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

Regulatory Failure I: Conduct of business:

“Incentivised Ignorance” and fraudulent general mis-selling- how and why it was denied by the Society and then deliberately overlooked by the regulators, Treasury and the PR.

The Aylesbury senior management team included sales and marketing personnel. Consistently with the importance of the sales drive, marketing director Ken Wills, who had been recruited by Sherlock, joined the board as an executive director as early as 1976.  The natural expectation would be that the material events of 1982-9 should have been included in the relevant policy documentation or in promotional material.  But if the Board of Directors had not been adequately informed it is hardly likely that the rank and file of the Society’s branch office staff, agents and field force would be told, let alone potential policyholders and members. In fact, every policyholder’s sad experience is that this was never done, and to the writer’s knowledge every salesman’s reported or broadcast statement has been to the effect that they did not know either. And despite what the Society told policyholders about the absence of commission fees, it paid its staff an as yet unspecified commission on sales. Nor do we know whether the commission was the same for all the Society’s products, or if it was greater for with-profits products. But whatever it was, surely it acted as a motivating and otherwise influential incentive for sales staff.

Even before the House of Lords decision in the Hyman case which finally made it essential, policyholders’ common experience indicated that there was a quick and inexpensive way of cutting to the chase, and establishing the essence of what had gone wrong, and when.  A handful of experienced regulatory and forensic investigators could have tracked back from a representative sample of policyholders, through their salesmen and a sufficient number of branch offices, to the hierarchical level in the executive function at which ignorance of the critical factors began.  Persons above that level would have been material to fraudulent non-disclosure and misrepresentation. Had this been done, much lengthy uncertainty, and perhaps even much of the Penrose Inquiry itself, might have been avoided. Unfortunately nothing of the sort happened then or since, and so it remains unclear whether departments and persons other than in the actuarial function were involved.

For these reasons, and in an effort to ensure that the Compromise Scheme did not later come unstuck by failing to take the matter into consideration, the writer had laid out the case for general mis-selling and hence establishing the level at which “incentivised ignorance” began in a letter to the Society.  The case remains unanswered.  The matter now becoming urgent as well as grave, an evidential paper entitled: “The Equitable Life Disaster-does it compare with the Lloyd’s asbestosis scandal of the 1980’s?” (ELD) was twice sent to the FSA, and when they failed to acknowledge it to FSA chairman Sir Howard Davies. Sir Howard Davies personally acknowledged receipt of the paper, but did not act.  ELD also went to Opposition Treasury Spokesman Christopher Chope via the writer’s MP Alan Duncan.  In due course Mr Chope asked from the floor of the House of Commons what effect class actions for general mis-selling might have on the Compromise Scheme, but he too received no answer from Treasury spokespersons.

After the Compromise had gone through, the writer sent ELD and relevant correspondence with the Society to the Penrose Inquiry.  Receipt was acknowledged, in spite of which the PR does not cover Conduct of Business or any analysis of the Society’s promotional material or sales platform- a fact that must be re-visited shortly for other reasons.  Likewise it makes little attempt to address common factors in what policyholders were or were not told by their sales representatives.  Not having addressed a common factor (such as mis-selling involving non-disclosure of inequities of guarantee and hence the impact of the GAR and the DTBP) and traced its origins, the PR can say nothing about the role of the sales and marketing departments in the critical events of 1982-7, or indeed later.

Later still, as related at the end of EARW section 11, the writer foresaw that the Society might delay making cuts in FSAVC annuities until the government FSAVC review was complete.  He forewarned Sir Howard Davies’ Office and the FSA, who offered no opinion and did not intervene.

Tedious and personal though it is, this list of informed and elective omissions by the Society, regulators, Treasury, the Financial Ombudsman Service and the PR is a point worth labouring.  By refusing to admit or document general mis-selling and non-disclosure, the Society and the authorities have transferred the burden of proof to each individual policyholder.  The individual burden of proof is implicit in the “lead case” explorations of policyholders’ situations adopted by the FOS, and now proposed by the Parliamentary Ombudsman.  Of necessity this can also limit what can be discussed to individual circumstances- which is rather like a random gathering of pieces of rotten flesh and broken bones, but affecting not to see the dead elephant unless or until the full anatomical inventory is absolutely complete.  Because they have refused to look, the authorities can thus continue to maintain that there is no evidence for any form of underlying general malfeasance. Without official substantiation of general harm or malfeasance where can be the originating fraud?  Under these circumstances it is hardly surprising that the FSA has belatedly said that it has conducted its own investigation and found no case for mis-selling by the Equitable, while refusing to publish the evidence.  In effect the FSA is claiming to have proved the impossible, which justifies giving the wrong answer long after the right one was really needed.  Like the Equitable with-profits fund, the FSA has become its own opposite.  In that this can be anticipated to exert pernicious influences on the working of other subservient bodies such as the FOS (Financial Ombudsman Service), it must now be guarded against.

The benefit of labouring the point is finally clear.  The list of elective omissions denotes regulatory failure before and after the Compromise, which was and remains knowingly deliberate.  Understandable though the pressures on the Government, specialist bodies and regulators are, the implications for our constitutional and national life are far-reaching.  But despite all it is now evident that here was no fruit on the tree, and that the branches were limed.  More than a million trapped birds are learning what bound them, and so it is only a matter of time before the defensive position breaks. We must prepare for the consequences as best we can.  Meanwhile some trapped birds have turned woodpecker, and attacked the tree with group legal action.  Because there is no statute of limitations on fraud, there will be time enough for yet more birds to learn the trick and develop it further as reports of its success grow.  Carried to its limits this can only lead to disaster, but as ELTA chairman Peter Scawen has pointed out, it is presently one of the few realistic ways of cracking the whole defensive edifice and forcing a more constructive reappraisal.

Regulatory Failure II: Prudential.

The evidence presented in the different sections of this paper is here brought together to support the itemisation of prudential regulatory failure which now follows.  Much of it has also been submitted by ELTA and ELCAG (Equitable Late Contributors Action Group) to the Parliamentary Ombudsman’s second inquiry.  It is instructive to compare the list with the Official Statement of Complaint which has appeared on the PO’s (Parliamentary Ombudsman’s) and EMAG’s websites.  Much credit is due to EMAG for the latter, because in the second round of negociations with the PO’s office they reformulated much of what had transpired in the first round in a publicly and politically acceptable format for the PO’s second Inquiry.  However, such considerations are secondary in a paper of this sort.

The authorities responsible for the prudential regulation of insurance companies (successively the Department of Trade and Industry, Her Majesty’s Treasury, the Security and Investments Board, the Personal Investment Authority and the Financial Services Authority, collectively referred to in the rest of this section as ‘the regulators’) failed properly to exercise their regulatory functions in respect of the Equitable Life Assurance Society (ELAS).

The Primary Failures

a.             It must be noted that the normal situation of Regulation, is that it oversees and checks upon actions already taken by the management of life assurance companies.  Where harm occurs to policyholders, actual or potential, the harm is caused by companies themselves and that harm is then compounded by the failure(s) of the Regulator. The evidence gathered and set out in Penrose, and subsequently extended in this paper and elsewhere, indicates that the primary causes of the claimants’ losses were inequitable dispersal of the Society’s traditional estate followed by deliberate over-bonusing over the years 1982-1986/7 which progressively increased contemporary realistic liabilities from a situation where they were in some degree of balance to one where those liabilities totalled £4.5-5.0 Billion, against assets of £3.0 Billion.

b.             The Regulators did not intervene in any effective way, although they should have known that such over-bonusing would have the following inevitable effects:

·         Early claimants would take substantially more than their fair asset share from the WP Fund;

·         Those benefiting from the over-bonusing would retain a larger claim on the WP Fund than their asset share would justify;

·         Those early claimants would drain capital from the Society, where that capital was properly required to service remaining policyholders and to maintain solvency;

·         Remaining policyholders would be deprived of their fair asset share;

·         The size of the effective asset shortage would increase in line with the allocated ‘investment growth’ of the Fund, unless steps were taken to negate the over-bonusing in one way or another.  In effect, therefore, a permanent rather than intermittent or temporary strain on the Society’s finances was allowed to accumulate.

In other words, the Regulator, by inaction, allowed the Society to be put in grave solvency peril, both in immediate terms (for example see Penrose on the situation in 1990-92 although not covered here), and in constructive terms by giving new cohorts of policyholders valid grounds of claim against the Society.

c.             With each passing year, a greater volume of losses was crystallised in claims, until by the end of 2000, such losses probably exceeded £8 Billion.  On any reasonably informed analysis it was these losses and the resulting capital shortage which prevented the sale of the Society as a going concern.

d.             As a further consequence, new policyholders were recruited on a basis where they shared in a substantial undisclosed deficit sufficient to undermine the viability of the Society, and they thereby received substantially less than their proper investment growth.  However, this deficit was concealed until the Society’s Ponzi operation effectively collapsed with the total policy value cuts of 16 July 2001, whereupon the entire deficit fell upon the shoulders of those policyholders who were still with the Society on or after that date.

e.             In conclusion:  The claimants’ losses flowed primarily from reckless behaviour by the Society’s management which over the period 1973-1987 had critical consequences. This behaviour was of a kind which fell squarely within the scope of the Regulator’s duties and powers to monitor, warn and compel retraction.  The Regulator took no action or no effective action and allowed actuarial etiquette to guide its conduct instead of statutory duty.  As a result the Prudential Regulator became equally responsible for the losses in question.

A. Organisational issues

a.           The regulators were not always sufficiently resourced, and did not all possess the necessary skills, to make an effective contribution to the regulatory process and responsibly exercise discretionary powers as intended by Parliament from 1973 onwards.  As a consequence they did not properly undertake their functions.

b.           The prudential regulators failed to communicate effectively with those responsible for the regulation of the conduct of business by insurance companies, particularly in relation to ELAS’ published actuarial and insurance business paradigm, or to advise the Conduct of Business Regulators that the realistic position rather than the Solvency position was the primary reference for potential customers, or in regard to changes in policy forms and the guarantees provided in accordance with this or annual statements and letters to members.

c.           Although ELAS were aware of the significance of non-guaranteed bonuses and showed them in their ‘Office Account’, the Regulators did not give the matter proper attention despite its importance for policyholders and for the financial viability of the Society

d.           The regulators and GAD allowed successive chief executives/managing directors of ELAS also to hold the post of appointed actuary, despite a recognition of the potential for conflict of interest in this position, and the fact that it completely undermined the basis of the regulatory process which was founded on the separation of powers between the AA and the rest of the Executive.

B. Operational issues

As a general point, the regulators spent over-much time debating the circumstances under which they might use their discretionary powers, and in the event never used them when the overall situation required them to do so.  As a result they did not recognise or react to any of the important successive stages in the development of that position, which were: 

a)       From 1973 onwards the regulators failed to react to ELAS making no explicit reservation for its increasingly dominant bonus form (terminal bonus), and did not examine the position from the realistic aspect required under a proper or reasonable interpretation of PRE.

b)       When in 1987/8 ELAS carried over into new policy forms a bonus record enhanced by the prior dispersal of its estate which had no prospect of continuing, it began trading on a false basis.  Regulators could and should have recognised this at the time, because the Society had also moved into over-allocation.  More seriously from the prudential aspect, the over allocation to the pre-87 policies was of such magnitude as to drain capital required for solvency within a few short years.  Nevertheless the Regulator did not intervene. 

c)       Despite contemporary informed actuarial comment the regulators failed to scrutinise the “With Profits Without Mystery” actuarial and insurance paradigm.  Had they done so, they would necessarily have discovered that it was in essence a post hoc sophistry-laden rationalisation for dispersal of its assets, and running a with-profits fund on an intermittently negative technical solvency gap.  Under the WPWM paradigm and/or given the Society’s underlying situation there was no prudently equitable assurance, or real prospect of fulfilling policyholders’ reasonable expectations.

d)       From 1987 onwards the regulators allowed a with-profits fund to operate on a mostly negative technical solvency gap which betokened liability for present and future policyholders rather than profit. 

e)       The regulators generally failed to appreciate the effects of conflicts of interest between the Society’s private and corporate/institutional clients, and the GAD’s position in recommending the Society as a civil service institutional pension scheme provider. 

f)         Despite helping to develop joint “net premium” and “gross premium” actuarial methods to probe ambiguities in hypothecation of assets and liabilities under different accounting and regulatory return conventions, the regulators did not use them on ELAS’s returns.  Had they done so, the fundamental weakness in ELAS’s position would have been exposed by 1996/7 at the latest. 

g)       Having turned a blind eye to gross solvency risks in 1990-92, the Regulator adopted thereafter a self-protective policy of denial, to conceal the maladministration that had taken place in previous years, and to absolve itself of responsibility when the collapse of the WP Fund eventually manifested itself.  It colluded throughout the period 1996-2002 in attributing the circumstances leading to the closure of the WP Fund to problems with Annuity Guarantees, rather than the earlier and far more serious over-bonusing of 1982-87. 

h)       The regulators failed to follow up disclosure of the Differential Terminal Bonus Policy on Nov 30th 1993, or assess its implications for regulatory solvency and PRE.  Had they been sufficiently diligent to trace the origins of the DTBP at that time, they would necessarily have concluded that its prior non-disclosure was fraudulent. 

i)         The regulators failed to question why the Society inappropriately extended its chronic over-allocation by using inappropriate quasi-Zillmer adjustments and subordinated loans which anticipated future premium income and impacted adversely upon future profits.  As a result they failed to digest the prudential and PRE implications. 

j)         Understandably, the regulators could not detect that the reinsurance arrangements made to cover the Hyman position were a show treaty without substance. The regulators did not, however, examine ELAS’s public statement in Feb 2000 that losing Hyman would cost members no more than £50 million, when reinsurance to the tune of £800 million was nominally being sought to cover the same situation.  At the same time the Society’s actuaries were valuing a “worst case” scenario based on 100% GAR uptake at over £3 billion.  These disparities demanded rigorous investigation. 

k)       Despite external representations and their own evidence to the contrary, the Treasury, judiciary and regulators, and in particular the FSA, supported ELAS’s position that there was no generic mis-selling of policies in respect of the GAR liability, and that ELAS’s problems were solely due to the GAR liability. On this public position the Compromise Scheme of arrangement was carried through to the detriment of members and with forfeiture of their legal rights. 

l)         In so doing, Treasury and the regulators necessarily permitted carry over of ELAS’s discredited WPWM fund paradigm and structure by the New Board under circumstances in which with-profits fund status was irretrievably lost.  They also allowed cuts in policy values well in excess of the nominal GAR liability without questioning their rationale, and without requiring any action to undo the over-bonus on outstanding GAR policies dating back to the 1982-86 era, which had become ever more substantial with the passage of time. Furthermore, if the Regulator had insisted on truly prudent action at that time or earlier, all final (i.e. discretionary) bonus would have been suspended indefinitely until the financial condition of the Society could be fully established, thereby retaining a vital £2 billion of capital which was subsequently lost.

m)     After the Compromise and despite forewarning, the FSA allowed the Society first to raise FSAVC’s in compliance with FSAVC review procedures, and then cut them again immediately afterwards along with deferred cuts in all other annuities.  In effect, therefore, the FSA permitted the Society to make post-Compromise upward revision of FSAVC’s which it knew the Society had no intention of honouring.

In sum, therefore, there is sufficient evidence to maintain that operational regulatory failure was total over an extended period, and that in the later stages it was deliberate, such that it had the effect of extinguishing many just claims without opportunity of recompense.  Had the regulators halted this progression, an eventually fraudulent position would have been averted, which effectively they condoned by allowing the Compromise Scheme to take place.  The writer is moreover confident that total operational failure of this ultimate kind can only be due to an overall deficiency in ethically responsible attitude.  Others have wished further to maintain that, over and above organisational and operational deficiencies, regulatory failure must also have been collusive.

C. Payment of excess bonuses

a.                Over a period of many years the regulators and the Government Actuary’s Department (GAD) permitted ELAS to declare bonuses in excess of available assets, while at the same time operating without a significant estate.  This was a major contributory factor in the Society’s demise and in the losses incurred by all those who held policies on 16 July 2001.

b.                Over this same period, the regulators allowed ELAS to publish financial results and projections that were misleading in that they did not reflect the Society’s true position.

D. Issues relating to regulatory solvency

a.                   From about 1990 onwards the regulators and GAD failed to give sufficient consideration to the fact that a number of the various measures used to bolster ELAS’ solvency position were predicated on the emergence of a future surplus (for details see operational factors above).  As a consequence, they did not properly assess the overall impact and adequacy of those measures.

b.                   During the same period, the regulators and GAD failed to act when ELAS adopted what Lord Penrose described as practices of ‘dubious actuarial merit’.  These included valuing future liabilities at an inappropriate rate of interest between 1990 and 1996; treating selling costs as an asset; making no provision for guaranteed annuity rates until much too late; valuing a financial re-insurance policy which proved to be useless, at over £800 million; and taking on a subordinated loan which was not counted as a liability.

c.                   On several specific occasions the regulators and GAD ignored or failed to action information that might have led to regulatory action against ELAS.

d.                   The regulators and GAD further failed to assess whether the New Board’s representation of ELAS’s situation was full and fair in the run up to the Compromise, and in the light of their own expert knowledge whether that description was consistent with PRE.

e.                   In July 2001 the regulators allowed the Society to boost regulatory solvency by making total policy value cuts that included the guaranteed portion of members’ funds.  De facto this denotes breach of guarantee and regulatory insolvency, and is also a flagrant violation of PRE.  By any ordinary criteria regulatory approval of such a manoeuvre is astounding.