 million of quasi Zillmer adjustment now had to come onto the books because both confidence and premiums dried up. The £350 million subordinated loan was also thereby exposed, and Chancellor Brown’s £500 million loading was a further embarrassment. But over and above this, a normally functioning with-profits fund should have had free reserves of £3-5 billion.  In truth the now hugely expanded fund was between £8-10 billion short of with-profits status, and over a million policyholders were involved.

·          In response to this the New Board proposed a compromise whereby GAR policyholders had to surrender their GAR rights in return for having their policy increased by 18%, i.e. slightly more than before the July 2001 cuts. Non-GAR policyholders did not receive any material uplift in the Compromise.  What remained was a null fund with no estate and no investment freedom, such that a defensive move into gilts and bonds was inevitable.  And the discredited WPWM paradigm with its residual inequities of guarantee and continuing threat to any remaining terminal bonus remained in place. Corporate/institutional Trustees and their actuaries compounded these inequities by extracting their members for a mere 5% penalty.  Inexplicably, the subordinated loan was not paid off, such that £750 million or so of the remaining fund is effectively earning no money.

·          At this point the regulators had failed totally for 30 years.  They misread the long inflationary wave and its distorting effects on competitive pressures. They allowed a w-p fund to disperse its estate inequitably, incur excessive new business strain and move into over-allocation, did not react to disquiet over the WPWM paradigm, did not probe ambiguities of hypothecation, allowed inappropriate gross premium valuation, and failed to react to the DTBP, subordinated loan and quasi-Zillmer adjustment.  

Despite energetic representations, the Society, Treasury, regulators and judiciary turned a deliberately blind eye to the surrounding irregularities, previous fraudulent non-disclosures, misrepresentation, mis-selling, and regulatory failure.  In February 2002 the Compromise went through, such that further trouble became inevitable.  Despite many further revelations and much protest their blindness, silence and denials have been obdurate.