EQUITABLE LIFE MEMBERS

EQUITABLE LIFE:  PENROSE AND BEYOND

- ANATOMY OF A FRAUD 

A paper by Dr. Michael Nassim

Last Updated: Friday, February 11, 2005 09:59 AM

Level 2: Narrative

Introduction: cipher, crib and key.

The Penrose Report is over 800 pages long.  Though its twenty chapters have highly relevant headings there is no index. Lord Penrose is scrupulous both in his careful reporting of important facts, and of the context in which they arose.  But having carefully prepared his ground he has usually stopped short of making deductions or inferences from it, and on contentious issues he often quotes the reasonable opinion of others rather than giving his own.  All this makes the Penrose Report (PR) somewhat like a cipher.  Without a crib and some prior knowledge it is very hard to find the key and crack it.  A halfway decent crib also tells the decoder what new information is of special importance, whether there is anything missing in the message, and if so where else to look.  Just as well, then, that a crib was prepared on evidential and logical grounds before the PR appeared, because the additional knowledge in the decoded message turns out to be vitally important, if in places also intentionally or of necessity incomplete.

The main crib is a preparatory article entitled: “An Equitable Assessment of Rights and Wrongs” (EARW). To establish its independent authority, and to pre-empt allegations of hindsight, it was published in advance of the PR. Its findings and conclusions have been brought forward elsewhere in this paper because it aimed to explain what was already known, and hence what a comprehensive inquiry should cover. It also provides an analytical and interpretative framework within which to place new evidence.  By using it in this way the following story has emerged.

The Auld Equitable.

Founded in 1762 as The Society for Equitable Assurances of Lives and Survivorships, the Equitable attained by degrees an unrivalled reputation for ethically prudent and fair management.  This was primarily due to the influence of the Reverend Dr Richard Price FRS and his nephew William Morgan FRS, who in over 50 years of loyal service as Actuary raised it to unparalleled heights of eminence and prosperity.  Part of the Society’s early prosperity was fortuitous, and rested on persistently conservative mortality figures and relatively high premiums based on mortality tables from the city of Northampton. More intentionally it relied upon Price’s insistence in 1775 that moneys be retained as “…a reserved stock, not to be entered upon save in seasons of particular mortality…the interest…to be added to the principal, till it shall rise to such a sum as may be deemed a sufficient surety in all events”.  This was the origin of the Society’s estate, and the source of its secure reputation.  How big the estate should be became a recurrent bone of contention in the late 18^th and much of the 19^th century; the Court of Directors had repeatedly to resist or moderate demands for a distribution of surplus to existing members.  If they were not to receive all the Society’s funds, existing members also had an interest in limiting new members’ access to them, and so they lobbied for restrictive conditions or delayed bonus entitlements for the newcomers.  Had these conflicts of interests not been resolved the Society might have died out, and indeed there was a prolonged period of stagnation before cautious and controlled expansion began later in the century, continuing in the first half of the 20^th.

Originally the Society gained interest on fixed interest securities, and after reserving for its liabilities distributed the surplus proceeds. Fairly soon it diversified into bonds and mortgages, and as the investment milieu developed it also began to invest in property and equities.  It distrusted the inherent volatility of capital appreciations in property and equities, and brought this officially onto the books only in small amounts.  As befitted its London origins most early members were Londoners, and throughout its history the London branch offices remained confined to the City, West End, Law Courts and Westminster.  It thus had close associations with the Establishment and City financiers, many of who were its clients, and from whom it drew its directors.  Even at the height of its expansion there was a preponderance of offices around London and in the South East.  Its head office was in London, but many of the support administrative and executive functions (including the actuarial and marketing departments) were later centralised in Aylesbury. On the increasing centrality and autonomy of the executive team there much was later to depend.

The Society’s organisation long reflected its social origins. There was in consequence a clear distinction between the Directors and the executives, very few of whom became members of the Board. Maurice Ogborn, who wrote a most informative history of the Society to celebrate its bicentenary in 1962 and was the last of the Society’s actuaries to champion the estate principle, was the first actuary to be appointed to the Board.  In the 1970’s and 80’s this changed.  Executive representation on the Board rose to 5 of 12 members, and there was less of the old master-steward/servant relationship.  This was properly so, and in the course of it the more able and ambitious executives might gain wider career horizons and more influential business contacts.  Events were to show that this blessing was a mixed one.

Those interested in the Society’s history prior to 1962 should in the first instance consult Maurice Ogborn’s bicentenary history entitled: “Equitable Assurances”.

Out with the Auld and in with the New.

Things might have continued without a marked change in direction had it not been that a large amount of the Society’s pension scheme and institutional/corporate business came from the Federated Superannuation Scheme for Universities (FSSU).  When insurance regulations were changed in 1969 the Society recognised that a newly competitive climate would emerge, and that it stood to lose a substantial amount of this business. To mitigate it new branch offices were opened and the sales force enlarged in preparation for a concerted expansion drive.  While preparations were in hand for this, in 1972 Maurice Ogborn retired.  This proved to be a bad omen, because 1973 was disastrous for the Society in no less than five ways.  Firstly, the Society had embarked on a five year expansion plan, to which it was now committed. Secondly, this was immediately compromised by the international oil crisis with the collapse in confidence and of the markets that attended it.  Thirdly, Ogborn’s successor Barry Sherlock and deputy actuary Roy Ranson elected to maintain a high level of bonus payouts that the Society could ill afford to avert collapse of the marketing drive. Fourthly, they introduced an un-guaranteed terminal bonus adjustment which was originally intended to bring policy values more into line with investment earnings on a triennial basis.  Fifthly and fatally, the Board of Directors was informed that terminal bonus was a relatively cheap benefit to service because it did not need to be reserved for with any stringency; a message that was to be repeated frequently over the years.

This reassurance was technically correct but in practice false, and dangerously so if too heavily relied on.  Implicit was the supposition that if the going became too hard the terminal bonus could be revoked.  This was an original and perilous seed of bad faith, which in time became a veritable tree, whose roots eventually exhausted and undermined the fertile inheritance in which it grew.  The initial phase of exhaustion was rapid, and brought about by maintaining bonuses in support of the sales drive.  Much of the Society’s estate was dispensed in the 1973-6 triennium as both declared and terminal bonus, and the more so because the estate’s investments were at a temporarily depressed value.  Solvency margins were maintained by bringing longer-term historical capital appreciation onto the books, and by increasing the valuation rate of interest required to support the liabilities- a device used again in subsequent years.

The crisis in market confidence was relatively short lived, and recovery began in 1974-5.  This merged imperceptibly with a prolonged period of inflation, which was at least partly due to a three to fourfold rise in the oil price.  Given the dominance of oil, and that in the modern economy energy is vital for the preparation of all goods and the implementation of most aims, stability could not return until wages and prices had risen by a corresponding amount.  Under these circumstances the first phase of the secondary inflation wave was unusually severe and prolonged. This initially restored and then increased the monetary value of the Society’s equity portfolio.  It also dealt a deathblow to the traditional belief that fixed interest securities were the surest haven for savings, because their real value was eroded correspondingly.

On these shifting sands a desultory attempt was made to rebuild the Society’s fortunes, but it was doomed to failure. Much of the Society’s capital appreciation of its investments was now inflationary, and hence an illusion. But taken at face value it seemingly justified holding bonus rates at high levels to maintain market competitiveness.  It also encouraged a progressively greater percentage of capital appreciation to be brought forward onto the books, and the rise in volatility that this engendered was in part offset by increasing the relative proportion of un-guaranteed terminal bonus, which over subsequent years grew to become the major bonus element.  All this had particular significance for the 1977-9 triennium, and Lord Penrose nicely explains how the three-call earnings allocation system was manipulated to increase the proportion of un-guaranteed terminal bonus at the expense of declared bonus, and all in the name of policyholders’ expectations. Whatever, it had the desired effect of retaining a gratifyingly large number of former FSSU policyholders, and increasing sales. President Murison contentedly announced that this left the Society well poised for the next decade, but in retrospect the exact opposite was the case, and with hindsight was clearly in bad faith.  While brisk inflation continued all looked rosy, and since at the same time there was a compensatory rise in interest rates, the existing contractual rights of policyholders to opt for a Guaranteed Annuity Rate (GAR) at maturity appeared well covered.  Indeed, the GAR was increased to maintain competitiveness while interest rates were high, and this later had dire consequences.

The New Equitable first turns sour-

As the inflationary 1970’s drew to a close the Society’s premium income had begun to increase exponentially, which rise continued until the collapse of 1999-2000.  Part of it must also have been due to inflation, although the sales drive was also increasingly successful such that there were 170,000 members with GAR policies before an attempt to end them was made in 1988. But now another problem was approaching, in the shape of more stringent financial and reporting standards to be imposed by the 1982 Insurance Companies Act.  In the event the changes of 1982-3 were also to prove as momentous as those of 1973.  They included the following:

1. All capital appreciation, whether past or current year’s, was now put on the books to support solvency.

2. Barry Sherlock stood down, and his deputy Roy Ranson became the Appointed Actuary.  However, Sherlock remained the Society’s General Manager and Actuary until June 30^th 1991.

3. The crude level of terminal bonus, before any smoothing, was now related more or less directly to the investment reserve (see also e. below).  The Society’s long history of a separate estate was effectively at an end.

4. Hence Ranson was later able to say that he did not inherit an estate on becoming Appointed Actuary.   Even so, Sherlock and he had been party to the disposal of that estate over the period 1972-83.

5. The absence of an estate, with terminal bonus now taking up virtually the whole of the remaining unconsolidated investments, may have been instrumental in a decision by the Aylesbury senior management team to put in place a fall-back differential terminal bonus policy (DTBP), in case falling interest rates later came to put GAR option holders “in the money”.  This fallback DTBP was not communicated to the Board of Directors.

Arguably this concealment of the DTBP by the management team (some of whom were also executive directors), in the particular context of the underlying fund structure and financial weaknesses which made it necessary, was the fateful first step in a subsequent descent into fraud. What is beyond doubt, however, is that it was the first branch on the growing seedling of bad faith. Consistently with this, 1982/3 was also when the sophistries later elaborated in the notorious “With Profits Without Mystery” (WPWM) paper and business manifesto began.

The extra margin of regulatory solvency the1982/3 manoeuvres produced was now also distributed.  The Society proceeded to erode the apparent strength of the 1982 balance sheet by progressively cutting back on the reserve for future (guaranteed) reversionary bonus until it was eliminated, they had used up a previously un-attributed accounting adjustment from 1982, and finally had explicitly, at least in 1987, made a bonus allocation in excess of available returns. This situation continued for most of the Society’s remaining life. It was therefore necessary to tread a narrow path very carefully, which was facilitated by keeping accounts reflecting no less than three approaches to asset and liability valuation, namely Companies Act accounts, Department of Trade and Industry (DTI) regulatory returns, and internally for management purposes, an “office” valuation.  Of these the private office valuation most closely approximated to the Society’s actual financial position. This too was fundamentally bad faith.

The year 1987 was fateful in other ways, because it heralded a change in pension regulations which permitted cessation of the old Retirement Annuity Plans containing the increasingly onerous GAR option, and the introduction of more flexible personal pensions.  Crucially however, the game had again been raised by more stringent requirements for the accurate disclosure of the essential nature of financial products by the Financial Services Act of 1986.  Given the Society’s underlying financial situation and that interest rates were falling to the point when the GAR option would bite, this was part welcome opportunity but part serious challenge if sales were to be maintained.  The response of the senior management team was to go beyond ingenuity.

-and then goes bad.

Lord Penrose prefaced his description of the team’s 1987response with the following extract from the Actuary’s report:  “A strategy document was formulated by the end of March and agreed by the senior management team.  A major component of the strategy was to make use of existing products, as much as possible, in order to minimise the changes needed to existing administrative and computer systems, and to enable the Society to exhibit an unbroken track record of past performance”.  He prefaced the extract with the following:  “The paper did not identify features of existing business that would be departed from”. –and continued:  “The new form of business was to be presented as aligned with the superseded retirement annuity contract to ensure that previous performance records could be used with reference to the new contract.  In management records it was noted that premium bases would be the same as for retirement annuity basis.  In the present context the decision was reflected in distribution practice going forward.

In relation to bonus policy, this was a momentous, and ultimately disastrous, decision.  Had the Society acknowledged liability to meet the annuity guarantees, it would necessarily have identified a difference in the benefits provided by the former and the new contract forms.  For equal premiums, the new personal pensions offered lower levels of contractual benefits.  On conventional actuarial practice the Board might have concluded that a higher level of bonus was appropriate for the new business accordingly (or, as was later observed during the actuarial discussion of the WPWM paper, explaining the significance of the guarantees and charging for them appropriately- MN).  The means of calculating the difference were available in the developing techniques of stochastic modelling.  The Society might have avoided the Hyman problem at the outset.

There would undoubtedly have been marketing implications.  Policyholders might have preferred to switch to the new forms, the marketing push of 1987 and 1988 could have been abortive.  The Board might have been forced to propose a new with-profits fund, closing the old fund to new business.  But adopting a market-driven policy, against the background of the management decision in 1982-3 to “solve” any emerging problem by discriminating at maturity (i.e. the DTBP- MN), established the bonus policies and practices that were thereafter to develop, and to lead to the confrontation of 1997”.

Lord Penrose omitted to make two most important conclusions about the consequences of this position. Firstly, because the record of past performance had been achieved by disposal of the estate to a fortunate minority and all was now gone, there was no prospect of repeating it.  From this point onwards the Society was trading on an inherently false prospectus.  Secondly, he did not add that, however uncomfortable it may have been, there was by any reasonable standard an absolute requirement for the executive directors on the senior management team to disclose the existence of the covert DTBP to the full Board at this fateful stage, and indeed to minute the ensuing debate.  But had they done so, it may safely be asserted that any reasonably competent non-executive director would not, could not or should not have contemplated the risk that, together with loss of the estate and persistent over-allocation, thereby transferred to the new fund and its future policyholders.  What was carried over was the very antithesis of a with-profits fund. From this point on, if not since 1982-3, the Society was trading on an entirely false basis.  The seedling of bad faith was now a sapling of fraud.

Over the next twelve years the sapling would become a specimen tree in every sense. The magnitude and duration of the resulting fraud is truly astonishing. Eventually the tree’s new branches would ensnare a further 930,000 unsuspecting new non-GAR members, and the older branches supporting the GAR policyholders would be cut from under them.  The burden of responsibility carried by the “senior management team” is correspondingly heavy.  We may with reason wonder who the instrumental members of that team were over the period 1982-8, and look forward to the Serious Fraud Office bestirring itself to tell us.  Not surprisingly, a number of non-executive directors since 1987 have pleaded their ignorance; under these somewhat undefined circumstances it hardly seems fair that, whatever their personal shortcomings, their fate should be left entirely to the whim of the adversarial process.

The events of 1982-7 thus overturned the traditionally successful business and insurance paradigm of the With-Profits Fund, affected all policies sold subsequently, and in time adversely influenced the manner in which the Fund was administered and represented.  That representation developed into a set of interdependent sophistries, which it is also relevant to observe are in essence antithetical denials of the major lessons previously learned in the Society’s own history.  Of special importance was an overarching sophistry to the effect that, in the absence of an estate, a With-Profits Fund could be run on what has euphemistically been termed a negative technical solvency gap.  This arises when the sum of all total policy values exceeds the assets, whereas absolute insolvency arises when the assets are exceeded by the sum of the guaranteed portions only in all policies. These two criteria can give rise to very different valuations and expectations of the asset shares of individual policyholders.

Though the un-guaranteed portions are unconsolidated, and might do multiple duties to cover other contingencies until required (of which more elsewhere), ultimately they are a “moral charge” on the assets.  In times when the unconsolidated terminal bonus element of policies is high this becomes important.  The Society maintained that it was in practice unimportant, because its declared practice was to pay out total policy values (including the unconsolidated element) in full, such that this was policyholders’ reasonable expectation.  Effectively, therefore, the moral charge was thereby made a real one, and the difference was only unimportant so long as the technical solvency gap remained small or intermittent.  But since this also implies a reserveless scheme, which could only work given well-nigh perfect forecasting, it was a vain and fallacious hope.  When formally delivered and published as a paper entitled:  “With Profits Without Mystery”(WPWM) to the London Institute of Actuaries in 1989 by Roy Ranson and the Edinburgh Faculty of Actuaries the following year by his deputy and co-author Christopher Headdon, expert members of the actuarial audience were unhappy with all this, essentially because it betokened a fund with scanty reserves, and perhaps insufficient financial strength in the event.  Actuaries were also concerned that all policies were indiscriminately placed in the same unitised fund and asset mix, irrespective of their maturities or levels of guarantee, because under conditions of technical or absolute insolvency some policies would acquire inequitable claims on the remnants of the fund.  Not surprisingly they wanted policyholders and their advisers to be informed of the potential risks that all this posed in accordance with the Financial Services Act of 1986.  To this Ranson in his responsible capacity of Appointed Actuary paid overt lip service, but in practice nothing effective was done in over a decade afterwards. And so all the important omissions, dissembling, concealments and deceits stem from this sophistry, including dual and conflicting presentations of the new paradigm, firstly to a select but sceptical actuarial forum but then not the Society in full, and secondly of the accounts, an optimistic total policy asset share value version for members and a pessimistic discounted policy value asset share version for the regulator, which overall position was privately monitored by a more realistic internal office valuation, and which enabled the Society to survive for so long.

WPWM has rightly been the focus of much subsequent interest.  Important though the details are (they are rehearsed and referenced elsewhere in this paper because they are not well covered by the PR), it is here more relevant to concentrate on four critical background factors.  Firstly, the underlying prospectus based on the Society’s past performance was as we have seen false. Secondly, undeclared DTBP meant that the relative amounts of guaranteed and un-guaranteed bonus could be crucial, in contrast to what WPWM stated.  Thirdly, the Society was by this time over-allocated, and its financial position was already weak.  Fourthly, interest rates had fallen to the point where the GAR option had become valuable, such that there was a real possibility that the Society’s covert contingency plan to revoke un-guaranteed bonus would be used.  And fifthly, despite what was written and published in the main paper, Ranson had during the 1990 Edinburgh discussion intimated that if things got difficult the un-guaranteed terminal bonus element would be the first thing to go.  Taken together, these factors indicate that the WPWM sophistries were motivated by more than bad faith, and that they were an integral part of what was by then a fraudulent position.

The unvarnished truths behind the WPWM gloss would hardly have been more acceptable to the Society’s WP policyholders and members than previously to actuaries, particularly since as members they were also its owners.  Judging by the extracts given in the PR, Barry Sherlock as senior actuary and general manager did not adequately disclose the whole situation and its attendant hazards to policyholders in his 1989 report. But though he was an executive director, he had since 1982 been more concerned with the overall direction of the Society from the London end, and it remains unclear how familiar he was with the background events of 1982-7.  We may nevertheless reasonably assume that he had read and sanctioned, if not actively edited and approved, the 1989 WPWM paper. And he it was who had given away the Society’s estate in order to supercharge the Society’s performance record, which gained it approbation, influential support, and an increasing amount of new business which was both private and institutional.