Examination of witnesses (Questions 158
THURSDAY 15 FEBRUARY 2001
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
(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 policyholdersof
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 sayingand I
was hoping to choose my words carefullyis 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 policyholdersas
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.
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 1998I
cannot remember precisely the date but the summera 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 bossesand in a direct line that went Mr Roberts,
Mr Foot and meabout, 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
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
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 guaranteeseven 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 compromisethat
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 envisagingand
we were not requiring them to reserve for the House of Lords judgment,
I think that must be absolutely clearwhere 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
(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 whatsoevereffectively to do in 1999
what the company had to do as a result of the House of Lords in
the year 2000and 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
(Sir Howard Davies) I am not sure that I do, no, and
furthermoreand this may seem a tedious technological pointI
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.