EQUITABLE LIFE MEMBERS

EQUITABLE LIFE:  PENROSE AND BEYOND

- ANATOMY OF A FRAUD 

A paper by Dr. Michael Nassim

Last Updated: Friday, February 11, 2005 10:01 AM

Level 3: The Evidential Base.

Scope and Limitations of the PR:

1. As anticipated (EARW Section 12 p21), in his opening letter to Financial Secretary Ruth Kelly (i – ii) and introduction (viii - x) Lord Penrose has been obliged to qualify the terms and scope of his inquiry. He had no formal powers, could not compel submissions or attendance, undertook to observe confidences and has not wished to compromise ongoing legal proceedings or tribunals.

2. Some of the resulting constraints are noteworthy and relevant.  They include:

1. Lord Penrose only covers events up to 31^st August 2001 (P4.104). Hence there is not much of direct relevance concerning the nature and effects of the Compromise Scheme, or of the conduct of the Society, New Board, legislature and regulators in the lead up to the Compromise, or indeed its later consequences. 

2. The New Board did not support and assist the Inquiry for the period beyond 31^st March 2001, and so the Enquiry could not go effectively beyond this earlier date (ibid), or indeed for any of the 8-month reference period in 2001 in any great detail (P4.105).  As a result the New Board of Directors has not revealed its reasoning about the Compromise Scheme, or provided information about the state of affairs which it inherited when it took office.  Such information is greatly needed in relation to matters discussed elsewhere in this paper.

3. Lord Penrose has neither examined nor explained how the Society managed its conduct of business at the points of sale in its literature or approach to private members and corporate/federation scheme trustees.  Policyholders’ reasonable expectations (PRE) are relevant to both groups; prudential and solvency management are of added importance to the latter, besides underpinning PRE as a whole.

4. Moreover the sales and marketing strategies for private policyholders and corporate/group schemes are different, and there are potential conflicts of interest between these client categories, generational cohorts, scheme administrators, consulting actuaries and trustees.  The circumstantial evidence is consistent with the Society having done overmuch to woo, win and retain important (but also influential) corporate/group clients, their administrators and trustees (cf. EARW Section 5 p12; et vide infra).  This is not covered, and so further information is required.

5. Overall, Lord Penrose has felt obliged to indicate overall limits on the use made of his facts and opinions.  For a comment on this see item 54 below.

3. An overall comment is that, as might be expected from its limited remit, the PR is much stronger on prudential and regulatory aspects than the conduct of business as governed by the Financial Services Act (1986).  This is apparent in four ways, viz:

1. it says very little about the evidence presented by individual policyholders. 

2. Analysis of the With Profits Without Mystery (WPWM) manifesto is centred upon financial strength rather than Policyholders’ Reasonable Expectations (PRE), inequities of guarantee or duties of information.

3. Lord Penrose is repeatedly careful to explain why he expresses no personal opinion on the issues of maladministration, negligence, breaches of faith and duty, non-disclosure, misrepresentation, deceit, mis-selling and fraud. He confines himself to discussing them only in a general way.  In order to address matters more specifically he quotes from other relevant sources, e.g. the 1987 Newton memorandum (see 31 below) or the Glick & Snowden opinion to the effect that there were valid grounds to allege mis-selling.  This may readily be confirmed by searching for these terms with Adobe 6.0.  Other pertinent terms such as “deceit”, “pyramid sales”, “Lloyd’s” and “Ponzi” receive no mention.    

4. Notwithstanding the fact that the Financial Services and Markets Act (2000) did not give the FSA statutory responsibility for insurance and conduct of business regulation until December 1^st 2001, there is little criticism of the FSA for its omission to supervise conduct of business by the Society prior to that date. 

Salient New Facts and Findings:

How, when and where did the Society’s estate disappear?

4. The PR’s forensic accounting over the period 1970-2001 is very helpful and insightful, because it presents the salient developments in both narrative and tabular form. It broadly corroborates Burgess Hodgson’s prior evaluation of the period 1990-2000, and provides important new information.

5. Prior to the inflationary 1970’s gilts were a traditional safe haven, and the Society had not fully embraced the cult of equities.  Servicing of its liabilities was based on interest earned from gilts, etc.  It was very cautious about how to account for equity capital appreciation of its investments, and distrusted the inherent volatility of share valuations. Hence it was not initially disposed to regard such appreciation as a real asset, allowing only very small amounts onto the books periodically prior to the retirement of General Manager and Actuary Maurice Ogborn in 1972 (P chap 19.31). “In fact, the Society’s reserves, in off-balance sheet capital appreciation and hidden margins in liabilities, amounted to over 40% of its long-term liabilities at the end of 1972, …” (P chap 19.8).

6.  A significant new finding in the PR is that the Equitable had commenced building a strong sales function to offset the gap created by the disappearance of its Federated Superannuation Scheme for Universities (FSSU) business, complemented by a 5 year expansion plan beginning in 1973, i.e. shortly before the 1973 oil crisis emerged (P chap 3.16).  It was thus committed, and adhered to, expansion at a time when rapid capital depreciation of its equity holdings resulted (for an overview of this and what it led to see EARW section 6 p 13).  Even so, declared reversionary bonus rates were increased, because as Ogborn’s successor Barry Sherlock later reported to the Board:  “-if bonus had to be reduced the effect on new business would have been catastrophic” (ibid).  This situation continued:  “The decisions on interim bonus levels for 1974 and 1975 involved serious risk” (P3.29).

7. Again significantly, 1973 was the year in which Sherlock & Ranson first introduced the unconsolidated terminal bonus to supplant final annuity bonuses, and a “three call system” to allocated the surplus income generated by the equity component. Equity earnings were supposed to go three ways: 1) as an equivalent amount to the yield of a comparable capital holding in fixed interest securities.  2) a positive or negative adjustment to compensate for any difference that resulted, and 3) allocation of excess positive adjustment as terminal or reversionary bonus.  In practice, because of recurrent pressure to allocate bonus, negative adjustments to the second call were usually not made good, and the “three call” system was abandoned by 1984.

8. The “three call” system was immediately frustrated; there was no second call, and for the first time a significant proportion of any remaining capital appreciation (£12 million out of £30.6 million) was brought onto the books to support the first call.  In addition, a terminal bonus rate of 10% was approved, which would have required an additional £ 12 million if fully reserved for out of the remaining £18.6 million, “-but the Board was advised that the actual expenditure over the following triennium was expected to be £1m.  It was to become a recurring theme of actuarial advice that terminal bonus was relatively cheap to service because the rate adopted did not impact on reserving requirements (my italics)” (P3.15- the other many refs. are not enumerated).  Indeed, the ratio of unconsolidated to consolidated benefits in policies came to be described by the aseptically euphemistic term “technical efficiency”- the higher the proportion of unconsolidated benefits the better from the Society’s point of view. And by no means can it be true that that no provision need be made for terminal bonus.  To say so was falsely reassuring, and it planted the fatal seed of bad faith which grew to destroy the Society, and all that it had previously stood for.   

9. “By 1976, the Board had used almost the whole of the Society’s inherited unrealised capital appreciation and the hidden reserves in liabilities to maintain competitive levels of declared and interim bonus at a time of market volatility. It had done so without applying the prudent reserving policy it had accepted in 1973” (P3.38). This was despite bounce-back capital appreciation in 1975, and increasing the valuation rate of interest to reduce the value of the liabilities- a stratagem used again in later years.

10. The situation was now to be compounded by a prolonged period of apparent capital appreciation as a result of inflation, all of which was distributed to create an increasingly large bonus burden.  This is well exemplified by the Penrose Report’s coverage of the 1977-9 triennium, which typifies how the Society failed to reconcile its traditional equitable assurance obligations with marketing considerations aimed at securing the final transfer of as much former FSSU business as possible. Hence:

“Bonus policy remained central to achieving the Society’s marketing objectives.  In January 1977 Sherlock commented on the relationship between the two factors.  At the same time, he acknowledged the Board’s unease that the plan of action recommended on 22 September 1976 did not itself contain the means of closing the gap between earnings and distribution completely.  (This was the clearest documentary evidence of the Board’s unease at the distribution policies that had been pursued during the previous triennium.)  He recommended investment policies aimed at increasing the revenue yield on the fund.

On 25 October 1978, Ranson submitted a paper on the treatment of unrealised capital appreciation.  He rehearsed the three call system and illustrated how it might apply at the 1979 valuation.  The returns from fixed interest securities were taken as a yardstick for declared bonus.  He stated that the method had not been applied at the 1976 valuation because, due to marked conditions then current, no appreciation was available.  Market values had recovered and there would be appreciation to bring into account at the 1979 valuation.  On the projected values illustrated, he expected that the system could be applied at the declaration.  It emerged that he had departed from benchmarking against current market interest rates in adopting the reference rate for interim bonus in order to avoid a sharply higher level of declared bonus for the triennium and might have led to a reduction three years later.  Despite the principled approach rehearsed in the report, pragmatism had prevailed over principle.

The expectations of the market were a material factor.  It is significant, in the light of what was to happen, that he said that the withdrawal of terminal bonus would be incompatible with the expectations of policyholders based on the Society’s statements of practice, and on the assumptions of smoothing (This is an illustration of what was to become an increasingly cynical manipulation of the concept of Policyholder’s Reasonable Expectations in support of a continuing increase in  unprotected terminal bonus at the expense of protected declared bonus, which  represents continuing bad faith. MN).  A further significant factor was the emphasis on setting bonuses at “desired” levels.  It was a further indication of the Society’s practice of setting bonus levels to meet objectives rather than allowing them to emerge from the calculated surplus.  Interim rates in respect of pensions business were increased for 1979.  This was the area in which marketing was concentrated, and the increase improved the Society’s competitive position.

On 20 December 1978, the Board approved interim bonus rates for 1979 on the basis of reports by Sherlock and Ranson.  Ranson said that the investment experience of the fund and the differential impact of tax on the various elements of it had resulted in the untaxed fund earning more than was paid to policyholders of that class.  Their interim rates should be increased.  The taxed fund continued to “pre-empt some capital appreciation”, but the untaxed fund required no support from capital.  Sherlock agreed with Ranson.  His comments were:

“It is evident that pension policies which become payable before 31.12.79 will have received an inadequate share of revenue surplus (and no share of capital appreciation) unless a change is made.

It will become evident to the actuary to the USS once he is instructed during 1979 to consider the future of former FSSU (Federated Superannuation Scheme for Universities) policies issued by the Society that they are not receiving their fair share of surplus and that would make the case for their long term maintenance difficult.

It seems undesirable to include in our pension policy illustrations bonus rates which might put us at a disadvantage against the market when, as at present, they do not properly reflect the earning capacity of those policies.”

A reason had been found to increase rates for the class of business that the Society wanted to develop.  The bonus rates were based on “general” considerations, backed by the office model of assumptions, i.e. the bonus levels had been set at “desired” levels and tested against the model (P3.43-7, all my italics).

By putting the cart before the horse in this manner, it was possible to manipulate increases in un-guaranteed terminal bonus at the expense of guaranteed bonus.  In 3.48 Lord Penrose explains:  “ The three-call system had become a framework for illustrating the implications of applying different interest rates.  The higher the interest rate assumed, the greater the second call, and the greater the ratio of the second to the first call.  At the highest rate the second call more than exhausted the capital appreciation available and left the third call negative.  Only at the lowest rate assumed was there sufficient capital appreciation to cover terminal bonus at current rates.  The third call was the reserve for terminal bonus, and maintaining it was an independent policy objective.  The system was used to support the analysis of results using an arbitrary range of reference rates rather than actual guilt market rates.  The critical reference point had ceased to be the objective market interest rate and had become instead a subjective factor selected to produce the desired spread of bonuses (my italics).  The second call represented a substantial reserve for future reversionary bonuses, but on the projection was well within the capacity of the Society.”  This does not match the writer’s criteria for professional and ethical competence, let alone bona fides.

Bona fides or not, it all had the desired effect.  As Lord Penrose says in 3.41:  “1979 was “the end of an era” due to the loss of FSSU business.  President Murison reported that a far higher proportion of university teachers had transferred to the new self-administered pension scheme than had been anticipated.  However:

“At the same time the planned expansion of the Society has taken place but with greater results than were, or indeed could have been, foreseen.  The marketing organisation is, as planned, roughly twice the size it was five years ago, giving better geographic coverage of the country and therefore better personal service to our policyholders.  Both in the marketing organisation and throughout the Society, much attention has been paid to training so that business growth has been matched with high quality advice, service, and administration.  As a result of a more positive marketing approach, the Society is better known than it was and is used very much more by professional advisers.

The Society has emerged from the last decade well poised for the challenges and opportunities of the next.” 

Nothing could have been much further from the truth.  A road to hell had been paved, and not with good intentions. Fraud and widespread misery were the eventual outcome.  And with regard to the underlying objective of retaining as much FSSU business as possible, it should here be recalled that the Finance Act 1978 had introduced the open market option, whereby funds could be transferred to other annuity providers at maturity.  The Society therefore had an interest in presenting its fund transfer values in the best possible light under the new regulations.  How it did so is described in P14.31-9, and is of more than passing interest because it set the scene of expectation up to the time that the DTBP was privately formulated.

11. 1982/3 marked a further significant turning point in the Society’s affairs, viz:

1. The Insurance Companies Act made for more stringent solvency and reporting requirements, from and including 1982 (P chap 3.82).

2. All capital appreciation, whether past or current year’s, was now put on the books to support solvency (P chap 3.81.  See also Tables A.1-4 for history of allocation of “Appreciations in value of investments treated as surplus”)

3. 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(P Appendix A p 749).

4. Ranson proposed abolition of the second call in Nov 1983.  “The reasoning for this is obscure (P chap 3.94)”

5. At this time, Lord Penrose also observed (P chap 3.91) that: “There had been a further significant stage in the development of bonus structures. It is necessary to note that the crude level of terminal bonus, before any smoothing, was now related more or less directly to the investment reserve” (P chap 3.91).  The Society’s long history of a separate estate was effectively at an end.

6. 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.

7. The absence of an estate, with terminal bonus now taking up virtually the whole of the remaining unconsolidated investments, may have been instrumental in an executive management decision put in place a fall-back differential terminal bonus policy (DTBP), in case GAR option holders later came to be “in the money” (P chap 2.60-65).  This fallback DTBP was not communicated to the Board of Directors, and there is still room for doubt as to whether Sherlock knew of it.  It is arguable that concealment of the DTBP, 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.  It was certainly a branch on the growing seedling of bad faith.

8. Consistently with this, 1982/3 was also when the sophistries later elaborated in the “With Profits Without Mystery” (WPWM) manifesto began.  Sherlock, in his role as General Manager and Actuary, would almost certainly have read and sanctioned, if not reviewed and approved, the resulting paper of the same name, which was first delivered in March 1989 to the Institute of Actuaries. At any rate it was his responsibility accurately to represent the new paradigm the paper described in his 1989 report to the membership. With hindsight we may doubt that he and President Roland Smith did this well enough. For this P14.68-83 is essential reading. 

12. Lord Penrose summarises the history thus far as follows:  “ …Until 1972, the Society had a conservative and relatively unsophisticated approach to bonus, concentrated on reversionary bonuses. Capital appreciation was used sparingly: not more than one-tenth of the appreciation at any time was considered available for distribution.

Terminal bonus was introduced in 1973 as a marginal adjustment of total allocations at maturity.  The three-call system of reserving provided a rational basis for the appropriation of capital appreciation.  The system was conservative, making full and prudent provision for future reversionary bonuses during the projected period of deficiency of actual investment returns as against the benchmark yield on gilts.  The terminal bonus “fund” was the balance of capital appreciation, initially off balance sheet, but in and after 1982 shown in the investment reserve (my italics).  Allocation of the investment reserve to terminal bonus was made on a three year rolling average (P4.33-34)”.

13. The extra margin of regulatory solvency the1982/3 manoeuvres produced was now also distributed.  Lord Penrose duly observes later on:  “By this stage, the Society had eroded the “strength” (my quotation marks) of the 1982 balance sheet by progressively cutting back on the reserve for future reversionary bonus until it was eliminated, they had used the previously un-attributed accounting adjustment from 1982 of £4 million, and finally had explicitly, at least in 1987, made a bonus allocation in excess of available returns”(P3.154).   As the PR and the various Burgess Hodgson papers on the EMAG website (www.emag.org.uk) make plain, this situation continued for most of the Society’s remaining life.

14. This involved treading a narrow path very carefully, which was facilitated by keeping accounts related not just to two approaches to asset and liability valuation as mentioned in EARW, but three, namely Companies Act accounts, regulatory returns, and internally for management purposes, its “office” valuation.  Lord Penrose adds:  “Subject to the discussion that follows, the office valuation approximates to a realistic presentation of the Society’s actual financial position” (P 6.2).  The implications of this are far-reaching.

15. The next turning point arose in anticipation of the new personal pension and cessation of GAO policies.  Lord Penrose relates:  “ On 24^th June 1987 the actuary presented a paper on the new personal pension then expected to be introduced from 4 January 1988. The paper did not identify features of existing business that would be departed from (my italics).  It stated, however:

“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”

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 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 (all my italics:  P 3.138-40).

Lord Penrose 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 never should, could or would have contemplated the inequities and risk that, together with loss of the estate and persistent over-allocation, thereby transferred to the new fund and its future policyholders.  From this point on, if not since 1982-3, the Society was trading on a false and fraudulent basis; one that went on to enmire a further 930,000 new non-GAR members.  The magnitude and duration of the resulting fraud is truly astonishing, and the burden of responsibility carried by the “senior management team” is correspondingly heavy.  One naturally wonders who the instrumental members of that team were over the period 1982-8, and looks 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 the circumstances there is a continuing and serious injustice in the authorities leaving their fate to the whim of the adversarial process without having helped to clarify the background.  On this subject Lord Penrose concluded:  ”…It appears unlikely that most members of the Board knew of the differential terminal bonus policy or its implications until the autumn of 1998, or that those who knew anything of the policy understood that it could have serious implications for the Society” (P2.112; my italics). 

16. The next important development came in 1988-9, and was marked by the delivery and publication of the WPWM paper, the origins of which (as the paper itself says) were heralded by the changes in 1982-3.  Lord Penrose discusses it in P4.1-11 and 4.24-6.  A more detailed criticism of it has been given in EARW Sections 3 & 4 plus Appendix I, which has been summarised above.  However, it must now be re-appraised in the light of knowledge that the Society was over-allocated when it appeared, and that the senior management team already had the undeclared DTBP in place.  Furthermore, at least three presumed members of that team (Ranson, Headdon and Driscoll) had devised the WPWM paradigm.  It is sufficient to add that sophistries based upon a premise which is secretly liable to renegation are fraudulent. Consider again whether P14.68-83 represented this correctly.  The sapling of fraud had sprouted new leaves, and each WPWM sophistry in time grew to become a branch on a mighty tree.