Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 158 - 179)




  158. Good morning, Sir Howard. I hope your injury is all right. Can you tell us what it is?
  (Sir Howard Davies) I could, but it is a complaint with a long name. It is not that I have been in a fight, nor is it a plea for sympathy!

  159. Would you like to start by introducing your colleagues?
  (Sir Howard Davies) If I could make a very brief opening statement, that would be helpful. First of all, my team is Michael Foot, who is a familiar regular appearer before the Committee and managing director for financial supervision, and Mr Martin Roberts, who is the director of insurance and friendly societies' supervision. Mr Roberts was appointed to be effectively in that role in the Treasury in February of 1998 with my agreement and came to the FSA on 1 January 1999. It may help if I clarify that at that point we took over the supervision of insurance companies on a contractual basis from the Treasury, and we took it over, if you like, as a going concern under Mr Roberts and Mr Allen for life insurance, including the legal advisers who had previously been in Treasury Solicitors. They all came over as part of a complete package along with, of course, the advice from government actuaries. There has been, therefore, a high degree of continuity of approach through 1998, 1999 and 2000. Secondly, briefly, we are, as the Committee will be aware, undertaking a review; we have asked our director of internal audit supported by lawyers Norton Rose and PricewaterhouseCoopers to look into the background to our assumption of responsibility for the supervision of the Equitable and also the actions taken by the FSA from the point at which we assumed that responsibility up to the time the Society was closed to new business. That review will be complete in the summer and it will be sent to the Treasury and published. Lastly, we recognise that this has been a very worrying time for Equitable policyholders—of whom I should perhaps say for completeness I am one, albeit of a small unit-linked policy and, therefore, not at the centre of the issues here—

  160. Are your colleagues also?
  (Sir Howard Davies) They are not, no. The particularly worrying feature for policyholders as we know from correspondence and, indeed, from our meetings with the various policyholder groups has been the uncertainty and the open-ended nature, if you like, of the uncertainty. I think that it is worth pointing out, however, that, since the deal with the Halifax on 5 February, the prospects have become somewhat better and, if a deal is agreed between the non-guaranteed and guaranteed policyholders supported by the Halifax injection into the fund, then, going forward, the position of Equitable policyholders should be considerably clarified and the fund should be strong enough not to need to take a defensive asset strategy which was, of course, one consequence of the closure in December. In other words, going forward, the fund would not be able to have a normal proportion of equities and, therefore, policyholders could look for a lower return. If the Halifax deal and the propositions put to the different groups of policyholders are supported, then the fund should be strong enough to bear a normal proportion of equities as we see it at this point, which would mean that the cost to policyholders of any problems would then be limited to the forgone bonuses last year which may be somewhere between 3 and 4 per cent of overall policy values for a normal long-term policyholder. Clearly that is not a welcome impact for anybody, but more quantifiable and less serious than had been thought at the time when the position was considerably more uncertain after the closure to new business in December. I just wanted to make those points by way of background.

  161. We want to take up some of them as we go along but could I start by asking a couple of general questions. Firstly, do you think different regulatory advice at an earlier stage could have stopped the Equitable crisis happening? Secondly, you have given us some assurances about the future. Do you feel now that in a sense we are coming out of the wood and that you can tell Equitable policyholders that matters are going to be better in the future, and of course people who invest in policies generally, because that is what they want to know, is it not?
  (Sir Howard Davies) I completely agree with that, Mr Chairman. Looking back into the past, the answer to your question might depend on how far one would ideally like to go in that the roots of the Equitable's difficulties lie in the guaranteed annuity policies and the particular nature of those policies which were sold between 1957 and 1988 in rather different economic circumstances. I think it would be fair to say one could wish that open-ended interest rate options of that kind had not been sold by this company on such a scale or that, had they been sold, some kind of hedging mechanism had been put in place to cope with the possibility that the cost of those guarantees would be greater in the future. That I have to say, however, is a very long way in the past and it would be fair to say that the insurance regime did not provide for that to be done, so I do not think one can say that anybody did not do anything that was required of them during that period. The regulations in force at the time, and now, did not require people to provide in that way. More recently, had the Equitable foreseen the outcome of the House of Lords case and had regulators foreseen it, which I think was difficult, I suppose reserves could have been put in place but, as Equitable Life tried to explain, that would effectively only have brought forward a little what was done in the year 2000. In other words, you would have had to reduce the bonuses payable to non-guaranteed policyholders in order to create that reserve. Now that might have been done in a smoother way had it been done over a period since interest rates started to fall quite sharply, particularly after the Bank of England independence in May 1997, but that would really have just brought forward the point at which those reserves were created from 2000 to 1998 and 1999, and it is not clear that policyholders would have been in a hugely different position today in terms of that phasing. Your second question concerned the prospects. As I said at the outset, this does depend heavily on the result of the vote which policyholders will be invited to make some time later this year where guaranteed policyholders will be invited to agree to a capping of their liabilities in return for a one-off uplift in their bonuses, and non-guaranteed policyholders will be invited to agree that that one-off uplift can be paid to guaranteed policyholders. If that deal is done, and you will appreciate this is essentially a redistributional mechanism within a fund, the advantage of doing so for everybody would be that that would trigger a further payment into the fund by the Halifax, so it is not a purely zero sum game. If that is done, then our current judgment is that the fund would be able to operate in broadly the same way as other comparable funds and therefore, going forward, policyholders would not be in a worse position ex ante being in the Equitable than any other. Of course ex post it depends on asset management and performance, both of which can and do differ very considerably from one life office to another but they would not be constrained by this problem. Obviously individual policyholders, when they see the details, will have to take a view. I would have to say that we believe that there is a possible deal which could be put forward which would be reasonable and fair and which would offer the prospect of a more certain and happier outcome for everybody.

  162. Basically you are advising the policyholders to vote yes?
  (Sir Howard Davies) Well, I would not wish to go that far at this point because the terms of that deal have not been worked out. We will, however, offer a view on the fairness of that deal at the time the terms come to be thrashed out and there are considerable uncertainties. What I was saying—and I was hoping to choose my words carefully—is we can see the prospect of a reasonable deal which would be fair to all sides and which would put the company and the policyholders on a much better footing for the future.

  163. So if policyholders ring your helpline, and you are convinced when you have seen the details of the deal that it is in their interests, you would be advising them accordingly?
  (Sir Howard Davies) We will set out the pros and cons, in as objective a way as we can, of the deal and of the consequences of accepting the deal or not. I think we would not wish to put ourselves in the position of advising an individual "Yes" or "No" because people will have different personal circumstances. We will be setting out whether we think this is a fair deal to offer and what the consequences are in an objective way which we think would be helpful to policyholders—as we believe it was in the AXA case last year where, in fact, the judge was very positive about the information that the FSA had put out to help policyholders make a decision.

Mr Plaskitt

  164. May I begin by declaring that I am a policyholder and then put my question to Mr Foot, which is do you recall the letter you received from Roger Allen, then head of insurance directorate in the Treasury, dated 5 November 1998?
  (Mr Foot) Yes, indeed.


  165. Is Mr Allen now working for you?
  (Sir Howard Davies) Yes, and perhaps I could clarify this for Mr Plaskitt, since I also received a copy of that letter, that was part of a process of what you might call internal briefing to prepare for the formal transfer of responsibilities. In the summer of 1997, the government announced that insurance regulation would transfer to the FSA in due course. In early 1998—I cannot remember precisely the date but the summer—a firm date was set of 1 January 1999. From that point on, there was a considerable amount, as you would expect, of briefing by Mr Roberts and Mr Allen, who was his deputy on the life side, of their future bosses—and in a direct line that went Mr Roberts, Mr Foot and me—about, as it were, the inheritance that they brought with them; on-going cases; and problems that we would need to pick up. The Equitable was one of those problems very high on the list, and Mr Allen's notes of 5 November explained that the Treasury at that time had some concerns about the reserving approach of the Equitable Life and how these problems were being dealt with. We picked up the dossier and, whereas the submissions for ultimate decision up to 31 December went to ministers, from 1 January they came to me so this was part of an internal briefing arrangement.

Mr Plaskitt

  166. Can we have a look at this "briefing", as you describe it? Mr Allen says in his letter to you, "Our primary concern is over Equitable Life's ability to reserve adequately for these guarantees. The information received to date is unconvincing, and raises serious questions about the company's solvency", and you describe that as a "briefing"?
  (Sir Howard Davies) Yes. It was alerting us to this problem.

  167. How many other briefings did you get from the Treasury at this time that made similar remarks about companies?
  (Sir Howard Davies) None.

  168. So this briefing stood out against all the others that you received?
  (Sir Howard Davies) Yes, absolutely.

  169. So how loud were the alarm bells ringing inside the FSA when you read Mr Allen's letter?
  (Sir Howard Davies) They were considerable. We recognised that this was one of the most serious, possibly the most serious, issue that was brought across to us. What happened after that was that, shortly after that in January, guidance was sent out of a general nature to the industry about the reserving practices for guaranteed annuities and we continued with a lively debate with the Equitable about their own position, which went on from the same personnel, though in due course involving Michael Foot and me; we pressed the Equitable to agree that they needed higher reserves for these guarantees—even in the context of our acceptance that the law was as it was and, was as Mr Roberts' letter of December 1998 had pointed it out to be, we did agree that their approach to changing the bonuses on guaranteed annuity policies was not unreasonable; nonetheless we did not think that their reserving approach was necessarily appropriate. We pursued that vigorously with the company; the company were not disposed to accept our view; the company, indeed, threatened to take us to judicial review on imposing our view on them but eventually we overcame those objections by our legal advisers convincing their legal advisers that our approach was appropriate and, in due course, the reserve was put in place in respect of their 1998 returns. This was, therefore, a continuing story: there was no discontinuity in the approach taken by the regulators between 1998 and 1999.

  170. So would you describe it as Equitable Life initially not wanting to accept your advice, or were you being tougher than that?
  (Sir Howard Davies) Ultimately it was a requirement.

  171. But they did not want to go along with it until you made it a requirement?
  (Sir Howard Davies) No, they did not.

  172. In effect, they did not in the end go down the building reserve route: they went for a reassurance route—
  (Sir Howard Davies) In part.

  173.— But did that not just hide the liability and take it off the balance sheet?
  (Sir Howard Davies) I think not. As I think was explained in the earlier evidence, the reinsurance was about half the additional reserve they put in place and it had particular features and was reserving for a particular set of economic circumstances, and I would fully accept Mr Headdon's description of that policy which accords with our understanding of what it did and did not do.

  174. Was that not a bit of a compromise—that they only went for half to cover half? It sounds a bit to me like you got together and did a deal.
  (Sir Howard Davies) I think in the circumstances it was a reasonable approach, and we accepted it. As the Equitable have explained, they did not operate with a large free asset ratio. In the economic circumstances that we were envisaging—and we were not requiring them to reserve for the House of Lords judgment, I think that must be absolutely clear—where terminal bonuses would be considerably lower and consequently the policy they had of adjusting terminal bonuses to take account of the value of the guarantees would no longer be open to them, the take-up of guaranteed annuities might be considerably greater than the company was expecting. We thought that, for that albeit relatively remote set of circumstances, some kind of provisioning should be put in place and a reinsurance policy to do that was, we thought, not an unreasonable approach. We were talking about rather the end of the curve of possibilities, if you like, whereby there had been such a fall in equity values that all the terminal bonus flexibility had been used up and the guarantees were triggered and, therefore, you would have to use future profits to pay those guarantees and you would do that by a reinsurance policy. That seemed to us, in the circumstances, to be a reasonable response to this particular risk. I agree it did not insure against the House of Lords outcome; that was not its intention; but there is no misunderstanding between us about the nature of that policy; the nature of the risks it reserved against and what it did not.

  175. But from 1998 you were advising other companies to start building stronger reserve positions?
  (Sir Howard Davies) Yes.

  176. And yet you came to this separate arrangement with Equitable Life. Why did you settle for that, given that it was top of the alarm bell list when it came in yet now you are telling us, "Well, all right, we will insure against half, with a bit of this and that, fingers crossed and hope that nothing goes wrong in the House of Lords, an `It will be all right on the night' policy"? It was running a bit of a risk, was it not?
  (Sir Howard Davies) I think by that time the only alternative in terms of creating cash for everything would have been to pay no bonus whatsoever—effectively to do in 1999 what the company had to do as a result of the House of Lords in the year 2000—and it did not seem to us to be at that point, given the state of the law and the view that the company had taken which was supported by our own legal advice, reasonable to insist on that against what was still thought to be an unlikely outcome.

  177. In view of what has happened since, do you not think you miscalculated the risk?
  (Sir Howard Davies) If you are saying "Did we miscalculate the outcome of the House of Lords case?", I think the answer is "Yes"—

  178. I am not saying that.
  (Sir Howard Davies)—Because that was the key that caused the need to create cash reserves quickly, which is what the company did in the year 2000.

  179. That was not what I was saying. You knew that was out there and could happen and you had to look at the entire range of evidence in front of you given that Mr Allen's letter had set alarm bells ringing. You should have been acting in a very prudent manner knowing the scale of the risk here; knowing how serious the situation was. Do you not think, in view of what has subsequently happened, that you miscalculated the risk to policyholders?
  (Sir Howard Davies) I am not sure that I do, no, and furthermore—and this may seem a tedious technological point—I call this a memo not a letter; it is an internal document effectively and, with a copy list, it looks like a memo. Absent the House of Lords judgment, we are not in economic circumstances which would have created the need for these reserves to be available in cash form, so no, I do not think I would accept that.

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