EQUITABLE LIFE MEMBERS
EQUITABLE LIFE: PENROSE AND BEYOND
- ANATOMY OF A FRAUD
A paper by Dr. Michael Nassim
Last Updated: Friday, February 11, 2005 09:59 AM
Level
2: Narrative
Introduction:
cipher, crib and key.
The
Penrose Report is over 800 pages long.
Though its twenty chapters have highly relevant headings there is
no index. Lord Penrose is scrupulous both in his careful reporting of
important facts, and of the context in which they arose.
But having carefully prepared his ground he has usually stopped
short of making deductions or inferences from it, and on contentious
issues he often quotes the reasonable opinion of others rather than giving
his own. All this makes the
Penrose Report (PR) somewhat like a cipher.
Without a crib and some prior knowledge it is very hard to find the
key and crack it. A halfway
decent crib also tells the decoder what new information is of special
importance, whether there is anything missing in the message, and if so
where else to look. Just as well, then, that a crib was prepared on evidential
and logical grounds before the PR appeared, because the additional
knowledge in the decoded message turns out to be vitally important, if in
places also intentionally or of necessity incomplete.
The
main crib is a preparatory article entitled: “An Equitable Assessment of
Rights and Wrongs” (EARW). To establish its independent authority, and
to pre-empt allegations of hindsight, it was published in advance of the
PR. Its findings and conclusions have been brought forward elsewhere in
this paper because it aimed to explain what was already known, and hence
what a comprehensive inquiry should cover. It also provides an analytical
and interpretative framework within which to place new evidence.
By using it in this way the following story has emerged.
The
Auld Equitable.
Founded
in 1762 as The Society for Equitable Assurances of Lives and
Survivorships, the Equitable attained by degrees an unrivalled reputation
for ethically prudent and fair management.
This was primarily due to the influence of the Reverend Dr Richard
Price FRS and his nephew William Morgan FRS, who in over 50 years of loyal
service as Actuary raised it to unparalleled heights of eminence and
prosperity. Part of the Society’s early prosperity was fortuitous, and
rested on persistently conservative mortality figures and relatively high
premiums based on mortality tables from the city of Northampton. More
intentionally it relied upon Price’s insistence in 1775 that moneys be
retained as “…a reserved stock, not to be entered upon save 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 in
all events”. This was the
origin of the Society’s estate, and the source of its secure reputation.
How big the estate should be became a recurrent bone of contention
in the late 18th and much of the 19th century; the
Court of Directors had repeatedly to resist or moderate demands for a
distribution of surplus to existing members.
If they were not to receive all the Society’s funds, existing
members also had an interest in limiting new members’ access to them,
and so they lobbied for restrictive conditions or delayed bonus
entitlements for the newcomers. Had
these conflicts of interests not been resolved the Society might have died
out, and indeed there was a prolonged period of stagnation before cautious
and controlled expansion began later in the century, continuing in the
first half of the 20th.
Originally the Society gained interest on fixed interest securities, and after reserving for its liabilities distributed the surplus proceeds. Fairly soon it diversified into bonds and mortgages, and as the investment milieu developed it also began to invest in property and equities. It distrusted the inherent volatility of capital appreciations in property and equities, and brought this officially onto the books only in small amounts. As befitted its London origins most early members were Londoners, and throughout its history the London branch offices remained confined to the City, West End, Law Courts and Westminster. It thus had close associations with the Establishment and City financiers, many of who were its clients, and from whom it drew its directors. Even at the height of its expansion there was a preponderance of offices around London and in the South East. Its head office was in London, but many of the support administrative and executive functions (including the actuarial and marketing departments) were later centralised in Aylesbury. On the increasing centrality and autonomy of the executive team there much was later to depend.
The Society’s organisation long reflected its social origins. There was in consequence a clear distinction between the Directors and the executives, very few of whom became members of the Board. Maurice Ogborn, who wrote a most informative history of the Society to celebrate its bicentenary in 1962 and was the last of the Society’s actuaries to champion the estate principle, was the first actuary to be appointed to the Board. In the 1970’s and 80’s this changed. Executive representation on the Board rose to 5 of 12 members, and there was less of the old master-steward/servant relationship. This was properly so, and in the course of it the more able and ambitious executives might gain wider career horizons and more influential business contacts. Events were to show that this blessing was a mixed one.
Those interested in the Society’s history prior to 1962 should in the first instance consult Maurice Ogborn’s bicentenary history entitled: “Equitable Assurances”.
Out with the Auld and in with the New.
Things might have continued without a marked change in direction had it not been that a large amount of the Society’s pension scheme and institutional/corporate business came from the Federated Superannuation Scheme for Universities (FSSU). When insurance regulations were changed in 1969 the Society recognised that a newly competitive climate would emerge, and that it stood to lose a substantial amount of this business. To mitigate it new branch offices were opened and the sales force enlarged in preparation for a concerted expansion drive. While preparations were in hand for this, in 1972 Maurice Ogborn retired. This proved to be a bad omen, because 1973 was disastrous for the Society in no less than five ways. Firstly, the Society had embarked on a five year expansion plan, to which it was now committed. Secondly, this was immediately compromised by the international oil crisis with the collapse in confidence and of the markets that attended it. Thirdly, Ogborn’s successor Barry Sherlock and deputy actuary Roy Ranson elected to maintain a high level of bonus payouts that the Society could ill afford to avert collapse of the marketing drive. Fourthly, they introduced an un-guaranteed terminal bonus adjustment which was originally intended to bring policy values more into line with investment earnings on a triennial basis. Fifthly and fatally, the Board of Directors was informed that terminal bonus was a relatively cheap benefit to service because it did not need to be reserved for with any stringency; a message that was to be repeated frequently over the years.
This reassurance was technically correct but in practice false, and dangerously so if too heavily relied on. Implicit was the supposition that if the going became too hard the terminal bonus could be revoked. This was an original and perilous seed of bad faith, which in time became a veritable tree, whose roots eventually exhausted and undermined the fertile inheritance in which it grew. The initial phase of exhaustion was rapid, and brought about by maintaining bonuses in support of the sales drive. Much of the Society’s estate was dispensed in the 1973-6 triennium as both declared and terminal bonus, and the more so because the estate’s investments were at a temporarily depressed value. Solvency margins were maintained by bringing longer-term historical capital appreciation onto the books, and by increasing the valuation rate of interest required to support the liabilities- a device used again in subsequent years.
The crisis in market confidence was relatively short lived, and recovery began in 1974-5. This merged imperceptibly with a prolonged period of inflation, which was at least partly due to a three to fourfold rise in the oil price. Given the dominance of oil, and that in the modern economy energy is vital for the preparation of all goods and the implementation of most aims, stability could not return until wages and prices had risen by a corresponding amount. Under these circumstances the first phase of the secondary inflation wave was unusually severe and prolonged. This initially restored and then increased the monetary value of the Society’s equity portfolio. It also dealt a deathblow to the traditional belief that fixed interest securities were the surest haven for savings, because their real value was eroded correspondingly.
On these shifting sands a desultory attempt was made to rebuild the Society’s fortunes, but it was doomed to failure. Much of the Society’s capital appreciation of its investments was now inflationary, and hence an illusion. But taken at face value it seemingly justified holding bonus rates at high levels to maintain market competitiveness. It also encouraged a progressively greater percentage of capital appreciation to be brought forward onto the books, and the rise in volatility that this engendered was in part offset by increasing the relative proportion of un-guaranteed terminal bonus, which over subsequent years grew to become the major bonus element. All this had particular significance for the 1977-9 triennium, and Lord Penrose nicely explains how the three-call earnings allocation system was manipulated to increase the proportion of un-guaranteed terminal bonus at the expense of declared bonus, and all in the name of policyholders’ expectations. Whatever, it had the desired effect of retaining a gratifyingly large number of former FSSU policyholders, and increasing sales. President Murison contentedly announced that this left the Society well poised for the next decade, but in retrospect the exact opposite was the case, and with hindsight was clearly in bad faith. While brisk inflation continued all looked rosy, and since at the same time there was a compensatory rise in interest rates, the existing contractual rights of policyholders to opt for a Guaranteed Annuity Rate (GAR) at maturity appeared well covered. Indeed, the GAR was increased to maintain competitiveness while interest rates were high, and this later had dire consequences.
The
New Equitable first turns sour-
As the inflationary 1970’s drew to a close the Society’s premium income had begun to increase exponentially, which rise continued until the collapse of 1999-2000. Part of it must also have been due to inflation, although the sales drive was also increasingly successful such that there were 170,000 members with GAR policies before an attempt to end them was made in 1988. But now another problem was approaching, in the shape of more stringent financial and reporting standards to be imposed by the 1982 Insurance Companies Act. In the event the changes of 1982-3 were also to prove as momentous as those of 1973. They included the following:
-
All capital appreciation, whether past or current year’s, was now put on the books to support solvency.
-
Barry Sherlock stood down, and his deputy Roy Ranson became the Appointed Actuary. However, Sherlock remained the Society’s General Manager and Actuary until June 30th 1991.
-
The crude level of terminal bonus, before any smoothing, was now related more or less directly to the investment reserve (see also e. below). The Society’s long history of a separate estate was effectively at an end.
-
Hence Ranson was later able to say that he did not inherit an estate on becoming Appointed Actuary. Even so, Sherlock and he had been party to the disposal of that estate over the period 1972-83.
-
The absence of an estate, with terminal bonus now taking up virtually the whole of the remaining unconsolidated investments, may have been instrumental in a decision by the Aylesbury senior management team to put in place a fall-back differential terminal bonus policy (DTBP), in case falling interest rates later came to put GAR option holders “in the money”. This fallback DTBP was not communicated to the Board of Directors.
Arguably
this concealment of the DTBP by the management team (some of whom were
also executive directors), in the particular context of the underlying
fund structure and financial weaknesses which made it necessary, was the
fateful first step in a subsequent descent into fraud. What is beyond
doubt, however, is that it was the first branch on the growing seedling of
bad faith. Consistently with this, 1982/3 was also when the sophistries
later elaborated in the notorious “With Profits Without Mystery” (WPWM)
paper and business manifesto began.
The
extra margin of regulatory solvency the1982/3 manoeuvres produced was now
also distributed. The Society
proceeded to erode the apparent strength of the 1982 balance sheet by
progressively cutting back on the reserve for future (guaranteed)
reversionary bonus until it was eliminated, they had used up a previously
un-attributed accounting adjustment from 1982, and finally had explicitly,
at least in 1987, made a bonus allocation in excess of available returns.
This situation continued for most of the Society’s remaining life. It
was therefore necessary to tread a narrow path very carefully, which was
facilitated by keeping accounts reflecting no less than three approaches
to asset and liability valuation, namely Companies Act accounts,
Department of Trade and Industry (DTI) regulatory returns, and internally
for management purposes, an “office” valuation.
Of these the private office valuation most closely approximated to
the Society’s actual financial position. This too was fundamentally bad
faith.
The
year 1987 was fateful in other ways, because it heralded a change in
pension regulations which permitted cessation of the old Retirement
Annuity Plans containing the increasingly onerous GAR option, and the
introduction of more flexible personal pensions.
Crucially however, the game had again been raised by more stringent
requirements for the accurate disclosure of the essential nature of
financial products by the Financial Services Act of 1986.
Given the Society’s underlying financial situation and that
interest rates were falling to the point when the GAR option would bite,
this was part welcome opportunity but part serious challenge if sales were
to be maintained. The
response of the senior management team was to go beyond ingenuity.
-and
then goes bad.
Lord Penrose prefaced his description of the team’s 1987response with the following extract from the Actuary’s report: “A strategy document was formulated by the end of March and agreed by the senior management team. A major component of the strategy was to make use of existing products, as much as possible, in order to minimise the changes needed to existing administrative and computer systems, and to enable the Society to exhibit an unbroken track record of past performance”. He prefaced the extract with the following: “The paper did not identify features of existing business that would be departed from”. –and continued: “The new form of business was to be presented as aligned with the superseded retirement annuity contract to ensure that previous performance records could be used with reference to the new contract. In management records it was noted that premium bases would be the same as for retirement annuity basis. In the present context the decision was reflected in distribution practice going forward.
In
relation to bonus policy, this was a momentous, and ultimately disastrous,
decision. Had the Society
acknowledged liability to meet the annuity guarantees, it would
necessarily have identified a difference in the benefits provided by the
former and the new contract forms. For
equal premiums, the new personal pensions offered lower levels of
contractual benefits. On
conventional actuarial practice the Board might have concluded that a
higher level of bonus was appropriate for the new business accordingly
(or, as was later observed during the actuarial discussion of the WPWM
paper, explaining the significance of the guarantees and charging for them
appropriately- MN). The means
of calculating the difference were available in the developing techniques
of stochastic modelling. The
Society might have avoided the Hyman problem at the outset.
There
would undoubtedly have been marketing implications. Policyholders might have preferred to switch to the new
forms, the marketing push of 1987 and 1988 could have been abortive.
The Board might have been forced to propose a new with-profits
fund, closing the old fund to new business.
But adopting a market-driven policy, against the background of the
management decision in 1982-3 to “solve” any emerging problem by
discriminating at maturity (i.e. the DTBP- MN), established the bonus
policies and practices that were thereafter to develop, and to lead to the
confrontation of 1997”.
Lord
Penrose omitted to make two most important conclusions about the
consequences of this position. Firstly, because the record of past
performance had been achieved by disposal of the estate to a fortunate
minority and all was now gone, there was no prospect of repeating it.
From this point onwards the Society was trading on an inherently
false prospectus. Secondly,
he did not add that, however uncomfortable it may have been, there was by
any reasonable standard an absolute requirement for the executive
directors on the senior management team to disclose the existence of the
covert DTBP to the full Board at this fateful stage, and indeed to minute
the ensuing debate. But had
they done so, it may safely be asserted that any reasonably competent
non-executive director would not, could not or should not have
contemplated the risk that, together with loss of the estate and
persistent over-allocation, thereby transferred to the new fund and its
future policyholders. What
was carried over was the very antithesis of a with-profits fund. From this
point on, if not since 1982-3, the Society was trading on an entirely
false basis. The seedling of
bad faith was now a sapling of fraud.
Over
the next twelve years the sapling would become a specimen tree in every
sense. The magnitude and duration of the resulting fraud is truly
astonishing. Eventually the tree’s new branches would ensnare a further
930,000 unsuspecting new non-GAR members, and the older branches
supporting the GAR policyholders would be cut from under them.
The burden of responsibility carried by the “senior management
team” is correspondingly heavy. We
may with reason wonder who the instrumental members of that team were over
the period 1982-8, and look forward to the Serious Fraud Office bestirring
itself to tell us. Not
surprisingly, a number of non-executive directors since 1987 have pleaded
their ignorance; under these somewhat undefined circumstances it hardly
seems fair that, whatever their personal shortcomings, their fate should
be left entirely to the whim of the adversarial process.
The events of 1982-7 thus
overturned the traditionally successful business and insurance paradigm of
the With-Profits Fund, affected all policies sold subsequently, and in
time adversely influenced the manner in which the Fund was administered
and represented. That
representation developed into a set of interdependent sophistries, which
it is also relevant to observe 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, in the absence of an estate, 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 (of which more elsewhere), 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, it was a vain and fallacious hope.
When formally delivered and published as a paper entitled:
“With Profits Without Mystery”(WPWM) to the London Institute of
Actuaries in 1989 by Roy Ranson and the Edinburgh Faculty of Actuaries the
following year by his deputy and co-author Christopher Headdon, expert
members of the actuarial audience 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 Ranson in his responsible capacity of Appointed Actuary
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 overall position was privately monitored by a more
realistic internal office valuation, and which enabled the Society to
survive for so long.
WPWM has rightly been the
focus of much subsequent interest. Important
though the details are (they are rehearsed and referenced elsewhere in
this paper because they are not well covered by the PR), it is here more
relevant to concentrate on four critical background factors.
Firstly, the underlying prospectus based on the Society’s past
performance was as we have seen false. Secondly, undeclared DTBP meant
that the relative amounts of guaranteed and un-guaranteed bonus could be
crucial, in contrast to what WPWM stated.
Thirdly, the Society was by this time over-allocated, and its
financial position was already weak.
Fourthly, interest rates had fallen to the point where the GAR
option had become valuable, such that there was a real possibility that
the Society’s covert contingency plan to revoke un-guaranteed bonus
would be used. And fifthly,
despite what was written and published in the main paper, Ranson had
during the 1990 Edinburgh discussion intimated that if things got
difficult the un-guaranteed terminal bonus element would be the first
thing to go. Taken together,
these factors indicate that the WPWM sophistries were motivated by more
than bad faith, and that they were an integral part of what was by then a
fraudulent position.
The unvarnished truths behind the WPWM gloss would hardly have been more acceptable to the Society’s WP policyholders and members than previously to actuaries, particularly since as members they were also its owners. Judging by the extracts given in the PR, Barry Sherlock as senior actuary and general manager did not adequately disclose the whole situation and its attendant hazards to policyholders in his 1989 report. But though he was an executive director, he had since 1982 been more concerned with the overall direction of the Society from the London end, and it remains unclear how familiar he was with the background events of 1982-7. We may nevertheless reasonably assume that he had read and sanctioned, if not actively edited and approved, the 1989 WPWM paper. And he it was who had given away the Society’s estate in order to supercharge the Society’s performance record, which gained it approbation, influential support, and an increasing amount of new business which was both private and institutional.