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

Winners and losers

Besides saying how the money may have disappeared, Lord Penrose has also indicated where and when it did so.   Professor Smith’s presidential statement in the 1992 accounts includes: ”… The fundamental philosophy is that each generation of policies should receive benefits commensurate with the earnings produced during its lifetime.  Beyond the bounds of normal commercial prudence, it would be alien to our culture to hold back benefits from one generation to build reserves for a future generation.  As we say in our literature, for new policyholders future bonuses must depend primarily upon the earnings produced on the investments of the new premiums.  Any deliberate cross subsidies between generations would not be “equitable”.  Lord Penrose comments:  “As appears frequently in these documents, there was an inherent contradiction in the statement.  If nothing was held back for the future, any over-allocation had to be recovered from the future.  That had to involve deliberate anticipatory cross-generational subsidy and to be, in these terms, ‘inequitable’” (P4.82-3; see also EARW p7).  Did Professor Smith know this?

A more detailed account of cross-generational subsidy is given in P6.71-3.  Lord Penrose explains: “…While the split between GIR, reversionary bonus and final bonus might vary depending on the policy structure, the same total return was credited to accumulated policy values regardless of duration.  This contrasted with the practices of many other companies with significant amounts of single premium business, where more flexible bonus systems allowed for variation according to duration in-force and financial experience over the relative periods.  This flexibility allowed inter-generational smoothing and enabled the company to avoid locking in to payout patterns in the way the Society did” (¶ 71).  And:  “More generally, it is unclear on what basis the Society could ever have expected to have been able to operate without inter-generational transfers in the absence of flexibility to differentiate by duration.  In With Profits Without Mystery it was acknowledged that each generation of maturing policies was dependent on capital provided by succeeding generations (cf. Ponzi in narrative below- MN). Flexibility to differentiate by duration would have been necessary for such a system to operate fairly in the absence of an inherited estate.  The Society’s practice did not provide that flexibility, and, given its full distribution policy, over-payment on older duration policies was the direct result” (¶ 73).  This, then, was a crucial piece of knowledge for better-informed policyholders or groups if they wished fully to exploit product flexibility, and the availability of total policy values from 1987 onwards.  It also seems fair to assume that few individual members without access to well-connected financial advice would have known of it.

With this explanation in mind it is also instructive to look at PR Table 6.13 and 6.16, which show how terminal bonus became increasingly dominant over the years 1980-2000.  The story can be made more complete and the effects of it judged by graphing a Society promotional table showing terminal bonus accumulation over the 35 years preceding 1999 expressed as a percentage of all the guaranteed elements. It forms part of Society leaflet (45J099 WP/UL 2.99) entitled:  “Pension and Life Assurance Plans. Annual Statements- Further Information”.  When plotted as in the figure below, the data show that the biggest relative annual terminal bonus additions were made over the 1973-86 period, i.e. that spanning the dispersal of the estate during which Barry Sherlock was the Appointed Actuary and subsequently Managing Director. This was also the period of steepest relative accumulation rate of terminal bonus.  The graphs also indicate how much terminal bonus was awarded retrospectively to policies in force during the decade prior to its introduction in 1973.

NB: The cumulation profile illustrated is relative to the guaranteed elements of individual asset share and guaranteed bonus cumulation (the cumulation of which is also important for determining the absolute amount of asset share, which in turn depends upon individual contribution history). It assumes a constant level of annual contribution, but, given the structure of the fund, suitably informed policyholders might have done well to increase their later contributions.  They would also then have had to crystallise their gains at an appropriate and advantageous time; later policyholders whose policies had more time to run were perforce left exposed, and had also to meet the costs of previous over-distributions (cf. Ponzi below).  After 1985/6 the real glory days of terminal bonus and potentially crystallisable gain were over.  From the sales point of view it all looked very impressive, and so it is not surprising that the senior management team wished to carry these figures over to support a new fund in 1987.  The prospect of such performance continuing on the same basis was, however, entirely without foundation, such that the use of these prior performance figures was inappropriate, un-representative, and misleading.

The beneficiaries of  “deliberate anticipatory cross-generational subsidy”, who received the rump of the estate and more between 1973 and 1987, were thus longer duration policyholders who were in other ways also selectively favoured (P chap 3.46, 51, 60, 74, 94, 103, 109, 112, 129, 144, 145 items 5 & 8, 152, 161 & 168; chap 4.16 &36; 14.68).  And since the GAR option was withdrawn for policies begun after 1988, this group was also essentially comprised of longer-term GAR policyholders.  Moreover after 1987,  “The advertisement of “policy value” to members who had reached an age at which it was open to them to take their benefits allowed those with the financial acumen or appropriate advice to elect for an early maturity date and crystallise their benefit entitlement at an unduly high value to the disadvantage of continuing members.  In the early 1990’s, this was facilitated by new flexible products developed by the Society” (P chap 4.29).  The implications of this are serious, and the more so if they involved fund switching.  One reason for the selective bonus allocation to policies of particular durations was said to be maintenance of the Society’s position in performance tables, i.e. marketing considerations. And yet, as initially explained, the historical problem was that established members would resist significant increases in membership because it diluted their own claims on the estate.  Given the Society’s commitment to expansion, it would have been politic to forestall this by awarding longer-term members a disproportionate share of the estate. One must also hope that similar favours were neither sought nor proffered for inward transfers of longer duration policies during the drive for expansion.

Depending upon personal and external circumstances, postponement of retirement could also achieve the same end.  Consider, for example, Headdon’s explanation of why the actual results for 1995 had shown payments to policyholders considerably in excess of those projected for the year.  “ It appears that some clients were delaying retirement until the managed pension contract became available.  A substantial part of retirement proceeds will, in fact, have been left with the Society and contributed to the premium income position…”.  In the same paragraph (chap 4.128) Lord Penrose continues:  “The consequences of the managed pension for policyholders was to become a significant factor in the closing years of the reference period.  Evidence from the independent financial adviser sector indicates that some at least some of its practitioners appreciated that it was to the advantage of their clients to take benefits at a time when policy values were high relative to underlying assets.”

Rough news on smoothing generates new insights.

If an investment fund holds free reserves in one form or another, they confer the ability to even out fluctuations in earnings from year to year.  The greater the reserve, the longer returns and bonuses can be maintained at what is deemed to be a safe average level in times of adversity.  If there is no estate or other free reserve, then earnings cannot be smoothed out in this way.  Not surprisingly, therefore, Lord Penrose was unable to establish that the Society had a defined smoothing policy despite its officers having repeatedly referred to the existence of one.  It is, however, possible to discern what substituted for one from the WPWM paper, parts of Sherlock’s 1989 letter to policyholders, and a revealing exchange recorded in the PR between Christopher Headdon and Ernst & Young audit actuary Ian Bannon in 1995. Under the WPWM paradigm there was no estate or free reserve; in the absence of one the unconsolidated surplus, i.e. all the accumulated terminal bonus, became what was referred to as the “investment reserve”.  One of the grey areas in the 1989 WPWM paper was exactly what the investment reserve would be called upon to do until it went to policyholders.  In concise technical terms it was unclear how such surplus was hypothecated before it “crystallised” on becoming contractually due in maturing claims.

First and foremost, in the absence of any other funds the investment reserve had now to be the surety for the guaranteed element in policies.  Effectively, therefore, policyholders’ un-guaranteed bonus was used to underwrite the guaranteed part of their own fund value, and with hindsight one may well question what sort of a guarantee that was.  The investment reserve had also to finance ongoing with-profits and other business, and to take up new business strain as the Society’s membership grew in advance of anticipated premium income.  A bona fide custom of paying out full policy values in a climate of good faith required the investment reserve also to stand as guarantor for itself. This in turn inevitably meant that in market conditions when underlying asset values were depressed, and all the previously awarded terminal bonus stood at more than market value after also having to cover any associated shortfalls in guaranteed bonus, the investment reserve would be negative. Under these circumstances, the only way individual total policy values could be maintained was to allow supposedly limited swings of the investment reserve between positive and negative.  And since this could only work under uninterrupted relative stability in market conditions, any capital smoothing capacity was more apparent than real.  Moreover once the Society had compounded this situation by attempting to extend it with loans and re-insurance treaties the position was ultimately untenable. Come the GAR liability payable in good faith and the situation was hopeless without the bad faith DTBP claw-back.

Whatever the deficiencies in this situation, it purported to maintain total policy values rather than to dampen pulsations in the yearly bonus stream.  Supposedly it smoothed capital value rather than any annual additions to it, which notwithstanding Sherlock’s limited explanation of it is not a layperson’s ordinary understanding of smoothing.  Moreover, rather than risk thereby reducing it extended indefinitely, and increased progressively as premiums and dominant terminal bonuses accumulated.  Meanwhile, if a steady stream of annual bonus additions were to be maintained at a level that satisfied market expectations, these were a deferred liability that did not require immediate further setting off against the investment reserve, and allowances for future premium income such as Zillmer adjustments, subordinated loans or bonds and internal business loans, all of which anticipated the income continuing could be swung in to cover them. But in fact most of the Society’s policies were recurrent single premium ones, such that a steady annual premium flow could not be taken for granted.  Even so, the PR demonstrates that an inappropriate quasi-Zillmer adjustment was ultimately extended to cover £900million of the Society’s shortfall in funds.  When the premium stream began to dwindle in 1998/9 the position became progressively more uncovered.

With these inherent weaknesses there remained but one means of sustaining the notion of smoothing, and paying out total policy values in full as they matured or were surrendered on contractual terms in a manner that did not further erode statutory solvency margins. As revealed in the Headdon-Bannon exchange, it was to pay the unconsolidated terminal bonus part of claims as they arose from a first call on the Society’s current earnings, always against the aforementioned backdrop of positive-negative swings in the value of the investment reserve. By contrast the guaranteed part of maturing claims was struck out from the guaranteed liability reserve.

This overview of smoothing or the lack of it is worth following because it allows several further significant insights.  Firstly one can recognize that different accounting standards may contain disparate conventions for hypothecating free assets, let alone a so-called “investment reserve” of assets which are not free because they are being held against an eventual liability.  Hence disparities or elective shifts in hypothecation of any resulting deficit, obscured by the Society’s sophistry-laden business paradigm, are what allowed key members of the senior management team successively to elude most of the Society’s directors, virtually all its members, the organisation of the Faculty & Institute of Actuaries, the Society’s auditors and the regulator.  Herein lay the usefulness of the three different sets of accounts. More sinister is the realisation that “first call” payouts from current earnings, and a bonus stream predicated on future earnings rather than inherent financial strength, are characteristics of accumulating new business strain followed by a Ponzi scheme. In this as in so much else, the many aspects of non-disclosure are paramount, but on the face of it the Ponzi scheme was legal, because it was all levered off the un-guaranteed part of policy values.  Even so, the London and Edinburgh discussions of the WPWM paper show that an informed and interested minority of the actuarial profession could and did deduce much of what was going on. As yet, history has not related what other representations they made within their profession, or how else they may have used their knowledgeable inferences.