An Equitable Assessment of Rights and Wrongs

by Dr Michael Nassim

6.  From Pyramids to Ponzi via Lloyd’s, or A Bubble is born

6.  From Pyramids to Ponzi via Lloyd’s, or A Bubble is born

Maurice Ogborn¹¹ and Marshall Field¹³ relate that the disputed surpluses of 1816 had accumulated mainly because stiffer premiums for a higher mortality (conservatively based on mortality tables from Northampton) had been charged than were applicable to the better social conditions of the Society’s members.  The origin of surpluses in the 1970’s and 80’s was more general, and different.  Those with a prior interest in the modern primacy of energy in the creation of goods and the implementation of aims foresaw that, when the price of oil rose abruptly by threefold in 1973, a wave of inflation and monetary devaluation would begin, and not work its way out of the system until wages and prices had risen by at least the same proportion. This duly happened, and in the ensuing inflationary period there was a scramble out of money and fixed interest securities and into possessions and assets with intrinsic and durable value.  This included equities once the immediate crisis of confidence had subsided, and it led into the longest bull market in history.  The market was also drip-fed by underlying real economic progress over the next two decades, of which the digital electronic revolution is the outstanding example.  It was also helped by the easing of political tensions as the Cold War came to an end.

Institutions with large equity holdings experienced gratifying increases in their monetary value, and this was further sustained when, once the inflationary wave had been absorbed and dissipated, the unprecedented compensatory rise in interest rates also began to subside. These were heady days for pension funds, and many showed surpluses.  Unless a Maxwell asked it their distribution became a legitimate question, and many firms and schemes enjoyed breaks from making contributions in order to take up the slack, or took the opportunity to let older and more expensive staff go on preferential terms.  The shareholders of publicly owned life offices must have benefited, but mutuals like the Equitable may have had a more subtle quandary over their burgeoning asset estates.  In such cases, growing the business and declaring big bonuses for the existing members would help take care of it, but so too alas would diversions into unwise or inappropriate investments.  Meanwhile, the investment aspects of modern life assurance would have made it seem uncompetitive and unprofitable to hold much in the form of what C.S.S. Lyon¹⁴ had called a mismatching reserve, let alone more conventional fixed interest securities in the liability estate, even if this denoted a reduction in safety margin.

Though it took a long time, there should have been no surprise that more normal conditions would eventually return.  The rise in stock values abated and then fell as their earnings capability once again assumed its longer-term importance, both in its own right and for valuing stocks themselves. At the same time interest rates fell to historically low levels and the price of fixed interest securities hardened.  There was now a squeeze on income, during which premium flows from new business became increasingly desirable.  And by the same token the GAR annuity option became of real value to Equitable’s maturing policyholders, who took it up in growing numbers.  At the same time the cost of providing those annuities was escalating.  This was about the worst time in history for the Chancellor of the Exchequer to have abruptly withdrawn tax relief from pension fund earnings, but that is what happened next, and in the ensuing crisis he has been obliviously unrelenting.

The combination of successive guarantees on annuity and interest accumulation rates, a paradoxical but deliberate paring down of smoothing surpluses, and the erosion of the Society’s estate were now to prove fatal.  The situation had been compounded by tacit pressure to keep paying out inappropriately highly rated surrender values and bonuses in full¹⁵, such that the Fund’s reputation for superior performance was sustained and an increasing tide of new premiums flowed in.  At the same time new business strain was further eroding safety margins. Sooner or later the resulting bubble threatened to collapse or burst.  Although the Guaranteed Annuity Rate issue and House of Lords decision pricked it first, an estimate of the overall cumulative deficit has subsequently indicated that the Society was already greatly endangered¹⁵.  The wonder is that a succession of qualified actuaries devised and implemented this process when they of all people should have known better.  What asbestos had earlier and slowly done for Lloyds, the 1973 oil crisis and the loss of its estate may finally have accomplished for the Equitable.  Contrast this now with Appendix II, which is a further extract from Maurice Ogborn¹¹ (p206-7), and ask whether most of the elements in this situation were not already well known lessons from the Equitable’s own history.  The extract also shows that Ogborn was an advocate of the estate concept in 1962, and it follows that a critical change must have occurred during the transition from his stewardship to that of Roy Ranson.  Ogborn chapters 11 and 12 give much more of the Society’s history in the same vein.  How all this could have been neglected is indeed bewildering.

At its height the size of the With Profits Fund bubble was truly impressive.  Between 1957 and 1988 the Equitable had acquired 170,000 members who held GAR rights.  By contrast a further 930,000 members without GAR rights were recruited in the succeeding 12 years, which is more like exponential than linear growth¹⁶. Given that the United Kingdom has some 60 million citizens who may not vote until attaining 18 years of age, this represents a good 2% of the electorate.  Put this way, the government’s silence on the matter is strangely inappropriate, because it could tip the balance at the next election.

The Lloyds bubble was in numerical terms much more modest.  Lloyd’s inner circle had continued to conceal their knowledge of massive impending losses while intensifying the aggressive recruitment of more and more external “Names” through members’ and managing agents in what became known as the “recruit to dilute” campaign.  There were about 6,000 Names in 1970, whereas by 1990 nearly 31,000 new Names had been added.  During this process two thirds of the old Names withdrew from the risk, such that the total involved reached 33,000.   Meanwhile, in their own version of dual accounting, the syndicates continued to under-reserve and/or inadequately insure for incurred but not reported losses, thus hiding the coming losses and maintaining an illusion of prosperity¹⁷.

Prior to the Lloyd’s and Equitable fiascos the most infamous (and hence eponymous) pyramid selling scheme was that hit upon by a nefarious US immigrant named Carlo “Charles” Ponzi, a native of Parma, Italy.  In 1920 he sought to capitalise on the fact that he could purchase postal credits abroad for considerably less than their encashment value in the US.  Even though the larger scale exploitation of this was impossible, his friends and acquaintances thought it such a good idea that they advanced him money.  On this he paid them advantageous rates of interest, which elicited an increasing influx of subscriptions.  When it finally emerged that the original idea was unworkable, people demanded their money back and the edifice collapsed, but not before 40,000 people had lost much of their investment. 

Not surprisingly, disaffected Lloyd’s Names have highlighted the parallels between their situation and Ponzi’s victims¹⁸. Professor David Blake of the Pensions Institute¹⁹ came to a similar conclusion when investigating the Equitable’s predicament prior to the Compromise in 2001. He made the point that, because the Equitable had to attract sufficient non-GAR policyholders to help it bail out the GAR policyholders if equity performance was inadequate, the With Profits Fund began to take on the characteristics of a Ponzi scheme when GAR policies ceased to be offered after 1988. He listed the characteristics of Ponzi schemes as follows:

• The high returns achieved by the initial members of such a scheme are paid in part out of the contributions of later joiners.

• They require an increasingly rapid inflow of new members to sustain themselves.

• They end abruptly when the inflow of new members ceases.

• Those who join very late in the scheme’s life lose a lot of money.

Professor Blake had no reason to divine that the situation was already both more serious and advanced than this by 1988, and Mr Ponzi’s ghost must now surrender his crown to the Equitable as the new champion in his field.  Mr Ponzi, though, has a cult following on the Internet for his chutzpah.  In this the Equitable is unlikely to be as successful.