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

So who gained the estate, plus further over-distribution at later policyholders’ expense?

1. Besides saying how the money may have disappeared, Lord Penrose has also indicated where and when it did so.   Professor Smith’s presidential statement in the 1992 accounts includes: ”… The fundamental philosophy is that each generation of policies should receive benefits commensurate with the earnings produced during its lifetime.  Beyond the bounds of normal commercial prudence, it would be alien to our culture to hold back benefits from one generation to build reserves for a future generation.  As we say in our literature, for new policyholders future bonuses must depend primarily upon the earnings produced on the investments of the new premiums.  Any deliberate cross subsidies between generations would not be “equitable”.  Lord Penrose comments:  “As appears frequently in these documents, there was an inherent contradiction in the statement.  If nothing was held back for the future, any over-allocation had to be recovered from the future.  That had to involve deliberate anticipatory cross-generational subsidy and to be, in these terms, ‘inequitable’” (P chap 4.82-3, my italics; see also EARW p7).  Did Professor Smith know this?

2. A more detailed account of cross-generational subsidy is given in chap 6.71-3.  Lord Penrose explains: “…While the split between GIR, reversionary bonus and final bonus might vary depending on the policy structure, the same total return was credited to accumulated policy values regardless of duration.  This contrasted with the practices of many other companies with significant amounts of single premium business, where more flexible bonus systems allowed for variation according to duration in-force and financial experience over the relative periods.  This flexibility allowed inter-generational smoothing and enabled the company to avoid locking in to payout patterns in the way the Society did” (¶ 71).  And:  “More generally, it is unclear on what basis the Society could ever have expected to have been able to operate without inter-generational transfers in the absence of flexibility to differentiate by duration.  In With Profits Without Mystery it was acknowledged that each generation of maturing policies was dependent on capital provided by succeeding generations. Flexibility to differentiate by duration would have been necessary for such a system to operate fairly in the absence of an inherited estate.  The Society’s practice did not provide that flexibility, and, given its full distribution policy, over-payment on older duration policies was the direct result” (¶ 73).  This, then, was a crucial piece of knowledge for better-informed policyholders or groups if they wished fully to exploit product flexibility, and the availability of total policy values from 1987 onwards.  It also seems fair to assume that few individual members without access to well-connected financial advice would have known this.

3. With this explanation in mind it is also instructive to look at PR Table 6.13, which shows the effect of accumulation in policy value alone or as a percentage of asset share, and of the different categories of bonus within policy value. It covers the years 1980 to 2000, and it illustrates how terminal bonus becomes the dominant element over time.  Table 6.16 is a similar breakdown, but based on asset share per £1000 invested annually over the same period, and it paints a broadly similar picture. Unfortunately however, these tables do not go back far enough to cover the whole of the critical period spanning dispersal of the Society’s estate.  Interestingly, however, there is a table of terminal bonus accumulation over the 35 years preceding 1999, albeit expressed as a percentage of all the guaranteed elements. It forms part of Society leaflet (45J099 WP/UL 2.99) entitled:  “Pension and Life Assurance Plans. Annual Statements- Further Information”.  When plotted as in the figure below, the data show that the biggest relative annual terminal bonus additions were made over the 1973-86 period, i.e. that spanning the dispersal of the estate during which Barry Sherlock was the Appointed Actuary and subsequently Managing Director. This was also the period of steepest relative accumulation rate of terminal bonus.  The graphs also indicate how much terminal bonus was awarded retrospectively to policies in force during the decade prior to its introduction in 1973.

NB: The cumulation profile illustrated is relative to the guaranteed elements of individual asset share and guaranteed bonus cumulation (the cumulation of which is also important for determining the absolute amount of asset share, which in turn depends upon individual contribution history). It assumes a constant level of annual contribution, but, given the structure of the fund, suitably informed policyholders might have done well to increase their later contributions, which they could do up to a maximum tax allowance limit.  They would also then have had to crystallise their gains at an appropriate and advantageous time; later policyholders whose policies had more time to run were perforce left exposed, and had also to meet the costs of previous over-distributions.  After 1985/6 the real glory days of terminal bonus and potentially crystallisable gain were over. From the sales point of view it all looked very impressive, and so it is not surprising that the senior management team wished to carry these figures over to support an extended fund in 1987.  The prospect of such performance continuing on the same basis was, however, entirely without foundation, such that the use of these prior performance figures was inappropriate, un-representative, and misleading.

4. The beneficiaries of  “deliberate anticipatory cross-generational subsidy”, who received the rump of the estate and more between 1973 and 1987, were thus longer duration policyholders who were selectively favoured (P3.46, 51, 60, 74, 94, 103, 109, 112, 129, 144, 145 items 5 & 8, 152, 161 & 168; P4.16 &36; 14.68).  And since the GAR option was withdrawn for policies begun after 1988, this group was also essentially comprised of longer-term GAR policyholders.  Moreover after 1987,  “The advertisement of “policy value” to members who had reached an age at which it was open to them to take their benefits allowed those with the financial acumen or appropriate advice to elect for an early maturity date and crystallise their benefit entitlement at an unduly high value to the disadvantage of continuing members.  In the early 1990’s, this was facilitated by new flexible products developed by the Society” (P4.29).  The implications of this are serious, and the more so if they involved fund switching.

5. One reason for the selective bonus allocation to policies of particular durations was said to be maintenance of the Society’s position in performance tables, i.e. marketing considerations. But, as explained in EARW Section 3 p9 et seq., the historical problem was that established members would resist significant increases in membership because it diluted their own claims on the estate.  Given the Society’s commitment to expansion and to retain FSSU members, it would have been politic to forestall this by awarding longer term members a disproportionate share of the estate. One must also hope that similar favours were neither sought nor proffered for inward transfers of longer duration policies during the drive for expansion.

6. Lord Penrose summarises some of this as follows: “In 1986 and 1987, the sums available in investment reserve were supplemented by the appropriation of general reserves amounting to £4m to massage total payouts on pension business at sensitive durations, taking the Society into a position of over-distribution by the end of 1987 at the latest.  Adverse market conditions aggravated the position, and an excess of aggregate policy values over available assets continued into 1988.  In 1989, when there was a good return, the Society deliberately distributed a high proportion of the available return for market-related reasons, and accordingly entered the 1990’s with a negative estate (P4.36)”. But, as revealed by the above account and graph, this is unlikely to be the whole story. 

7. Depending upon personal and external circumstances, postponement of retirement could also achieve the same end.  Consider, for example, Headdon’s explanation of why the actual results for 1995 had shown payments to policyholders considerably in excess of those projected for the year.  “ It appears that some clients were delaying retirement until the managed pension contract became available.  A substantial part of retirement proceeds will, in fact, have been left with the Society and contributed to the premium income position…”.  In the same paragraph (P4.128) Lord Penrose himself continues:  “The consequences of the managed pension for policyholders was to become a significant factor in the closing years of the reference period.  Evidence from the independent financial adviser sector indicates that some at least some of its practitioners appreciated that it was to the advantage of their clients to take benefits at a time when policy values were high relative to underlying assets.”

8. These inequities were complicated by the fact that group pension scheme trustees were able to delay the withdrawal of GAR policies in 1998,” insisting on the right to introduce new members to their schemes for a further five years” (P2.43-4). This would also have made the introduction of the DTBP a very sensitive issue until the five grace years were up, which is highly likely to explain why it did not surface until 1993, even though the need for action of some sort was increasingly urgent.  If so, it also had the effect of extending the period during which GAR crystallisable gains could be made with impunity.  For a discussion of the significance of this and related matters see the “Fat Cats and Poor Mice” section of the Level 2 narrative. 

9. Assuming that they were members of the Society’s pension funds, we may follow the combined effects of all this on the pension fund contributions of Sherlock, Ranson, & Headdon.  The PR does not say when Sherlock joined the Society, but that he retired in 1991.  He would have been a contributor for several years before Ogborn retired, and so would have got all the retrospective terminal bonus additions as shown in the figure.  He would also have crystallised his gains at full value with all his fund choice options intact.  Ranson, who joined the Equitable in 1951, would likewise have accumulated the same terminal bonus as Sherlock.  He retired in 1997 after the DTBP had been announced and implemented, and so assuming he stayed in the w-p fund he would have had to take the hit if he exercised the GAR option. However, his GAR in possession would have been at a low rate, such that he might not have considered himself sufficiently “in the money”. Under the prevailing circumstances and given his expertise, he may not have elected to remain in the w-p fund.  Headdon joined in or around 1978.  The figure indicates that his terminal bonus accumulation would have been approximately 2/3 that of Sherlock and Ranson.  However, he would have had a higher GAR in possession.  Even so, at the time of his forced resignation on March 1^st 2001 he would have been most unwise to take his benefits from the w-p fund.  Nash’s situation would presumably have been closer to Headdon’s than Ranson’s-  he resigned on Dec 8^th 2000.

 No estate + no un-hypothecated reserves = no smoothing policy…

10. Accordingly, despite looking, Lord Penrose has found no evidence that any defined smoothing policy ever existed under the WPWM concept. He summarises:  “There was at no time a statement of the Society’s smoothing policy.  There was no specification of smoothing parameters, as regards a target line of equilibrium, deviation above or below any such line, target durations of any smoothing cycle or any other factor.  The description of the position in the late 1980s as a point on the smoothing cycle appears to have had no basis in reality.  It would have been possible to consider the restoration of reserves between 1976 and 1982 as part of a smoothing process if the parameters had been defined.  From 1982 until the end of the decade the Society had progressively weakened its reserves until a negative position had become established where policy values intimated in illustrations and on payout exceeded available assets.  If there had been a smoothing cycle, it was without defined limits of value, and it was without defined limits of time” (P3.169. See also P6.22 & 12.121-3.)

…so how did the Society maintain the semblance of one under circumstances of chronic over-allocation exacerbated by debt?

11. What passed for a smoothing policy was expressed rather differently, and to understand it one must first make a distinction between the mechanisms the Society used to meet the guaranteed and non-guaranteed portions of maturing claims. In Lord Penrose’s words:  “Terminal bonus payouts were made out of current year surplus with the remainder of the actuarially determined surplus being made available for declared bonus or carried forward.  Consequently the value of a claim would represent a policy’s aggregate policy value with the guaranteed portion being met by a reduction in the Society’s liabilities and the non-guaranteed (terminal bonus) portion being met by a reduction in current year surplus.  This method was adopted in both the accounts and the return.

The Society’s ability to account for terminal bonus in this manner circumvented recognition in any form in either the statutory accounts or the regulatory return of the balance of the accumulated terminal bonus accrued on in-force business and intimated to policyholders (my italics; cf. EARW Section 4: Sophistries of the Second Order Item 3).  Whether or not the Society was under any obligation to account for the accrued value of such terminal bonus allotments (which gave rise to an off balance sheet exposure) in either its accounts or returns depends on meaning and effect of the various reporting requirements discussed earlier” (P10.78-9). Bluntly, the guaranteed element was booked for without the backing of a free asset or mismatching reserve, while the floating terminal bonus element was both taken off the books and “ponzified”, i.e. allowed to be the first call on the Society’s annual income as policies successively matured in an uncontrolled, albeit not entirely unpredictable fashion.   Ponzification of the un-guaranteed element thus became the mainstay of short term “smoothing”

Thus informed we can address P12.121-3, which state:  “Ernst & Young sent a monthly insurance letter to the Society.  In October 1995 the letter was entitled “Creeping Insolvency”.  It raised a number of points.  It suggested that non-executive directors of life offices might want to consider the following issues (my italics):

i.                     Not all the surplus represented by the difference between assets and liabilities would be available as “free capital”.

ii.                   Part of this surplus would need to meet the cost of terminal bonuses, and the amount would be determined using assets share techniques.

iii.                  It was, of course, true that until the terminal bonuses were paid, the relevant funds were available for investment, including investment in new business (i.e. the so-called “investment reserve” mentioned in the WPWM paper- MN), but care needed to be taken in matching cash flows, taking into account the maturity profile of the with-profits portfolios.

iv.                  The non-executive director might therefore ask the Appointed Actuary to demonstrate the level of free capital after allowing for terminal bonuses and additional capital required to smooth bonuses.

v.                    It was quite possible that the resulting free capital could be negative, which would indicate an urgent need to reduce bonus rates and move to a lower risk investment strategy.

Headdon responded to Ernst & Young stating:

“I was very interested in the above newsflash on questions a non-executive director of a life office might ask the Appointed Actuary.  There was, however, one point, which caused me some concern.  That was the suggestion on page 3 that, if the free capital after allowing for terminal bonus is negative, that indicates an “urgent need to reduce bonus rates and move to a lower risk investment strategy”.

If one considers a with-profits mutual which operates on the “revolving fund” principle with no estate and which aims for a “full distribution” policy, then, on average, policy values should be above underlying asset values half the time.  (They would, of course, be below for the other half of the time.)  For such an office that is what smoothing would mean” (my italics: see also EARW Section 3: Sophistries of the First Order Items 3-7).  Headdon’s “smoothing” was thus maintenance of total policy value  by means other than more formal reserving, and not by easing any fluctuations in the annual overall rate of return.

Bannon (E & Y’s audit actuary John Bannon- MN) replied on 8^th November saying,

“I agree entirely with the point you make regarding free capital in the context of a revolving fund principle with no estate”.  He agreed that the sentence quoted by Headdon should therefore be qualified.  He added, “I have to say I am very much in favour of the “full distribution” policy, but when I wrote the article I had more in mind those offices which maintain a cushion of free assets to facilitate smoothing.”

It is not clear from his reply that Bannon had fully appreciated what Headdon was saying, and which did not tally exactly with Sherlock’s account of smoothing in his February 1989 letter to RAP policyholders (P14.71). Sherlock wrote:” …the benefits under our with-profits policies depend primarily on the successful investment of the premiums and only marginally on profit arising from other policies.  Further, we aim to ensure that the total proceeds members receive reflect the investment returns on the fund during the course of the policy.  However, the essential nature of with-profits business, namely the steady addition of declared and, therefore, guaranteed bonuses, means that there is no automatic link between asset values and policy benefits (which with hindsight resembles Ponzi by another name-my italics).  In simple terms there is a smoothing of asset values over time and of the peaks and troughs through the bonus system. Although the with-profits system contains within it an essential element of smoothing, nevertheless the Society’s practice is to limit that to evening out peaks and troughs and unduly sharp changes from year to year.  Specifically, we do not set out to build up excessive “free reserves”, which some describe as “strength”.  This could only be done by deliberately, or worse still, accidentally, withholding part of the return due to members for the benefit of their successors. What is important is that there should be sufficient strength to avoid any unplanned constraints on investment freedom or growth in business (if only it had been so- MN), while still giving “full value” return to existing members.”  Policyholders would not have welcomed the idea that policy values were subject to fluctuation from year to year, and would have understood smoothing in its more normal sense of operating on the annual rate of return only, and not policy values as well.  And since Lord Penrose stated earlier in the same paragraph that the hidden DTBP was not mentioned, policyholders would not have known what else was implicit in the above italicised sentence. Once again the rest of P 14.68-83 is useful background information, and cf.16-17 above.

These extracts are of particular interest because they bring so many critical aspects of the story together, and illustrate why their combination had such far-reaching effects. They also give an inkling of John Bannon’s expectations as to the degree of working knowledge that non-executive directors should have had, but which had not been provided at the Equitable.  One is also bound move beyond Lord Penrose’s exposition and ask what hope there could have been for keeping policy values above underlying asset value even half the time once more debt had been taken on to extend the original over-allocation.  Next, factor in the belatedly and obscurely disclosed DTBP, and attempt to reconcile it with the “ponzification procedure” in a climate of good faith: at which point the edifice finally collapses. In essence, this is the sophisticated position that eluded directors, E & Y, the F & IA and the regulators. We should not too readily assume, however, that individual actuaries and auditors in various branches of their professions had not suspected or deduced the essence of what was afoot.