EQUITABLE LIFE MEMBERS

EQUITABLE LIFE:  PENROSE AND BEYOND

- ANATOMY OF A FRAUD 

A paper by Dr. Michael Nassim

Last Updated: Friday, February 11, 2005 10:00 AM

Of Ponzi schemes in general, and the Society’s in particular. 

Pyramid selling scams are also known eponymously as Ponzi Schemes.   In the 1920’s Carlo “Charles” Ponzi elicited subscriptions to buy postal credits cheaply abroad, and cash them in more expensively in the USA.  Though the idea sounded attractive it was unworkable, but Ponzi maintained the illusion of success by paying earlier contributors “interest” from the growing stream of proceeds from newcomers.  So long as the income stream comfortably exceeded payouts it was worth continuing, but when questions began to be asked confidence was eroded, whereafter the stream at first hesitated and then dried up.  At this point Ponzi defaulted, and 40,000 people lost their subscriptions.  From this one sees that:

·         Because it is unworkable, the central rationale is not what it purports to be.

·         If the rationale is unworkable, any prospectus based on it either false or unsound. 

·         Since the perpetrator knows the prospectus is false, or has good reason to suspect that it may prove to be unsound, there is an implicit but secret point of default, and the scheme is in bad faith.

·         An unworkable rationale cannot create genuine wealth for monetary returns.

·         Even so, success is mimicked by paying past contributors with the income from present and future ones.

·         The illusion of success is thus a confidence trick.

·         Apparent success plays on the confidence of yet others to contribute, and so on.

·         So long as subscription income and any interest it earns stay ahead of payouts, the scheme is worth maintaining.  Meanwhile everything hangs on confidence.

·         When confidence collapses, and payouts threaten to overtake income, the scheme defaults.

·         Besides the perpetrator(s), a minority of earlier contributors can end up better off.

·         Beyond paying for the gains of others, latecomers also incur the running costs of a barren scheme and lose their money.

In the context of the Equitable it is now apparent that:

·         After the loss of the estate and yet further over-bonusing plus the GAR liability, the so-called “with profits” fund was a “with liabilities” fund, and no longer what it purported to be.

·         Since the traditional “with profits” fund no longer existed, any rationale based on it had to be traduced, and was thereafter either false or unsound.

·         Instrumental members of the executive function knew that the resulting prospectus was false, or had good reason to suspect that their assumptions might prove to be unsound.

·         Since they knew that the WPWM business paradigm was false, or had good reason to suspect that it might not hold, they had privately put in place a default, whereby the terminal bonus element of GAR policies could be revoked in proportion to the size of the GAR advantage. From this point on the “with profits” business manifesto was uttered in bad faith.

·         As eventually brought out by the vagaries of the market, there was no longer an estate or free reserve with which properly to finance an investment policy that permitted safely genuine monetary returns as befitted “with-profits” fund status.

·         Even so, the illusion of success was initially maintained by awarding existing members at least a portion of the estate, and once it had all been dispensed by over-bonusing them to create a liability that needed financing by present or future members.

·         Though the impression of success was illusory, it led to consistent triple A ratings from the financial press. The reality was more of a confidence trick.

·         Apparent success was material to the entrapment of 930,000 further policyholders.

·         Since all now depended on confidence, in the absence of sufficient genuine returns over-bonusing had to be maintained and credit extended in order to maintain it.

·         The interest rate climate changed, GAR policyholders were “in the money”, and despite sharing out the liability more widely over new members it became necessary to revoke their terminal bonus.  The DTBP emerged from its 10-year secret existence, and the Society defaulted on its declaredly bona fide position.

·         This was challenged by GAR policyholders, and eventually the Hyman case of 1997 led to the default being declared illegal by the House of Lords decision in 2000.  In response to this confidence first seriously faltered in 1999, and then evaporated in 2000.

·         With the loss of confidence, the premium stream dwindled and all but died over 1998-2001. Since the premium stream was being used to cover some £1.3 billion of over-allocation, this sum had now to come onto the books, and be added to the existing deficit and cost of the GAR option, whatever they were.

·         At this point, the Society’s 1.25 million or so policyholders had to share the full deficit among themselves.  Older GAR policyholders, who had previously benefited from the 1973-87 giveaways and over-bonusing roughly in proportion to the duration of their membership, were not so badly off.  Those policyholders who had crystallized their claims prior to the market value adjustment in July 2001 and subsequent Compromise retained all their previous gains, but they were by no means all the170, 000 GAR policyholders.  The reward for non-GAR policyholders and latecomers was thus in many cases entirely liability, and no profit.

All this came more or less within the letter, if not the spirit, of contemporary legislation.  This is because “ponzification” was confined to the unconsolidated and un-guaranteed fraction of policy values. And as we have seen, this modified Ponzi scheme also provided the illusion of smoothing.  One way or another, under the now discredited WPWM paradigm Society could renege on the whole of the un-guaranteed fraction, so long as it continued to pay the guaranteed fraction in full. What was and remains at stake is thus substantially more than the GAR liability, because the WPWM fund structure is still largely in place.  Here it is again worth recalling the extraordinary impropriety of the officially sanctioned 16% cuts to total policy values in July 2001, which reduced guaranteed portions pro rata. 

Prelude to Regulatory Considerations:

Policyholders’ reasonable expectations, issues of good faith and related duties.

First note that, in discussion following C.S.S. Lyon’s paper The Financial Management of a With-Profit Long Term Fund- Some Questions of Disclosure in 1988 (EARW section 5, p11), Roy Ranson had said:  “I support the author’s suggestion that the, to use his words, “moral charge” which existing terminal bonus has on the free assets might be reported.  If the free assets remaining after such an exercise were used as a sign of so-called “strength”, such a disclosure would need to be supplemented by a note about the office’s approach to with-profits business”.  But by this time the Equitable was over-allocated, such that Roy Ranson as its Appointed Actuary had no basis for making this important statement, which under the circumstances could only obscure and mislead. The simultaneously emergent reality, which would have been both revealed and supported by the Society’s triple accounting process, was very different. The triple accounts were, moreover, deployed in a manner antithetical to Ranson’s 1988 statement, such that we can only conclude that this was done in deliberate bad faith.  Lord Penrose observes: ”However, the accelerating growth in terminal bonus payments was fairly consistent over time.  And that pattern emerged whatever the current financial experience of the Society (it should have implied the existence of an effective smoothing policy if all was otherwise well, whereas it was symptomatic of degeneration into a Ponzi scheme- MN).  The reasonable expectations of policyholders at any given time would have been that the pattern would be sustained in the reasonably foreseeable future in the absence of financial catastrophe.  Had the Society recognised terminal bonus in its statutory accounts and regulatory returns on any basis consistent with PRE, its financial weakness would have been exposed throughout the 1990s”(P14.186).

More specifically, while summarising Ranson’s role, in chap 19.128 Lord Penrose says:  “In relation to the Society’s regulatory returns, Ranson did not apply successive regulatory requirements requiring the valuation of

Guarantees explicit on the face of the with profits pension business; and

Any options that were from time to time in the money, relative to the Society’s primary obligations

As a result, the Society’s regulatory returns failed to identify and value the growing guaranteed obligations that resulted from a combination of falling interest rates and lightening mortality experience.  Such references as were made to these guarantees in and after 1994 (relevant to the 1993 return {i.e. when the DTBP finally emerged after 10 years below stairs- M.N.}) failed properly to disclose their nature and extent to the regulators.”

In chap 19.147 Lord Penrose concludes:  “In the case of the Companies Act accounts there was a failure to identify and to quantify in an intelligible way differences arising from changes in assumptions, and a failure to relate the consequences to PRE.  In particular, between 1990 and 1997 (which the writer takes to be for the years 1989-96, i.e. from the official start of WPWM until the end of the GIR period) the Society’s published financial statements failed to inform policyholders of the analysis of the movements in value resulting from changes in actuarial assumptions, and failed to draw attention to resulting discrepancies between the policy values intimated to them and the relative liabilities reflected in the accounts”.  In other words, there was persistent non-disclosure of crucially relevant information to policyholders, let alone risk-carrying mutual society owners who had every right to it.

It has previously also been shown that C.S.S. Lyon’s “moral charge” was effectively made a real one by Ranson and Headdon’s statement in their WPWM paper to the effect that, since the Society’s practice was to pay out policy values in full, then the relative proportion of the guaranteed and un-guaranteed elements was of minor importance (R & H section 3.2.6; EARW section 5 p 12). Of this Lord Penrose says:  “…That representation was consistent only with a bona fide intention to pay a final bonus according to current market conditions and the stage in the Society’s smoothing cycle, if there were a relevant smoothing policy…” (P19.78). And yet in discussion of the Edinburgh reading of the paper in 1990 Ranson had belied this statement by saying: “…In practice, we also pay full value on withdrawal and surrender at any time.  That is not guaranteed and that could be the first thing to go if things got difficult…” (EARW p 9).  But at the same time “Ranson did not advise the Board of the risk that persistent practice associated with published statements of practice would develop policyholders’ reasonable expectations (PRE) that existing patterns of payment would continue to characterise the Society’s bonus practice in the future.  In particular the advice that future terminal bonus payments were not guaranteed (that is not contractually due) diverted attention from the risks associated with the generation of non-contractual expectations of future bonus payments” (P19.121.)  Where, then, was the good faith?  And how is all this to be reconciled with the prior covert existence of the DTBP?

The expression “policyholders’ reasonable expectations” (PRE) first appeared in Ronald Skerman’s paper A solvency standard for Life Assurance Business, published in 1966.  His reference to PRE came in his discussion of the essential characteristics of with-profits business and of his five principles of valuation (P13.34).  Skerman’s paper identified three problems, of which the third was:  “Participation in profits.  Holders of with-profit policies have taken them out in the expectation that they will benefit from a share in profits from time to time.  Although an office is not under a contractual obligation which can be quantified in relation to the benefits which its policyholders will derive from future profits, it would be unsatisfactory not to take some account of the policyholders’ reasonable expectations when determining the value of the liabilities.”  Lord Penrose says: “Skerman identified the expectation that concerned him: the expectation of benefit from profits arising from time to time.  He thought that the valuing actuary should have regard to the reasonable expectations as to participation in future profits in selecting the method used in determining the value of liabilities.  His five principles were elaborated against that background (P13.35)”.

In ¶ 37 Lord Penrose observes:  “Skerman was not concerned with the content or meaning of the expression “policyholders’ reasonable expectations”.  He was concerned that the actuary should have regard to the reasonable expectations as to participation in future profits in determining the value of the liabilities.  That required the adoption of a valuation method that avoided setting off against current liabilities that part of the future flow of premium income that was not related to guaranteed benefits, so leaving surplus generated by that part to emerge over the duration of the contract and to create the bonuses that policyholders reasonably expected to emerge in parallel with it”.  But, at the Equitable that surplus, plus the prior estate and a charge raised against the future had been “deliberately” distributed elsewhere.

“The prospect of failure to meet the “reasonable expectations” of policyholders and potential policyholders was introduced as a trigger for regulatory action in the Insurance Companies Act of 1973 sections 12(1) and 21.  The expression was not defined by Parliament” (P13.9).  “The provisions as finally enacted in 1973 were consolidated in the Insurance Companies Act 1982, sections 37(2)(a) and 45(1)(a)” (P13.40).  All five versions of the Faculty and Institute of Actuaries Guide Note 1 (GN1) issued over the period 1/05/75 to 1/09/96 make reference to the above provision in the 1973 and 1982 Acts, and the resulting duties of appointed actuaries in regard to them.  This included advising their companies on relevant contributory factors, and from version 2 onwards their own interpretations of policyholders’ reasonable expectations (P13.57-94).  Furthermore, “…It may be appropriate to note that paragraph 2.3 of GN8, from 1994 onwards, mentions that the appointed actuary would be expected to make investigations in order to be satisfied that the long-term fund was able to support a proper level of future terminal bonus having regard to the bonus smoothing policy followed by the office…”(P6.111. See also EARW section 5 p 11).

With this summary in mind, it is relevant that the earliest comprehensive written presentation on PRE was made to the Equitable Board by Headdon on 26^th Nov 1997, i.e. not until both Sherlock and Ranson had retired (P14.1). Lord Penrose comments (¶ 3): “The broad statement in paragraph 8 stated that PRE was a function of the policyholders’ response to what was communicated by the office about the management of the business is incomplete.  But, even on that basis, distribution policy would be an aspect of PRE, but not the measure of it.  Further, as appreciated by the departmental officials in discussing PRE, the regulator may become aware of facts and circumstances that had not been communicated to policyholders in any way, but that might threaten the office’s ability to meet reasonable expectations.  In his analysis Headdon gave inadequate weight to the conduct, as distinct from the comments, of the Society as a factor contributing to PRE.  But the statement provides a valuable insight into the understanding of the Society’s staff of the requirements derived from policyholders’ reasonable expectations, both generally, and in relation to participation in surpluses.  It was also an explicit acknowledgement of the appointed actuary’s responsibility that had no real precedent in the Society’s practice”.  As to why the presentation may have been made to the Board, Lord Penrose says in ¶ 4:  “This report was presented a few months after Headdon had advised Nash of his analysis of the Society’s past over-distribution and of his view that it would take some fifteen years to achieve equilibrium.  That analysis of actual experience was not reflected in the advice”.

When it comes to the specific issue of the GAR, it is sufficient to quote from Lord Penrose’s analysis of the Society’s communications on PRE and bonus:   “But, given the Society’s advertised commitment to openness of communication, there was no basis for a reasonable expectation that the Society had created a potential conflict between guarantee annuity policyholders and other with-profits policyholders (P14.13)” – and:  “But so far as the new personal pension policyholders are concerned the search by the inquiry for an indication that there might be an adverse impact on policy proceeds arising from competition between classes has been in vain” (P14.69). This is also, of course, an inherent characteristic of general mis-selling by the Equitable (vide infra)-a conclusion that the PR refrains from making.

As initially explained, the primary purpose of this article is not examination of the regulatory position.  But with regard both to PRE and the official Opposition case for organisational and operational regulatory failure, readers are invited to consider the PR’s extensive quotations (P chap 13.107-12) from a memorandum dated 21^st Sept 1987 by George Newton, who was directing actuary for the insurance directorate at the Government Actuary’s Department (GAD) from 1982-8.  Newton clearly described a desired and responsible regulatory position despite contemporary uncertainties over the definition and importance of PRE.  Some of his specific concerns were highly relevant to the Equitable; readers are invited to consider whether history has since proved him right. As they read the next two sections they are also invited to consider whether there is or is not always a hard and fast distinction between conduct of business and prudential regulation, and the extent to which both underpin the concept of PRE.