Select Committee on Treasury Minutes of Evidence

Memorandum by The Equitable Life Assurance Society


  This memorandum describes the actions taken by the Society in connection with the guaranteed annuity rate ("GAR") issue. It outlines the reasons why the board took the actions it did both before and after the decision of the House of Lords on 20 July 2000. The board of directors of the Society sought at all times to act lawfully by full compliance with the relevant life assurance statutes and regulations, by frequent liaison with the regulators and by the proper exercise by the board of the powers granted to it by the Society's articles and by law all in the interests of all members.


  The Society was founded in 1762 and is the world's oldest mutual life assurer. It has no shareholders. Its business is conducted on principles of mutuality for the benefit of its "members". Members are persons who have effected a "participating policy", namely, a policy which confers a present entitlement to participate in the profits of the Society—in other words, holders of "with-profits" policies.

  Before the decision of the House of Lords on 20 July 2000 the board of the Society adopted what it considered to be a policy of "full and fair" distribution of its surplus to with-profits policyholders. This policy was described to policyholders at various stages over many years. In particular, the explanation given made it clear that the Society did not therefore build up an "inherited" or "orphan" estate. This approach avoided cross-subsidy of one generation of policyholders by another. In other words, if part of the surplus otherwise available for distribution to policyholders was set aside for future emergencies, this would have been at the expense of policyholders whose policies were in force or maturing when those surpluses arose. In the view of the board, such an approach would have been inconsistent with full and fair distribution.


  The introduction of a new statutory pensions regime in 1956 caused the Society to design a new form of with-profits pension contract for the self-employed. This was novel and successful and enabled variable contributions to be paid into it as incomes varied from year to year and to suit the policyholder; Inland Revenue maximum contribution limits applied if tax relief was to be obtained.

  The specific details of each class of policy differ. However, they all provide policyholders with the right to take the benefits of the policy at an age of choice, within IR limits, either in the guaranteed annuity form of benefit written into the policy or in "fund form" to purchase an annuity at current market rates either from the Society or from another provider by way of what is known as the "open market option". This latter form of option was introduced into the Society's guaranteed annuity rate ("GAR") policies following a change in the relevant legislation in 1978.

  Various classes of pensions policy issued by the Society, and by most other life offices, included provisions for guaranteed annuity rates ("GARs") The Society regarded its GAR provisions as providing a minimum level of annuity or "floor" below which the pension provided by the policy could not fall. While the inclusion of such provisions was standard industry practice, they were not used by the Society as a major marketing tool. However, the Society was unusual, but not unique, in not requiring policyholders with these contracts, the great majority of which were with-profits retirement annuity policies, to specify in advance when their benefits would be taken in the future.

  Pensions contracts containing GARs were issued by the Society between 1957 and July 1988. No charge was made for the inclusion of GARs. In July 1988 the new personal pension policy was introduced to replace the 1956 Act retirement annuity policies. No GAR was included in the new contract but the Society's obligations in relation to GAR provisions remained and GAR policies remained open for payments-in of further contributions.

  It should here be noted that the interest rate underlying the guarantee was 4 per cent up to 1975. The rate was increased to seven per cent for policies issued between 1975 and 1988. Interest rates were well in excess of these levels in the period from 1956 to 1988 and did not fall below 7 per cent until late in 1993. Until then, current annuity rates exceeded GARs and current rates were accordingly applied to the cash fund available at the time benefits were to be taken from such contracts.


  For the last 20 years at least, the board of the Society, supported by actuarial advice, has taken the view that each with-profits policyholder has a notional stake in the overall with-profits fund and that the eventual benefits received should, so far as possible, reflect the policyholder's share of that fund. This was, and remains, the "asset share" concept widely recognised by actuaries to provide equity between policyholders—the essence of mutuality. This asset share is made up of individual contributions to the fund and the returns earned, after expenses, over the period of investment of each contribution. To achieve the normal smoothing of with-profits results, returns on invested contributions are averaged out by the board on the advice of the appointed actuary when determining a policy's accumulated asset share.

  Depending on the kind of policy held, policy benefits comprise a mixture of basic guaranteed benefits and annual declared or reversionary bonus on those guaranteed benefits, to which is added a non-guaranteed final bonus payable only when the contractual benefits are taken. Final bonus is the means whereby the Society sought to bring benefits into line with asset share for all with-profits policyholders. Final bonus is not guaranteed until policy maturity, and is payable at the discretion of the board.

  Traditional with-profits contracts carry a guarantee, which is increased year by year by the addition of reversionary bonus. If the value of the benefits on maturity as a result of guarantees exceeds the asset share, the cost is met from other sources—reduced bonus payments to other with-profits policyholders or, in the circumstances of other companies, payments from inherited estate or shareholders.

  Contracts with GARs have guarantees expressed in two forms, one expressed as a cash sum and one expressed as a pension amount, each of which increases year by year with reversionary bonus. These two guarantees will almost always have different values.

  The rates for annual declared reversionary bonus have always been the same, whether benefits are expressed as a cash value or as a pension amount. The purpose of the non guaranteed final bonus before 20 July 2000 was to top up the value of the guaranteed benefit to asset share.

  Prior to 1993 the cash sum was higher. To avoid penalising policyholders who took their annuity from Equitable Life, the open market option (the cash value) was reapplied at current annuity rates ("CARs") rather than being restricted to the guaranteed annuity rate. In effect this was a differential bonus rate, although not presented as such. This practice was followed throughout the long-term insurance industry. For certain periods after 31 December 1993, GARs exceeded CARs and there was extra value attributable through the GARs.

  The board decided at the bonus declaration at the end of 1993 to adopt a "differential final bonus practice" to equalise, so far as possible, the benefits taken by policyholders in GAR form with those benefits in cash form. Using that approach the cost of GAR provisions was estimated by the Society (at the time the representative action was begun) to be £50 million arising from the individual cases where the value of benefits taken in GAR form was greater than the asset share.

  The decision by the board to adopt the differential bonus practice was made after a recommendation by the appointed actuary and was seen as being consistent with the GAR policyholders' policies and well within the wide and general discretion conferred on the board by the articles of association of the Society.


  Late in 1998, following complaints by policyholders to the ombudsman about the Society's practice of awarding differential final bonuses, the Society decided to seek guidance from the courts as to whether its practice was lawful. It was apparent to the board that if the ombudsman decided a case on the basis of the individual circumstances of that case, the pressure to follow the same treatment for all cases would be overwhelming—even if the particular case decided had special features not applicable to the portfolio of business in general. Certainty on the issue was clearly in the interests of the Society and all its with-profits policyholders. A representation order was made by the court: the Society was appointed to represent the non GAR policyholders and a Mr Hyman, separately advised, was appointed by the Court to represent the GAR policyholders.

  The case was heard at first instance by the Vice-Chancellor, the head of the Chancery Division of the High Court of Justice, who confirmed in September 1999 that the board had discretion "well wide enough" to grant final bonus of an amount dependent upon the form in which the benefits were taken by a policyholder. Having considered all the relevant policy documentation, he considered that there was no "policyholder's reasonable expectation" ("PRE") that the same rate of the final bonus would be applied to all policyholders. He also held that there was "nothing contractually improper" in the allotment of differential final bonuses. Finally, he confirmed that the Society's approach did not deprive policyholders of any part of their asset share. All seemed well.

  Leave to appeal to the Court of Appeal having been granted, the representative action went up to the Court of Appeal which overturned the Vice-Chancellor's decision in January 2000 by a 2:1 majority. Lord Justice Morritt agreed with the Vice-Chancellor. He held that, as a matter of contract, there was no promise given to GAR policyholders that guaranteed annuity rates would be used in the calculation of final bonus and that GAR policyholders had not been deprived of what had been guaranteed to them, namely payment of an annuity of an amount not less than that derived from the application of the guaranteed rates to the accumulation value of their premiums. He held that the board's discretion was well wide enough to allow differential final bonuses, depending on whether benefits were taken in GAR or non GAR form. Accordingly, he rejected any claim that the Society had committed any breach of the GAR policyholders' contracts. His approach was on all fours with that of the Society.

  Lord Justice Waller considered (contrary to Lord Justice Morritt) that the Society was not entitled, as a matter of contract, to adjust the final bonus of a GAR policyholder, depending on whether the GAR policyholder opted to take a GAR annuity or benefits in other forms. But he went on to express the view that the Society was entitled to "ring-fence" the GAR policyholders, and award lower rates of final bonus to GAR policyholders (so as not to deprive non GAR policyholders of their asset share). This was the so-called "ring-fencing" approach. Although Lord Justice Morritt did not specifically deal with ring-fencing in his judgment, ring-fencing would have been, on the basis of his reasoning, an entirely legitimate approach for the Board to adopt. Lord Woolf MR held that it was not a permissible exercise of discretion for the board to award lower final bonuses to policyholders taking benefits in GAR form.

  It was estimated that, if the approach of Lord Justice Morritt to the analysis of the GAR policyholder's contract, or that of Lord Justice Waller to ring-fencing, had been upheld in the House of Lords, the costs to the Society would be no more than £50 million, for which there were adequate reserves. Nevertheless a prudent provision of £200 million was included in the Companies Act accounts for both 1998 and 1999 on which the Society's auditors expressed a "true and fair" opinion.

  The decision of the Court of Appeal did not deliver the certainty which the Society sought through the representative action. The conclusions and the reasoning of the three judgments were each different. The Society was granted leave to appeal to the House of Lords. While different possibilities were considered, a ruling by the House of Lords that "ring fencing" of the GAR policyholders was impermissible was viewed as remote.

  In the event and much to the dismay of the board, the House of Lords ruled unanimously on 20 July 2000 that different levels of final bonus for those policyholders taking their benefits at GARs compared with those taking benefits in cash or using the open market option was an unlawful exercise of the board's discretion and that "ring fencing" was impermissible.


  In order to understand what has followed it is necessary to examine the House of Lords decision critically.

  The principal judgment was that of Lord Steyn. He held that it was not open to the Society to award differential rates of final bonus. The essential steps in his reasoning were, first, that it was an implied term of article 65 of the articles of association that the Society would not exercise its discretion in a manner which had the effect of undermining the GARs. This principle was common ground between the parties. Second, and this was the critical point, the purpose of the GARs was to ensure that, if a fall in annuity rates occurred, the policyholder taking a GAR annuity would be better off than he would have been with market rates. In other words, he rejected the analysis of Lord Justice Morritt, endorsing the Society's approach, that the GAR benefit was simply a "floor" below which the pension provided by the policy could not fall. He went on to hold that, having regard to the purpose of the GAR benefit, "ring-fencing" was impermissible.

  The only other reasoned judgment was that of Lord Cooke. He held that the assumption on which the GAR policy was based was that, when current rates fell below GARs, the GAR policyholder would receive higher benefits than if he had no GAR provisions in his policy. He did not accept that the wide and general discretion in the articles was adequate to justify the differential adjustment of policy benefits.


    "Although it may be regarded as presumptuous to criticise our court of final appeal, it is wholly proper to do so. Judges as persons, or courts as institutions, are entitled to no greater immunity from criticism than other persons or institutions. Judges must be kept mindful of their limitations and of their ultimate public responsibility by a vigorous stream of criticism expressed with candour, however blunt."

  We adopt, with approval and respect, the sentiments of Justice Felix Frankfurter, one of the most famous of US Supreme Court justices, as expressed in Bridges v California, 314 US 252, 289 (1941).

  The judgment of the House of Lords may be criticised in a number of ways.

  The central point in the judgments was the finding by the House of Lords that, as a matter of contract, the purpose of the GARs was to ensure that, if current rates fell below the GAR, GAR policyholders would be contractually entitled to receive higher benefits than they would have done if they had not had GARs in their policies. It rejected the argument advanced by the Society, and approved by Lord Justice Morritt in the Court of Appeal, namely that the GAR benefit only afforded a limited guarantee whose purpose was simply to provide a minimum contractual "floor", below which the value of benefits could not fall.

  How did the House of Lords reach their conclusion as to the purpose of the GAR? The House of Lords did not do so on the basis of a detailed analysis of the terms of the GAR policy. Indeed, Lord Steyn expressly took no account of the "minutiae" of the policy. This is significant because the express terms of the GAR policy did not, in the Society's view, support the House of Lords' conclusion as to the purpose of the GAR. Lord Justice Morritt endorsed that view. The policy wording did not show that the purpose of the GAR benefit was to ensure that, if the GAR was higher than the current annuity rate, GAR policyholders would receive more valuable benefits than non GAR policyholders. Instead of focusing on the wording of the policy, the House of Lords based its conclusions as to the purpose of the GAR benefit on what it considered to be the "reasonable expectation of the parties".

  However, the Society considers that the House of Lords' assessment of the "reasonable expectations of the parties" was unwarranted and unrealistic. In the Society's view, GAR policyholders had a reasonable expectation or "PRE" that they would receive benefits which reflected their asset share. The Society's view of PRE was consistent with, and supported by, many years of unchallenged practice by appointed actuaries and boards of directors charged with taking PRE fully into account. In the life assurance industry, PRE is treated as synonymous with asset share.

  The House of Lords' assessment of the parties' reasonable expectations appears to be based on speculation that the GAR benefit must have been an important selling point in the marketing of the policy. No evidence was before the House of Lords to this effect. In reality, in the economic conditions prevailing at the time the GAR policies were issued, the GAR benefit was not considered to be an important feature of the policies. Many policyholders would have been completely unaware that their policies contained any GAR provisions and are unlikely to have had the expectations found by the House of Lords.

  The other main criticism of the House of Lords we make is that, despite the fact that the House of Lords must have appreciated it, judgments failed to take account of the impact of their decision on the non GAR policyholders. It was, however, repeatedly emphasised in the course of the proceedings by Leading Counsel for the Society that the effect of awarding the same level of bonus indiscriminately would be to enrich the GAR policyholders at the expense of the non-GAR policyholders. Indeed, that was clear and inevitable result of the House of Lords' decision.

  In fairness to the House of Lords, of which in this case we are unashamedly critical, it may be said that if they were correct in the analysis of the contract, the prejudice to non GAR policyholders is irrelevant. However, this seems implausible since most House of Lords' decisions (and this is no exception) are to some extent based on unspoken policy considerations, not pure legal reasoning. That we can accept. But in this case, the House of Lords appears to have bent over backwards to adopt a so-called "consumerist" approach towards the most generous interpretation of the GAR policy in favour of the GAR policyholders, but, only in the absence of ring-fencing, at the expense of other "innocent" consumers, ie the non GAR policyholders on whom the cost of the GAR provisions would fall disproportionately. In effect the House of Lords' judgment means that the final bonus granted to GAR policyholders cannot be adjusted so as to ensure that the GAR policyholders receive more than their asset share, as would be the normal actuarial practice.

  The result now is history. The board was, faced with this decision, forced to offer the Society for sale to mitigate the impact of the House of Lords' decision on non GAR policyholders and also to mitigate new constraints on investment freedom caused by changed reserving obligations. The sale process failed and, in December 2000, the Society closed its doors to new business. It was at all times and remains solvent—as to which more below.


  Monitoring the solvency of a long term insurance business is not a simple matter.

  The intrinsic profitability of the business is not known until individual contracts have run their course. In order to assess the position of the long term fund at any time, it is thus necessary to conduct a valuation of the assets and liabilities by making assumptions about the future economic and business variables. There can never be certainty of the solvency of a long term fund because, for example, a pandemic might cause exceptionally high mortality rates resulting in almost any long term insurance fund becoming insolvent. True insolvency, that is to say, where the long term fund does not have enough assets to meet its liabilities, is extremely unlikely in a with-profits fund in the UK. After all, bonuses can be reduced or eliminated so that only the basic policy guarantees remain and the fund is able to pay at least these benefits.


  In the UK there is a complex system of supervision which it is outside the scope of this memorandum to describe in detail. The Insurance Directorate of HM Treasury/the FSA is the regulator and the system also relies on the appointed actuary of the particular fund. The concept of prudent actuarial reserving with margins on each of the assumptions (compared to the best estimate assumption) and imposing a supplementary reserve to provide resilience to variability in the economic factors provides the regulator with an early warning system so that failure to meet the statutory reserving requirements occurs much earlier than true insolvency. It is then possible for the regulator to arrange a soft landing or to allow the company to trade its way out of its difficulties. There is every reason to believe that this well tried system has worked effectively throughout the past 25 years as no significant UK life assurer has become truly insolvent during this period.


  The system is not without deficiencies or imperfections. The statutory basis can be too demanding for a with profits fund at a time of abnormal market conditions. Virtually every company would have failed to meet the statutory requirements had the current regulations applied in December 1974, despite the fact that it was perfectly possible to trade through those conditions (as the companies did). The conditions of October 1998 also presented very serious difficulties in terms of the statutory reserving requirements. The undesirable side-effect of such a demanding system is that at such times the appointed actuary may be obliged to advise the investment team to sell equities and buy gilts at just the wrong time. This is a well-known and well understood defect in the system.


  In the autumn of 1998, the Society's management attended a series of meetings with the DTI as the then prudential regulator and with representatives of the Government Actuary's Department (GAD). At those meetings the issue related to the Society's approach to with-profits policies with GARs were outlined in the economic conditions prevailing and with proper regard to ("PRE") and the policy contracts. Reserving requirements were also discussed.

  In December 1998 the letter from Martin Roberts setting out guidance covering the handling of GARs was issued to the industry, followed by the issue of new guidance on reserving in January 1999 by the GAD. The Society's statutory reserves fully reflected all the requirements in both 1998 and 1999.

  The Society, although a mutual organisation, has also chosen to comply voluntarily with the various corporate governance provisions of the Combined Code. That it has done for all relevant years and is fully compliant with the Turnbull recommendations from the end of 2000.

5 February 2001

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