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

Valuation and hypothecation considerations.

1. With the understandings of the previous section behind us, we may usefully consider the potential ambiguities in hypothecation and valuation methods, of which the Society took over-liberal advantage during the period we have been considering.  In P13.36 Lord Penrose quotes Ronald Skerman as follows: “If solvency were understood to mean no more than the fulfilment of contractual obligations, it would be appropriate to use a gross-premium method of valuation (i.e. one under which the net liability is the value of the sums assured, and any existing reversionary bonuses, less the value of the office premiums actually payable reduced by an appropriate allowance for future expenses).  It is not considered, however, that this would be satisfactory in relation to with-profit policies.  Under with-profit policies policyholders pay premiums greater, and sometimes materially greater, than are required to provide the sums assured on death or maturity.  If credit is taken in the valuation for these premiums less an appropriate allowance for expenses, this would mean that amounts included in premiums payable in the future which ought to be available to provide future profits would be capitalized so as to reduce the amount of the liabilities, and that for some years after issue the net liability under a policy would be negative.  Thus, an office would be able to fulfil a solvency test using the gross-premium method of valuation, even though it had spend the amounts included in premiums payable in the future which the policyholders would expect to be used to provide future profits.  Such an office would not, however, be in a position to fulfil the reasonable expectations of its with-profits policyholders because it would have little or no prospect of providing profits to them in the future. 

Under the net-premium method of valuation, the premiums valued exclude any amounts included in with-profit office premiums which would provide profits to policyholders.  Thus, these amounts receivable in the future are not capitalized so as to reduce the amount of the liabilities and, if solvency is demonstrated using a net-premium method, then, broadly speaking, the amounts included in future premiums which should provide profits for policyholders will, in fact, emerge as surplus from year to year in the future and be available for this purpose.  The use of the net-premium method leads to the thought that in relation to with-profit policies the suggested standard dose a good deal more than achieve solvency in terms of ensuring the fulfilment of contractual liabilities.  It might better be regarded as a standard of good conduct so far as with-profits contracts are concerned (my italics).”

2. With Skerman’s thoughts in mind, we move next to pages 2 & 3 of Appendix 3 to the Corley Report:

7.       “The Equitable reported to its members through its Companies Act Accounts (the “Accounts”) and also through returns to the FSA (the “Returns”).  These FSA Returns have the specific objective of demonstrating that the excess of assets over liabilities, both conservatively assessed, exceeds a minimum level of capital specified by European legislation.

8.   The standard approach by most UK long term insurers is for the long term provisions in the Accounts and the equivalent provisions in the FSA Returns to be identical.  However this is not prescribed, provided that the provisions are calculated in accordance with the actuarial principles set out in the EU Directive on the solvency of long term insurers.

      The Equitable was exceptional, if not unique, by adopting a “Gross premium” valuation basis in their accounts, and this was the item rationalised in their 2000 accounts as “realistically prudent technical provisions.

9.       A Gross Premium basis establishes as a long term business provision a present value for future cash flows, including an allowance for bonuses payable on with-profit policies.  The Equitable’s returns indicated that they made a specific allowance for rates of future reversionary bonus additions at levels consistent with the valuation interest rates used.  They indicated that the balance of total policy proceeds would be met by final bonus additions at the time of claim.  Such additions were not explicitly reserved for in advance but were implicitly covered by the assets in excess of the provisions.  Until 1998, no explicit provision was established for the guarantees as they were regarded as covered by terminal bonus adjustments (my italics).  Paragraphs 3.11 and 3.12 of the Annuity Guarantee Working Party’s report (listed in Appendix 9) are of some relevance here.  The accountability for such provisions in the Accounts is that of the directors, who would look to a “reporting actuary (as envisaged by Guidance Note 7) for comfort.  The reporting actuary is not necessarily the Appointed Actuary.

10.   The returns require a “Net Premium” valuation basis- the “statutory reserve”.  This generates an ultra prudent assessment of the provision to pay contractual liabilities (but not of the amount needed to satisfy policyholders’ reasonable expectations).  An additional margin is added through a resilience reserve to provide for the extra liability if certain prescribed adverse deviations from the basic assumptions occur.  The Appointed Actuary has to certify the technical provisions and resilience reserves.  Compliance with GN1 and GN8 also has to be certified.  GN8 says that the actuary must be satisfied that the long term fund is able to support a proper level of future terminal bonus having regard to the bonus smoothing policy (always assuming there was a valid smoothing policy- my italics).  This support may be available in any excess of the asset value of the fund over the statutory reserve and in prudential margins in the technical reserves.

11.   In the pre-resilience reserve era it is conceivable that a Gross Premium basis might have looked quite strong compared to a typical Net Premium valuation with allowance for deferred acquisition costs, particularly in the financial conditions of the time.

The existence of margins in the valuation basis, especially pre valuation regulations, enabled a company to provide in an implicit fashion for options. 

The fact that an explicit provision for an option was not established does not necessarily mean that a liability has not been provided for.  We can merely note the existence of margins; we were not able to assess the adequacy of these to cover the additional liability related to options (on any of the three bases outlined in paragraphs 4to 6 above- my italics).

12.   Neither the accounting bases nor the solvency reporting bases described above include an explicit allowance for terminal bonus.  It follows that, to the extent that GARs could be met by reductions in terminal bonus, the accounting and solvency provisions would not necessarily have to be augmented to cover the cost of the options”.

Lord Penrose summarises this situation and the modified Ponzi element in P10.78-9:

“78.  Terminal bonus payouts were made out of current year surplus with the remainder of the actuarially determined distributable 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.  The method was adopted in both the accounts and the return.

79.  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.  Whether or not the Society was under any obligation to account for the accrued value of such terminal bonus allotments (which gave rise to and off balance sheet exposure) in either its accounts or returns depends on meaning and effect of the various reporting requirements discussed earlier (my italics).”

One way or another, this state of affairs could only have been contrived and consistently maintained in deliberate and conscious bad faith.  In considering this further, please refer to the next section, which deals with PRE, issues of good faith and related duties.

3. It is therefore of interest that Corley was in the Presidential Chair and Skerman was in the audience when Ranson presented WPWM to the Institute of Actuaries in London.  Skerman did not comment on the inappropriate use of the gross premium method described in Section 3.1 of that paper, possibly because he expressed approval of the working definition of PRE given in section 4.2.4, which said:  “A natural consequence of those views is that “policyholders’ expectations” expressed as a relationship of future bonus rates to current levels are also meaningless.  In our view the reasonable expectations of policyholders are that an office will conduct its affairs so as to produce the best return it can in the conditions which prevail, and will distribute those returns fairly between different participating policyholders in a way which smoothes the emergence of the earnings.  Such an approach is, of course, very much in tune with that expressed by C.S.S. Lyon in his recent paper.  The approach is also useful internally in, say, discussions with directors about maintenance or otherwise of bonus rates.  If future bonus rates are clearly seen to depend upon future earnings then it is not difficult to paint the various pictures arising in different investment climates.” It is now clear, however, that the Equitable senior management team had not adhered, did not adhere and would not adhere to this definition, such that Skerman was among the many who were deceived.  Nevertheless J. Plymen (WPWM p332-3) was very clear about the virtues of the net premium method, and pointed out that other valuation systems were inequitable, if more competitively attractive over the short term.  He concluded that a “…system of analysing the surplus of a net premium valuation by an adjusted gross premium valuation gives all the answers on the following counts:  The size of the estate; the strength of the investment reserves; the effects of rising costs; projected profits for the next three years, using a form of model office; the long term growth rate of profits; for proprietary offices, and evaluation of the share price.”  Events were to show that, given their special knowledge and the questions they needed to be answered, both the prudential and conduct of business regulators should have been making similar complementary use of valuation methods.  They should also have been alive to the dangers of the gross premium method in the Equitable’s peculiar circumstances.  In due course the need for complementary valuation methods became more widely recognised, and a similar complementary valuation methods were proposed and debated from 1996 onwards (P13.88-98).  Since GAD (government Actuary’s Department) actuaries made contributions to this debate and publication record, their failure to follow the position up is the more surprising.  And it is also clear that the Society’s use of the triple accounting process was antithetical to Ranson’s 1988 statement in discussion of Lyon’s paper, from which we can only conclude that it was done in deliberate bad faith.

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

4. Having just touched upon valuation and the regulatory returns in relation to PRE we may move on to 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” (my italics).  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.  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- 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”(my italics; P chap 14.186).

5. 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 (my italics).”

6. 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.

7. 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 1989 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…” (P chap 19.78; my italics). 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; my italics).  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” (P chap 19.121.)  Where, then, was the good faith?  And how is all this to be reconciled with the prior covert existence of the DTBP?   

8. 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).

9. 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; my italics)”.

10. Having in ¶ 36 quoted Skerman’s exposition of his first principle in a most informative discussion of the gross and net premium valuation methods, (which is given in relation to hypothecation in the preceding section,) 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”(my italics).  But, at the Equitable that surplus, plus the prior estate and a charge raised against the future had been “deliberately” distributed elsewhere.

11. “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” (P chap13.9).  “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).

12. 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).

13. 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).

14. With this summary of PRE in mind, it is relevant that:

1. With regard to the Society, 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 (my italics).  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” (my italics).  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” (my italics). For an analysis of the Nash memorandum see P6.47-53.

2. 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; my italics). 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.

3. This is just one aspect of a more general conclusion from the PR:  “Certainly the Society’s single with-profits fund incorporated a very wide range of different types of business:  traditional life products, pensions products and pure investment products, domestic and overseas business, and even within policies of the same class there were often widely different types or levels of guarantee.  The Society’s bonus declaration resolutions ran to many pages of detailed allocations varying in kind and value.  The system depended on the exercise of the management’s wide undefined discretion and resulted in impenetrable complexity” (P20.10). That complexity became as impenetrable from within the Society as from without, for reasons explained under Corporate Governance below, and it all had the effect of precluding effective scrutiny. 

4. It also reflects the difficulties in equity and potentially excessive mutual insurance that can result from the indiscriminate placement of different policy types and maturities in one pooled unitised fund. Many aspects of this emergent situation had already been foreseen and criticised by the actuarial discussants of the WPWM paper in 1989 and 1990 (EARW section 3 p7-8; Appendix 1).  Of this Lord Penrose says:  “ At the inquiry reference date of 31 August 2001 there were therefore in issue pension contracts (a) incorporating an implicit guaranteed roll-up investment rate of return, and a guaranteed conversion rate in possession comprising a fixed rate of interest and a pre-determined mortality factor; (b) incorporating an explicit guaranteed investment rate of return and an explicit expenses deduction*; and (c) without guaranteed rates of any kind.  In the remainder of this section discussion relates to the pensions business, with particular reference to retirement annuity contracts, since that was at the heart of the Hyman case and was thought to lie at the roots of the Society’s difficulties at the reference date.  However, there were guarantees in other classes of business, and contrasts within similar groups of business.  For most of the relevant period, endowment assurances reflected implicit guarantees of investment return in the guaranteed sum assured.  Premium scales were constructed by adding together a charge for the basic benefit and a loading for profit participation.  In contrast, in 1990 the Society introduced recurrent single premium life contracts with no guaranteed growth at all.  Most business of this kind was sold in the form of single premium bonds.  The variety of contractual rights among policy types participating in the with-profits fund was considerable” (P2.50).

15. As initially explained, examination of the regulatory position is a secondary objective of this article.  But with regard both to PRE and the official Opposition case for organisational and operational regulatory failure (32 below), readers are invited to consider the PR’s extensive quotations (P13.107-12) 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.  This position had both prudential and conduct of business implications, and some of his specific concerns were highly relevant to the Equitable.  Readers are invited to consider whether history has since proved him right, and if so why the position was not followed up following his departure.