An Equitable Assessment of Rights and Wrongs

by Dr Michael Nassim

CONTENTS

AN EQUITABLE ASSESSMENT OF RIGHTS AND WRONGS

A paper by Dr Michael Nassim

12 January 2004

SUMMARY AND OVERVIEW

Overall objective

This article attempts to provide a general picture of what the underlying problems were at the Equitable Life Assurance Society, and hence how the different classes of member have been wronged and suffered losses.  Without it there is no yardstick by which to judge the relative importance of its many aspects, or balance the conflicting legal opinions that spring from different interests and which are otherwise a premature distraction. With it we can make the necessary assessments, and gauge the appropriateness of other broadly based opinions such as the Penrose Report when they appear.  We may also develop it further as other relevant facts emerge, and carry the new understandings forward as circumstances dictate.  But for the Internet and the work of many people thereby made available, the task would be impossible. From it the important facts, representativeness of extracts, and the faithfulness of abstracts in the main article can mostly be checked.  The result is as much story as picture, and it touches a number of areas:  historical, actuarial, insurance, business and marketing, investment and financial, accounting standards, loss adjustment, socio-economic, legal, ethical and regulatory, institutional and corporate governance, and political.

Sophisticated Plans and Practices 

Of central importance were seminal decisions and actions which took place prior to 1989/90, i.e. around the time that Guaranteed Annuity Rate (GAR) policies were discontinued.  They overturned the traditionally successful business and insurance paradigm of the With-Profits Fund, affected all policies sold subsequently, and adversely influenced the manner in which the Fund was administered and represented.  Sophistries were the bedrock, and it is also relevant that they are in essence antithetical denials of the major lessons previously learned in the Society’s own history.  Of special importance was an overarching sophistry to the effect that a With-Profits Fund could be run on what has euphemistically been termed a negative technical solvency gap.  This arises when the sum of all total policy values exceeds the assets, whereas absolute insolvency arises when the assets are exceeded by the sum of the guaranteed portions only in all policies. These two criteria can give rise to very different valuations and expectations of the asset shares of individual policyholders.

Though the un-guaranteed portions are unconsolidated, and might do multiple duties to cover other contingencies until required, ultimately they are a “moral charge” on the assets.  In times when the unconsolidated terminal bonus element of policies is high this becomes important.  The Society maintained that it was in practice unimportant, because its declared practice was to pay out total policy values (including the unconsolidated element) in full, such that this was policyholders’ reasonable expectation.  Effectively, therefore, the moral charge was thereby made a real one, and the difference was only unimportant so long as the technical solvency gap remained small or intermittent.  But since this also implies a reserveless scheme, which could only work given well-nigh perfect forecasting, this was a vain and fallacious hope.   Other actuaries were unhappy with all this, essentially because it betokened a fund with scanty reserves, and perhaps insufficient financial strength in the event.  Actuaries were also concerned that all policies were indiscriminately placed in the same unitised fund and asset mix, irrespective of their maturities or levels of guarantee, because under conditions of technical or absolute insolvency some policies would acquire inequitable claims on the remnants of the fund.  Not surprisingly they wanted policyholders and their advisers to be informed of the potential risks that all this posed in accordance with the Financial Services Act of 1986.  To this the Chief Actuary of the Society paid overt lip service, but in practice nothing effective was done in over a decade afterwards. And so all the important omissions, dissembling, concealments and deceits stem from this sophistry, including dual and conflicting presentations of the new paradigm, firstly to a select but sceptical actuarial forum but then not the Society in full, and secondly of the accounts, an optimistic total policy asset share value version for members and a pessimistic discounted policy value asset share version for the regulator, which enabled the Society to survive for so long.

The Slippery Slope

The solvency gap arose because the Society’s estate had disappeared, or was in process of doing so. How, why and when this occurred is a matter of pivotal forensic importance, because the central sophistry sprang directly from it.  In the Equitable’s long history members and outsiders have repeatedly been tempted to raid the estate, and the Boards of Directors and the actuaries of the day had resisted this. It is therefore important to ask what other influences affected the Board and management on this final and fatal occasion, and if so why they were allowed.  The resulting gap led to the transition from a With-Profits Fund for old and established members to a With-Liabilities Fund for newer and future members, which in turn could not have happened unless the fund also degenerated into a Ponzi pyramid selling scheme, fuelled by irresponsibly high bonus declarations and total policy values.  In this it resembles the Lloyd’s debacle, and the ensuing “recruit to dilute” campaign whereby asbestos claims liabilities were transferred from old to new “Names”.  Hence there is also a need to find out from what level in the Society any “incentivised ignorance” of sales personnel originated.  This must be balanced against the more innocent picture of an office which was unduly influenced by commercial and marketing considerations and expanded too rapidly, giving away overmuch as incentives to gain new business and incurring excessive strain on any remaining reserves in the process.  The Society may also have ascribed overmuch importance to the profitability of investments in its sole asset mix when investment certainty and insurance should have been its overriding priority.  Though there may be elements of truth in this, it does not explain the Society’s persistently duplicitous and irresponsible conduct or the origins of the faulted paradigm on which that conduct was based. Nor does it explain why the repeated warnings against injudicious expansion by eminent actuaries in the Society’s own past were also neglected.

The coherence, consistency and duration of the ensuing misdemeanours indicate that when traced fully backwards they will have relatively few origins. They are also tantamount to fraud because they satisfy its cardinal elements.  These are:

• Knowledge of facts, events or circumstances by one party;

• Misrepresentations (including non-disclosure) of that knowledge in dealings with another;

• Reliance on those misrepresentations by the second party;

• An agreement, contract, or transaction between the parties which a reasonable person would not have entered into if privy to the first party’s knowledge, and

• Harm or damage to the second party as a result.

Human nature and corporate life being as they are, there is no point in calling for a witch-hunt until it is clear to what extent the situation was a response to the pressure of evolving circumstances, or was more deliberately contrived.  What those circumstances may have been, and the corporate and contemporary culture through which they may have operated is also explored at some length in the main article.  And if the Society’s descent into fraud was insidiously cumulative, many officers and directors are likely to have been either too closely or loosely engaged to be aware of what the whole amounted to.  Even so one cannot escape the conclusion that some did know, or perhaps that others too long suppressed their real doubts.  For the sake of the innocent this needs close attention.

The Fall

The underlying situation all this created was thus highly fertile ground for future trouble. In the 1970’s there had been brisk inflation and high interest rates such that equities also increased in monetary value and many pension funds began to acquire surpluses; at the same time traditional safe investments like fixed interest securities became less attractive.  But when more normal conditions eventually returned interest rates fell and there was an eventual secondary reactive dip in the value of equities, which were no longer an indiscriminate hedge against inflation. Under these circumstances growing numbers of earlier policyholders (pre-1988) exercised their rights to guaranteed annuity rates (GAR) when they retired and took their annuities.  The Equitable With-Profits Fund became technically insolvent, and to such an extent that the Society reneged on policyholders’ reasonable expectations by cutting the terminal bonuses of those exercising the GAR option. As is now common knowledge, the House of Lords deemed this selection against one group of policyholders unlawful, and this decision precipitated the current crisis.

Another expensive crisis waits in the wings, because when the Society stopped policies with the GAR option, from 1988-96 they awarded a guaranteed interest rate of accumulation of 3.5% per annum (GIR) to policies until they matured.  In practice this could be arranged to cost it little or nothing, mainly because although the accumulation rate was guaranteed, the proportion allotted as guaranteed and un-guaranteed annual bonus was at the Society’s discretion. What the product particulars did not relate is that once an annuity was taken, the minimum total rate of return to ensure it remained level was also raised by 3.5%, such that it suffered an automatic below-the-line compound drain rate 3.5% p.a. on both its guaranteed and un-guaranteed elements. Hence GIR policyholders and annuitants are at a disadvantage compared to earlier GAR and later non-GIR policyholders, because their annuities erode at a greater rate.  Ironically, now that the fund is closed to new business the Tontine effect also threatens to disadvantage GIR policyholders selectively versus newer policyholders who do not have them. Increasing life expectancies will exacerbate this problem, and place more strain on the remnants of the fund.  Alas this issue was not addressed in the Compromise Scheme, which is why further troubles now threaten.

Causes and Consequences of Regulatory Failure

Though individual actuaries had between them spotted the big trees, their vision of the whole wood was less clear.  Neither they nor the Government Actuary’s Department appear to have articulated it.  They had, however, been informed that the paradigm they faulted had been presented to and deemed attractive by an unspecified number of policyholders. This may have allayed their suspicions somewhat, but it begs the question as to why, if the paradigm was so well received, it was not thereafter disseminated to all policyholders and their representatives either as a whole or in any reasonable degree of detail.  Beyond this, lack of awareness by the profession of its own history and communication deficiencies in the regulatory network identified in the Baird Report may have contributed to the ensuing regulatory failure.  But in practice, no regulatory apparatus can function any better than the milieu in which it operates.  Sadly, the informing and guiding influence of Government was also deficient; had this been better exercised the consequences of regulatory failure would not have attained their present dimension. Instead the Government has chosen to be inactive and silent, which gains it three advantages:

• A low profile and reduced need for uncomfortable decision-making

• Avoidance of responsibility

• Delay in settling for its share of financial consequences until as many Society members as possible have in different ways accepted less than their due.

This is a familiar position, and in that the deficiencies occurred long before, during and after the Compromise Scheme vote, both political parties may have some responsibility for it.  Here warily recall that the government of the day indemnified Lloyd’s by special Act of Parliament before the Lloyd’s Bubble burst.  It would be unfortunate for Her Majesty’s Opposition if this now inhibits them, because the Equitable Bubble is big enough to involve around 2% of the electorate directly, not to mention their dependants.  Moreover this inaction has had three enduring consequences for the Society and its members:

• It denied the New Board of Directors constructive external help at a crucial time.

• It allowed the Financial Services Authority to avoid reassuming its responsibilities, and advise on whether or not members should accept the Compromise Scheme.

• It has condemned the New Board to persist with and defend the discredited paradigm and all its consequences, to the detriment of members past and present.

Even so, the New Board should have known better than to maintain that mis-selling did not have a central and generic character such that future litigation could only be individual and piecemeal, or that the total shortfall in the funds was solely due to the GAR liability and could be as little as 1.5 billion pounds.

Basic Wrongs Suffered by Policyholders

At last we can glimpse something of how the various categories of member have been wronged, and gain a more accurate impression of their losses.  Most if not all have suffered the following:

• Loss of the security and benefits of a longstanding and traditional estate, most notably including:

• Loss of ongoing With-Profits Fund character and status

• Excessive and inequitable mutual insurance, partly caused by unequal guarantees or the hidden penalties thereof; not yet fully resolved.

• Greater deficiencies in the Fund than revealed by the New Board.

• Harm arising from fraud, whether intended or in response to circumstance.

• Harm resulting from regulatory deficiencies and government inaction, notably including:

• The necessity for the Society to persist with a discredited and deceitfully imposed paradigm.

The main article also addresses factors affecting individual categories of policyholder.  These largely depend upon their guarantee class, whether or not they accepted the Compromise Scheme, whether they are now annuitants and their status as voting members or otherwise, which in turn calls into question the role of their Trustees.

Expectations of the Penrose Report

This, then, is the kind of structure that we should expect the Penrose Report or any other comprehensive inquiry to probe, illuminate, refine or expand.  If it fails to do so in any important respect then the reasons for this will need to be exposed, and further prompt action will become necessary.  To help forestall such an unsatisfactory outcome the main article also attempts to anticipate why it might come to pass. In that lamentable event Equitable victims and the electorate must also remind Government of its responsibilities, and lay them plainly at its door.