Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum from Ernst & Young


  1.1  This paper is in response to the invitation to submit written evidence to the Committee dated 19 January 2001. We have been asked, as auditors of Equitable Life Assurance Society (the "Society"), to comment on our role in the recent events surrounding the Society.

  1.2  Ernst & Young and its predecessor firms have acted as auditors to the Society for many years. Until the last two years, our services to the Society have been predominantly carrying out the audit. More recently, we have been asked to help the Society in a number of other areas, and brief details of other assignments can be found in section 5.

  1.3  The recent events surrounding the Society have centred on the treatment of policyholders' rights in relation to policies containing Guaranteed Annuity Rate Options ("GAR"). This issue was the subject of a representative action, funded by the Society, which culminated in the judgment of the House of Lords in July 2000 in Equitable Life v Hyman.

  1.4  In addition to providing a summary of the regulatory background as it applies to both directors and auditors, this paper addresses the manner in which GARs were reported and accounted for in the accounts and the regulatory returns of the Society for 1998 and 1999. We have not included a detailed analysis of how the Society's GAR contracts operate. If the Committee requires information on this or any other matter, we would be happy to submit further evidence as requested.


  2.1  A UK life assurance company is required by statute to prepare two sets of financial reports:

    —  the annual accounts (the "statutory accounts") required by the Companies Act 1985; and

    —  the regulatory return required by the Insurance Companies Act 1982.

  2.2  The basis for the preparation of each set of financial reports is different and auditors have different responsibilities in relation to each set of reports. We explain this further below.

Statutory accounts of life assurance companies

  2.3  The directors are required by section 226 of the Companies Act 1985 to prepare accounts which give a true and fair view of the state of affairs of the company as at the end of the financial year and of the profit or loss for the financial year and which comply with the detailed provisions of the Act. There is no set definition of what constitutes a "true and fair view". For working purposes, however, it is important to note that this does not mean wholly accurate. What is involved is a judgment to ensure that the accounts as a whole do not present a materially misleading picture of the state of affairs of the company.

  2.4  Detailed requirements and guidelines for the preparation of the statutory accounts are set out, in particular, in:

    —  Schedule 9A of the Companies Act 1985;

    —  the Statement of Recommended Practice on accounting for insurance business published by the Association of British Insurers in December 1998 ("ABI SORP") which sets out details of the Modified Statutory Solvency Basis of accounting ("MSSB"); and

    —  Financial Reporting Standards published by the Accounting Standards Board.

Regulatory return

  2.5  The regulatory return is required under the Insurance Companies Act 1982 and has to be prepared in accordance with the Insurance Companies (Accounts and Statements) Regulations 1996 (the "1996 Regulations"). The return is prepared by the company and is submitted annually to the company's prudential regulator, currently the Financial Services Authority (the "FSA") and formerly HM Treasury and, before that, the DTI.

  2.6  The regulatory return is significantly longer and more detailed than a company's statutory accounts. The Society's return for 1999, for instance, ran to 420 pages. The contents of the return are prescribed by the 1996 Regulations but the regulator can modify the requirements for a particular company by issuing an order under section 68 of the Insurance Companies Act 1982.

Valuation differences between statutory accounts and the regulatory return

  2.7  The method of valuation of assets and liabilities in regulatory returns is prescribed by the Insurance Companies Regulations of 1994, and requires the use of detailed rules, the application of which is more pessimistic than the prudently realistic basis used for statutory accounts.

  2.8  The valuation rules, for instance, require that certain assets contained in the statutory accounts be disallowed from inclusion in the regulatory return and also that liabilities be increased for the purposes of the regulatory return in order to include substantial resilience and contingency reserves. The MSSB, in particular, sets out significant adjustments that may be made, when preparing statutory accounts, to the basis used for preparing the regulatory returns.

  2.9  The statutory accounts and the regulatory return are, therefore, very different reports which reflect their different objectives. The statutory accounts provide information on the overall performance of the company whereas the regulatory return is intended to provide the regulator with a wide range of information to facilitate its monitoring functions.


  3.1  As indicated in paragraph 2.3 above, the responsibility to draw up the statutory accounts is that of the directors of a company. The responsibility of the auditors is to form an independent opinion, based on their audit, as to whether the statutory accounts prepared by the directors give a true and fair view of the state of affairs of the company as at the balance sheet date, and of the profit or loss for the financial year. An audit is planned and performed such that the auditors obtain sufficient evidence to give reasonable assurance that the accounts are free from material misstatements.

  3.2  While the role of the auditors with regard to the regulatory return is also to express an independent opinion, there are some significant differences as a result of the requirements of the 1996 Regulations. The 1996 Regulations provide that only specific parts of the regulatory return are covered by the opinion expressed by the auditors. In respect of the Society's 1999 regulatory return, for instance, the auditors' report only covered 28 out of the 420 pages. In particular, the auditors do not report on Schedule 4, which is the part of the Society's regulatory return that contains the reserves in respect of GARs. In addition, the report that has to be provided is not an opinion on a "true and fair view" but is a report on whether the particular parts of the regulatory return subject to audit have been "properly prepared" in accordance with the 1996 Regulations and any modifications specific to that company.

  3.3  In conducting audits of assurance companies, the latest specific guidance is given in Practice Note (PN) 20 "The audit of insurers in the UK" issued by the Auditing Practices Board in 1999. PN20 superseded earlier guidance from the Auditing Practices Board which was extant at the time of the 1998 audit, including the Auditing Guideline on life insurers in the United Kingdom and Bulletin 1998/3—"Auditors' reports on regulatory returns made under the Insurance Companies 1982".

  3.4  In addition to the specific responsibilities to review the regulatory return, the auditors have a right under the Insurance Companies Act 1982 to report to the regulator any information or opinion which is relevant to the regulator's functions. There is a duty to report to the regulator in respect of the matters set out in The Auditors (Insurance Companies Act 1982) Regulations 1994; in essence, these cover matters that would be of material significance to the regulator in determining whether to exercise its powers of intervention.


  4.1  Our audit work, both on the statutory accounts and the regulatory returns, was carried out in accordance with the applicable UK auditing standards and using relevant accounting guidelines. The audit team was primarily staffed from a specialist insurance group within the firm and used methodologies and support tools that have been adapted specifically for the life assurance industry.

1998 Statutory Accounts

  4.2  In determining the required level of provisions to be included in the statutory accounts for the year ended 31 December 1998, the Society had to consider the challenges raised by some policyholders to the Society's treatment of GAR policies and also new guidance on GARs issued by HM Treasury Insurance Directorate on 18 December 1998.

  4.3  The Society increased the relevant provision in the 1998 accounts (the long-term business provision) by £200 million to £21.9 billion in order to reflect the additional cost of the GARs. The increase was made on the basis that the approach then being adopted by the Society to award differential terminal bonuses was wholly within the wide discretion conferred on the Board by the Society's Articles of Association. This approach was supported by a joint opinion from two senior Counsel.

  4.4  Actual experience of the take up of GARs in 1998 indicated that a much smaller amount (£50 million) would probably be required but on the grounds of prudence, the increase in the provision was set at £200 million.

  4.5  As auditors, we reviewed the calculations prepared by the Society and discussed them with the actuarial staff and the Appointed Actuary and the Audit Committee. We also discussed with the Society the legal advice it had received and we formed the view that the action the Society had taken and the provisions made were reasonable.

1998 Regulatory Return

  4.6  The Society calculated the additional reserves for the 1998 regulatory return in respect of GARs in the light of the guidance from HM Treasury referred to in paragraph 4.2 above and specific guidance on regulatory returns issued by the Government Actuary's Department ("GAD") on 13 January 1999. The calculations required an assumption that the take up rate of GARs would be greatly in excess of the Society's actual experience. The calculations provided a figure of £1.59 billion for inclusion in the reserves in respect of GARs.

  4.7  The Society also negotiated a reassurance treaty in order to mitigate the impact of these additional reserves on the excess of the available assets over the required solvency margin. One of our life actuarial specialists (who was not part of the audit team) assisted the Society in reviewing the terms of the reassurance treaty and the terms of the policy were discussed with and accepted by the regulator and the GAD prior to its inception. The net figure for the additional reserves, after taking into account the reassurance, was £784 million.

  4.8  Details of the reserves and the level of reassurance were set out in Schedule 4 of the regulatory return. The 1996 Regulations do not require an audit of Schedule 4 and it was not, therefore, included in our report on the regulatory return. We were, however, aware of the contents of Schedule 4 and that the regulator had been consulted specifically in respect of the reassurance.

  4.9  It is important to note that the reassurance had no impact on the additional provision for GARs made by the Society in its statutory accounts. It was only taken into account in connection with the reserves in Schedule 4 of the regulatory return. The provision in the statutory accounts was based on assumptions as to the take up rate of GARs that would not have triggered the right to make a claim under the reassurance treaty; it would, therefore, have been inappropriate to adjust the provision.

1999 Statutory Accounts

  4.10  At the time that the company was finalising its accounts for the year ended 31 December 1999, the state of the court proceedings was as follows. In September 1999, judgment had been given in the High Court confirming that the Society was entitled to award differential terminal bonuses to GAR policyholders. In January 2000, the Court of Appeal had given judgment in which the majority of the court had held that there should not be differential terminal bonuses. Leave was granted to take the case to the House of Lords. A detailed report on the state of the case was included in the Society's 1999 Annual Report which was sent to policyholders at the same time as the statutory accounts.

  4.11  One of the main issues in preparing the 1999 accounts was, therefore, to determine what provision and disclosure should be included in relation to GARs following the Court of Appeal judgment.

  4.12  Whilst the Court of Appeal had ruled that the Society should not award differential terminal bonuses depending on whether a GAR policyholder exercised his rights to take a guaranteed annuity, the Society concluded that the detailed reasoning of the court allowed the Society to "ring fence" assets of GAR policyholders so that, as a class, their terminal bonuses were not paid from the asset share of other policyholders. This approach was consistent with the HM Treasury guidance referred to in paragraph 4.2. It was also consistent with the Position Statement issued in March 1999 by the Life Board of the Faculty and Institute of Actuaries to assist its staff in responding to questions from members of the actuarial profession and the public on this issue. We were also aware that the Board had taken independent legal advice.

  4.13  Specific consideration was given by the Board to whether the outcome in the House of Lords would be significantly more adverse than the Court of Appeal judgment. The Board concluded that, having considered the legal advice received, such an outcome was no more than a remote possibility.

  4.14  The approach adopted by the Society to meet the requirement to prepare accounts to a "true and fair view" standard in accordance with the MSSB, was to select a provision that was realistically prudent and not excessive. In line with this approach and given its conclusion that the likelihood of a significantly more adverse judgment was remote, the Board considered that it was not necessary to make an additional provision for this eventuality or to make any more detailed reference to the matter in the notes to the accounts.

  4.15  We discussed at length the issue of the GARs, both with the management of the Society and with the Audit Committee. We reviewed the Society's calculation of the provision which, in the light of the Court of Appeal judgment, was prepared on different assumptions from those used in 1998 and we concluded that the Society was acting reasonably in maintaining a provision of £200 million for the GAR liabilities. This provision formed part of the total long-term business provision of £23.9 billion which was included in the 1999 statutory accounts for the Society.

  4.16  We also considered whether there was a requirement to disclose contingent liabilities under the Companies Act 1985 and the relevant accounting standards. In our view, no such additional disclosure was necessary as the risk of the House of Lords producing a judgment more adverse than the Court of Appeal was seen as remote.

1999 Regulatory Return

  4.17  For the 1999 regulatory return, updated guidance on reserving had been issued on 22 December 1999 by the GAD and the reserves were established in the light of that guidance. The calculation of the additional reserves in respect of GARs produced a figure of £1.66 billion.

  4.18  Following the Court of Appeal decision, it was necessary to amend the reassurance treaty and the Society renegotiated the treaty with the reassurer and informed the FSA of the revision. Taking into account the reassurance, the net reserves in respect of GARs came to £565 million. Details of the reserves and the level of reassurance were disclosed in Schedule 4 of the regulatory return which, as indicated above, was not subject to an auditors' report under the 1996 Regulations. Once again, it should be noted that the amended reassurance had no impact on the provisions made by the Society in the statutory accounts.

Auditors' general duty to report to the regulator

  4.19  For the sake of completeness, we would note that no report was made by us to the FSA under the general duty to report referred to in paragraph 3.4. The FSA was already actively reviewing the issue of GARs in the industry generally and the Society was specifically discussing its position with the FSA throughout the period, as well as providing the standard, detailed information required in its regulatory returns.


  5.1  In addition to our audit appointment, Ernst & Young has carried out other non-audit work for Equitable Life. Most recently, this has included:

    —  Provision of actuarial advice. This has involved providing assistance on a number of matters but predominantly relates to the potential sale of the Society's business. As indicated above, we also assisted the Society in the arrangement of the reassurance effected in 1998 in relation to GAR policies.

    —  Assistance in the enhancement of the Society's risk management processes in order that it could achieve voluntary compliance with the requirements of the Turnbull guidance.

    —  Assisting the Society in a tax review on part of its business and in the preparation of tax computations for part of its business.

6 February 2001

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