An Equitable Assessment of Rights and Wrongs

by Dr Michael Nassim

3.  A New With-Profits Fund Manifesto, or Sophistries of the First Order 

3.  A New With-Profits Fund Manifesto, or Sophistries of the First Order

This questionable subject was broached by Roy Ranson and Christopher Headdon of the Equitable in their paper entitled: “With Profits without Mystery”⁸ presented to the Institute of Actuaries in London on March 20^th, 1989; an analysis and commentary on it has appeared previously⁹.  Headdon delivered the paper again the following year on the 19^th February at the Faculty of Actuaries in Edinburgh¹⁰.  As will become apparent, it cannot have been easy to deliver the paper, let alone act on any comments or advice thereafter received, and so we shall later consider why it might have seemed necessary at the time. As to the origins of the changes described, in paragraph 1.1.3 Ranson acknowledged the help of his colleague D.C. Driscoll and the later help and involvement of C.P. Headdon, and that he formulated the position while working for his predecessor, M.E. (Maurice) Ogborn.  Though the wording is sometimes opaque, the more important points in the argument can be summarised as follows:

1. With-Profits Fund Members rather than shareholders are the owners of the Equitable as a mutual insurer (Ranson & Headdon section 2.2.1).  It is thus their premiums which finance all classes of the insurers’ business, and hence they who receive the resulting surpluses or meet the liabilities.  Members who do not participate in the With-Profits Fund are not owners of the Society, and any profits arising from the administration of their funds would pass to the With-Profits Members.
2. This said, the returns made from other business should be small, because otherwise the principle of mutuality would be denied to non-owning members not in the With-Profits Fund (R. & H. section 3.3.7).
3. The current generations of living With-Profits Members also own the Society’s accumulated asset estate, which includes all unassigned assets not reserved against known liabilities.  It can therefore be distributed to them in proportion to their (current) asset shares (R. & H. 3.2.1).
4. Current members also own the liability estate, namely those assets reserved against known liabilities, whether actual or foreseeable.  Ordinarily the actuary has then to ensure that this reserve is sufficient in the event, but without being excessive.  In effect, therefore, it forms the main smoothing reserve of a With-Profits Fund.  However, if the fund is effectively run as a pooled unitised managed fund which is ultimately (if indirectly) rooted in current market values (R. & H. section 3.2.4), then the smoothing reserve need only be minimal, and the deemed excess can also be distributed to current members as their policies mature.
5. It is thus possible to dispense entirely with the concept of an estate, and the former asset estate not used for the benefit of current With Profits investors can be termed an investment reserve for the financing and development of existing and new business.  The unconsolidated surplus (i.e. non guaranteed bonus fraction) of the with-profits policyholders then becomes the main source of the reserve (R & H sections 2.1.2(iii), 4.1.1 & 4.1.2).
6. Should the remnants of the asset (investment reserve) and liability estates become depleted such that they are together less than the potential liabilities, the fund will reach technical insolvency.  Under these circumstances, however, existing With Profits members can be regarded as underwriting the technical solvency gap (R. & H sections 2.1.2(iv), 3.2.16) to the total value of their unconsolidated bonuses (and in extremis future premiums).  Only when the solvency gap exceeds this total value is the fund insolvent. (See R. & H. section 3.1.3).
7. This being the case, the fund can be operated equally well with a negative as a positive technical solvency gap for greater or lesser periods of time (see again R. & H. section 3.1.3), and maturing policies can continue to be paid at the full value of their guaranteed and unconsolidated portions.  And over time, therefore, the intention and practice of payment in full will become established as “policyholders’ reasonable expectations”, and used as a market advantage.  In these relaxed circumstances, payment in full is what matters, regardless of the proportion of the guaranteed and unguaranteed elements (R & H section 3.2.6).  A further element of flexibility can be gained if the guaranteed portion is made as small as possible.
8. If payment in full is the norm and there is no practical difference between the guaranteed and unguaranteed portions, then it is simpler, and indeed permissible, to pool all the different types of guarantee-containing policy as well as those that do not have them into one fund, irrespective of what those disparate guarantees are, and what the different generations and classes of member have paid, might have paid, are paying or will pay for them (R. & H. sections 3.2.1 & 3.2.2).

This précis of necessity reads more bluntly and less blandly than the Ranson-Headdon paper.  Yet whether we react to it with hindsight or attempt to see it in context, the outcome is much the same.  Not only is it pragmatic rather than principled, but also it contains several notable sophistries, all of which were represented as refining simplicities at the time. First and foremost, the traditional estate is not a windfall inheritance to be squandered by the current generation(s), but is rather a charitable benefice held in trust, to be deployed for future generations as much as the present.  Secondly, moving beyond disinheriting future generations and requiring them also to finance the “profligacy” of the current one only compounds this unfairness.  Thirdly, the actual or potential running on a negative technical solvency gap is the very antithesis of prudent axioms of insurance, and flies in the face of experience, which argues for positive financial strength.  Worse, it flouts the core concept of policyholders’ reasonable expectations, and the consequent appellation of unconsolidated bonuses and benefits as a “moral charge”. For this reason alone the House of Lords Decision was essentially correct.  Albeit imperceptibly, such a fund sooner or later crosses over from being a “With-Profits” fund for maturing policyholders, to become a “With-Liabilities” fund for current and future premium payers.  As this transition takes place, the fund risks becoming crucially dependent upon future premiums unless very definite actions are taken.  And fourthly, if guarantees are not meaningless, then they must be properly explained, and charged for openly rather than by stealth. The impropriety of this is compounded by causing those without guarantees unwittingly to underwrite the guarantees of those who have them by placing their asset shares in the same fund, especially when the safety margins of the fund have been eroded deliberately.  Subsequent developments require that this be qualified further, as in Section 10.

Not surprisingly, these issues were reflected in the ensuing discussions in London and Edinburgh.  To aid continuity extracts and a commentary are given in Appendix I, although they may be read at this point.  It will be seen that discussants repeatedly emphasised the following:

• Adequacy and continuity of estate or reserves, to meet the needs of both present and future policies.
• The relative size of terminal and reversionary bonuses in policies, and the need to reserve for them.
• Potentially excessive mutual insurance arising from a pooled unitised fund in which the interests of policies of different lengths and levels of guarantee are indiscriminately placed.
• Given that the investment profile of a pooled unitised fund cannot be ideal for all policy types and durations, an additional mismatching reserve must be held.
• There is a consequent need to explain the potential inequity and risk this poses to policyholders and their advisers.
• Conversely, there is a need to explain the relevance of the guarantees, and how they will be met and charged for.
• Concerns about financial strength under all circumstances, given that the unconsolidated bonus element is used to take up new business strain while continuing to be paid out in full in the absence of an estate.
• The resulting duties of information. For ease of reference the extracts pertaining to this in Appendix I have been italicised.

Mr Roy Ranson closed the Edinburgh discussion for the Equitable.  The full flavour of his remarks should be enjoyed entire and verbatim, but space must be found here for the following:

“The Paper covers practically the whole range of activities associated with the operation of a predominantly with-profits office. The kind of points made through the paper are discussed with the Board and senior colleagues very much in the way we put them in the Paper (the wording is a bit different on occasions) and to the extent that we can, with policyholders.  That of course is a difficult exercise but we are making efforts.”   This now seems an over-liberal, rather than a too economical version, of the emergent truth. It will be interesting to learn in due course how far Board Members past and present (and the non-executives in particular), let alone local office representatives, now agree with him. It seems unlikely only to be humble policyholders who do not. And:

“Regarding the estate, of course we do not have objections to its existence and of course if it exists it is of value to existing policyholders, but I will keep asking the questions: - who created it, which generation, and why was it created?  Those points need to be taken up and answered.  What contribution is required towards it from the current generation?  When are the holders of estates going to tell the public what it is all about?  How did they have this flash of inspiration to create it and who paid for it?  Who is going to go on paying for it?  As a matter of interest I did not inherit one so perhaps that influenced my views.”  One can admire the sheer effrontery of this, but still must ask- had Ranson also helped spend what he might otherwise have inherited?

Bombast aside, Roy Ranson’s remarks now look disingenuous. He above all others present should have known the answers to the rhetorical questions he posed, since they are given in his predecessor Maurice Ogborn’s bicentennial history of the Equitable¹¹, published in 1962.  Richard Price, DD, FRS (1723-1791) was a nonconformist minister, a friend of Benjamin Franklin, the Rev. Thomas Bayes and Adam Smith, and a leading radical figure in the English Enlightenment.  He was also a not inconsiderable mathematician in his own right, and one of the earliest and most important formative influences on the Society from 1768 onwards.  In 1775 he wrote that £4,000 or £5,000 should be “established as a reserved stock…never to be entered upon except in seasons of particular mortality…the interest…to be added to the principal, till it shall rise to such a sum as may be deemed a sufficient surety to the Society in all events (Ogborn p104).”

Price was also instrumental in securing the appointment of his nephew William Morgan, FRS (1750-1833) who rapidly succeeded to the post of Actuary at the Equitable, and by whose probity and prudent industry the Society was raised to unparalleled eminence and prosperity in over fifty years of his service.  At his uncle’s instigation Morgan conducted the first valuation of 1776, and wrote an early book entitled: “The Doctrine of Annuities and Assurances on Lives and Survivorships” in 1779.  Ogborn (p108) described how Price took the opportunity to give the Society some good advice in the introduction to this book.  Price had given only qualified approval of the reduction of one-tenth in the premiums which had followed Morgan’s valuation, for he disagreed with the return of the “whole overplus”:

“Different opinions have been entertained of this measure; but the truth is, that (however safe and just the prosperous state of the Society then rendered it) it is in itself a measure of the most pernicious tendency…A repetition…might hurt the Society essentially, by withdrawing from it that security which it has been providing for many years, and bringing it back to infancy and weakness.”  True words indeed, but even then there were detractors, viz the rejoinder:  “Ergo - A Society or company not encumbered by such engagements may safely make that reduction and charge only as much premium as the value of the life requires.”  This comes from annotations to the preface in a copy of Morgan’s book owned by an original director of the Pelican, a rival Society (Ogborn p135-6).  Not so safe in the event, because the lean scheme can only work given perfect forecasting; thus it may be considered only to be dismissed.   More than two hundred years were to pass before the point was decided at the Equitable itself.

Back now to Roy Ranson, who continued:  “There were quite a lot of comments about mix of assets and asset shares.  We quite deliberately do not look at individual contracts and I think that when considering that point, we need to bear in mind that for all practical purposes, I repeat practical purposes, our business is all effectively short. We have contractual guarantees with a very wide range of pension ages on our business (80% of our business is pensions).  There is also a contracted payment basis on prior death.  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.  On the regulatory side, we take account of the earliest possible contractual age for pension purposes in the costs of our guarantees.”  Here Ranson himself gave the lie to First Order Sophistry Items 7 & 8; practical realities later determined that he could not have it both ways.   

“On investment mix, we made a point in the paper that we try to keep the balance between declared and final bonus such that it does not influence investment strategy.  What I mean by that is that I like to advise the Board, whom I advise each year on investment strategy, that investment managers may form their own views.  The mix of assets we have is a direct outcome of what our investment managers choose to do.  It is five years or more since I recommended any kind of investment constraint.  On the point of asset mix we are always puzzled as to why these offices which promote to (sic) the philosophy that, as you approach maturity, you move into fixed interest, have such high proportions of fund proceeds in terminal bonus?” This pictures the Equitable as an office less concerned with assurance than investment return, and it is consistent with the notion that the management was unduly influenced by commercial and marketing considerations⁹.  Here we may note that over-rapid expansion can create a very heavy weight of potential claims (i.e. strain) on a life assurance office. In essence this is because the assurance element dominates in the early phases of a policy before much premium income has been received, and so the ratio of assurance obligation to asset share is high.  And if the number of policyholders doubles rapidly because of an indiscriminate influx of new and younger members while the size of the estate or reserves remains constant, the additional demand can erode the reserve safety margin. At the same time the newcomers expect their share in the benefits of the estate in due course, but this expectation must diminish as their numbers increase unless appropriate measures are taken to increase the estate pro rata. Longer established members therefore have an interest in keeping the rate of influx down, so that their asset share is maintained. If not, they may demand that a higher proportion of the surplus is given to them. Hence one way a bubble threatens, and on the other stagnation looms- a classical dilemma which dogged the Society into the second half of the 19^th century (Ogborn Chapters 11 & 12)¹¹ and will surface again later.

All this aside, as will later emerge it is also pertinent to ask why, if part of the reason for presenting the paper was, as it should have been, to seek peer review and advice, the various caveats and advice (and particularly the items in italics which relate to the duties of information, to which Roy Ranson himself had paid lip-service) were neither heeded nor acted upon.  Suffice it for now to note that as a result it may be concluded that there were germinating seeds of maladministration, misrepresentation and negligence in the ground no later than the end of March 1989.