Memorandum by Cazalet Financial Consulting
Basis of evidence
This evidence has been supplied to the House
of Commons Treasury Committee further to an invitation issued
by the Committee on 17 January 2001.
The Committee's invitation was non-specific
as to the aspects of the Equitable Life Assurance Society's conduct
and that of other parties upon which it sought comment.
Given free rein, we thought is would be helpful
to set out our views on the background to Equitable financial
philosophy, the matter of the emergence of the guaranteed annuity
problem in industry-wide terms and, then, with specific focus
on Equitable's treatment of the issue, with regard to its conduct,
the impact or potential impact of the liabilities on the financial
health of the Society and what was communicated to its policyholders
at various stages of the matter. We have also commented briefly
on the Equitable's deal with Halifax.
About the author
The Committee's guide to witnesses asks that
written evidence should contain a brief introduction to the persona
or organisations submitting it.
This evidence has been prepared by Mr Ned Cazalet,
who is principal of Cazalet Financial Consulting.
Cazalet Financial Consulting specialises in
the provision of strategic and corporate finance advice as well
as product development, training, analytical and data services
to the life assurance, fund management and retail banking sectors.
It has very broad and deep connections, formally interviewing
at least once each year practically all heads of function of almost
all UK life assurance companies (over 90 groups are covered).
Cazalet Financial Consulting's principal, Ned
Cazalet, is an adviser to HM Treasury on matters relating to the
UK life assurance fund and management industries. Cazalet Financial
Consulting's client base includes a wide range of life offices,
reinsurers, fund managers, banks, investment banks, actuarial
and consultancy practices, which breadth of contacts helps enhance
our insights into the life assurance and fund management sectors.
Those that have used our services in the past 3 years include
ABN Amro, Allied Dunbar, American International
Group, AMP, Andersen Consulting, Arkwright Consulting, Arthur
Andersen, AXA Sun Life, Bacon & Woodrow, Bain & Co, Bank
of Ireland, Bankers Trust, Banque Nationale de Paris, Barclays,
Britannic, Brough Skerrett, Cameron McKenna, Canada Life, Centre
Re, Century Life, CGU, Chartered Insurance Institute, Charterhouse
Securities, Clerical Medical, Clifford Chance, Colonial, Commerzbank,
Co-operative Insurance Society, Countrywide Assured, Datastream,
Deutsche Bank, DLJ International, Dresdner Kleinwort Benson, Equitable
Life, ERC Frankona, Ernst & Young, Fidelity, Financial Services
Authority, Fox-Pitt Kelton, Freshfields, Friends Provident, FT
Information, GE Capital, General Atlantic Partners, Greenhill
& Co, Goldman Sachs, Grant Thornton, Halifax, Hammerson, Herbert
Smith, HSBC, Hymans Robertson, Japan Research Institute of Life
Insurance, Jardine Reeves Brown, KPMG, Lane Clark & Peacock,
Lazards, Legal & General, Lehman Brothers, Liberty International,
LIMRA, Liverpool Victoria, Lloyds TSB Group, Lovell White Durrant,
Marlborough Stirling, McKinsey, Mercury Asset Management, Merrill
Lynch, M&G Group, MGM Assurance, Midland, JP Morgan, Morgan
Stanley, Munich Re, NFU Mutual, Nippon Life, Norwich Union, Old
Mutual, Paymaster, Pearl, PricewaterhouseCoopers, Prudential,
Rebus Group, J Rothschild Assurance, NM Rothschild, Royal Bank
of Scotland, Royal Liver, Royal London, Royal & Sun Alliance,
Schroders, Scottish Amicable, Scottish Equitable, Scottish Life,
Scottish Mutual, Scottish Widows, Skipton Building Society, Slaughter
& May, Societe Generale, Sun Life of Canada, Swiss Life, Swiss
Re, Tillinghast Towers Perrin, UBS Warburg, Unisys, Virgin, Warburg
Pincus, Wasserstein Perella, Watson Wyatt, JB Were, Wesleyan,
Winterthur, Zurich Financial Services
Mr Cazalet is widely consulted by the media
as an authority on the UK life assurance, pensions and fund management
sectors and, in recent months has been cited, inter alia,
by the following:
the BBC (various radio and TV programmes),
Bloomberg, Channel 4 TV news, the Daily Mail, the Daily Telegraph,
the Economist, the Express, Financial Adviser, Financial News,
the Financial Times, the Guardian, the Herald, the Independent,
the Independent on Sunday, Insurance Post, Investors Chronicle,
Investment Week, the London Evening Standard, the Mail on Sunday,
Money Marketing, Money Management, the Observer, Pensions Age,
Pensions Management, Pensions Week, Pensions World, the Press
Association, Professional Pensions, Reuters, the Times, Scotland
on Sunday, the Scotsman, Sky TV news, Sunday Business, the Sunday
Herald, the Sunday Telegraph and the Sunday Times.
Ned Cazalet for many years has been a regular
contributor to FT Business (in particular, its titles Money Management
and Pensions Management magazines) on matters relating to the
life assurance, pensions and fund management sectors, and has
been a guest contributor to the Daily Telegraph and Financial
In recent months, Ned Cazalet has been a speaker
at the Acquisitions Monthly Conference on Valuing and Pricing
Mergers & Acquisitions in Financial Institutions, and has
lectured at the Faculty and Institute of Actuaries' 1999 and 2000
annual Life Conventions (respectively on the techniques for analysing
long term insurance businesses and on capital management within
life offices). He has been a speaker on the subject of the appraisal
of life office financial strength at Society of Financial Advisers'
1999 annual conference and on the same topic at a conference organised
by IFA UK in 2000. He chaired the "Life Assurance 2000"
conference organised by the Institute of Economic Affairs.
Mr Cazalet also recently has appeared as a guest
speaker/external adviser at non-public conferences, seminars and
management/client briefings given by organisations such as CGU,
CIS, Merrill Lynch Investment Management, Pearl Assurance, Prudential,
J Rothschild Assurance, Royal Bank of Scotland Capital Markets,
Scottish Mutual, Swiss Re, UBS Warburg and Unisys.
Preliminary comment on Equitable's communications
We think it worth remarking at the outset that,
in general, we have tended to regard Equitable Life Assurance
Society as consistently having been very open with its policyholders
(far more so than any other life office we can think of) in terms
of communicating its strategy and its operating and financial
position. In particular, in our opinion Equitable's annual reports
and accounts have been models of informative clarity and easy-to-understand
explanation. All of which makes the events recounted below concerning
Equitable's treatment of the vexed issue of guaranteed annuity
options ("GAOs") the more regrettable.
Equitable's philosophy on solvency
At the root of Equitable's recent difficulties
has been its long-standing and oft-stated philosophy of not maintaining
substantial excess capital (ie funds over and above those necessary
to meet its liabilities and to satisfy the solvency requirements
imposed by law).
Indeed, Equitable, implicitly at least, had
tended to be critical of other life offices that maintained proportionately
higher levels of excess capital. Equitable's stated position was
that, unlike many of its peers, it always had sought to pay out
the highest possible amounts when policies became claims (whether
at maturity, death or premature surrender) and, for that reason,
had not accrued the higher levels of excess capital held by most
of its rivals.
The fact that Equitable made a virtue of paying
out relatively very high claims values was a strong selling point
for the Society and was widely endorsed by the financial press
as being a "good thing", particularly during the 1980s
and early 1990s when its surrender values tended to be significantly
ahead of those offered by other life offices and when its maturity
values were also at or very close to the top of the league tables.
In contrast, other life offices could be said
to have "benefited" from not paying out such high claims
values as Equitable, such "benefit" to some extent being
represented by the ability to build up and maintain a plumper
cushion of excess capital. (Think of the recent controversy surrounding
the treatment of so called "orphan estate", which is
another word for excess capital, accrued by AXA Equity & Law
Life Assurance Society.)
SUMMARY WITH PROFITS FINANCIAL STRENGTH RATINGS
FOR SELECTED LIFE OFFICES
|AXA Equity & Law||56.2
||Uncertain/Very Low Cost||2
|Legal & General||41.3
||Fair||Positive/Low Cost Drive
||Conservative||Poor But Improving
||Poor But Better Prospects||10
Source: Cazalet Financial Consulting.
Assessing life office financial strength is a highly complex
issue. To illustrate Equitable's position relative to a cross-selection
of with profits life offices, the above table (which contains
data and commentary greatly distilled from our proprietary life
office rating system) shows a measure of solvency we call "WPXA"
(being the amount of spare capital held by a life office relative
to its in-force with profits business) together with other key
pointers as to how conservatively we think the individual life
office has chosen to calculate its liabilities (there is a great
deal of actuarial discretion in this area), and the characteristics
of its cashflow. The final score, which is out of "10",
is our overall with profits financial strength rating. These ratings
were assessed in November 2000 (before Equitable's announcement
that it had failed to find a buyer for the Society as a whole),
and it can be seen that Equitable's raw WPXA score is far lower
than the generality of its peers and that, further, when account
is taken of the approach to reserving, a very low rating of "2"
was called for.
To be clear, Equitable historically did not shy away from
revealing its relatively thin solvency cover but, instead, promoted
it as the desirable outcome of what it viewed as its virtuous
approach to returning to policyholders as high as possible a proportion
of the returns earned on their premiums. Given the wide reporting
of this in the media, we think it likely that many persons who
became policyholders during the past two decades (our memory does
not extend beyond that time) would have been aware of Equitable's
philosophy on not accruing and maintaining substantial excess
The point about Equitable's relatively thin solvency cover
is that it always was going to be more exposed than most other
life offices to financial adversity, whether in the form of bad
news on the asset side of the equation in the event of poor investment
market conditions, or on the liability side in the event of unplanned
liability inflation brought on by issues such as regulatory intervention
(such as would be the case with pensions mis-selling or changes
to liability valuation regulations) or actuarially-based factors
such as the emergence of previously submerged guaranteed annuity
Equitable's cost base and systems
Equitable was exceptional not just because of its solvency
philosophy, but also because of its approach to cost controls
and operating efficiency. On the one hand, its achievements in
this area were remarkable and to be applauded but, by the same
token, the development of Equitable into a very low cost and hyper-efficient
life office (in terms of the acquisition of new business and the
maintenance of in-force policies) meant that it was always going
to be peculiarly unattractive to a prospective purchaser (even
leaving aside problems with guaranteed annuities and the like)
for the simple reason that it had become what might be described
as a life assurance administrator so efficient and lean that there
would be only very slim profits to be generated for a shareholder
were the Society ever to demutualise.
The driving down of acquisition and administrative costs
achieved by Equitable was a remarkable feat of management (which
has been somewhat forgotten amid all the rancour currently prevailing)
and positioned the Society miles ahead of any other UK life office
in efficiency terms.
Equitable's operating superiority was driven on the new business
front by a sales force that was astonishingly productive. We calculated
that, in recent years, a typical Equitable sales person was generating
something like up to 10 times the volume of new business achieved
by run of the mill direct (non-bancassurance) sales plodder elsewhere
in the industry.
As for Equitable's wafer thin administration costs, these
were enabled by the substantial volumes of new business generated
year-in and year-out by the highly productive sales force, which
strongly positive cashflows led to significant and increasing
economies of scale.
What is more, Equitable's focus on cost control and drive
for operating superiority caused the Society to be an early mover
in seeking gains from advanced technology applications. This focus
paid off big time, leading Equitable to be regarded as having
the best life and pensions administration systems in the UK, if
not in the world. Equitable's prowess in this area has been such
that it developed a thriving consultancy activity in helping develop
or supply administration systems to other financial services companies
in the UK (such as Marks & Spencer Financial Services, Merrill
Lynch Investment Management and the Royal Liver friendly society)
and overseas (the long term insurance business of the Harare-based
insurer, Southampton Life, is administered remotely on Equitable
Life's systems in Aylesbury).
The table below shows the progression in recent years of
Equitable's new business (split between new regular and single
premiums), and shows total premium income (which additionally
takes account of regular contributions continuing to be paid on
the existing book of in-force business) and income and gains from
investments, together with the quantum of the Society's total
EQUITABLE LIFE: PROGRESSION OF INCOME AND ASSETS (£
BILLION) AND EXPENSE RATIO (PER CENT)
|New regular premiums||234
|New single premiums||408
|Expense ratio (per cent)||8.5
Source: Equitable Life; Cazalet Financial Consulting.
The bottom line in the table above illustrates how Equitable
drove down its cost ratios during the course of the 1990s. We
can put these numbers into the context of the UK life assurance
industry as a whole by firstly breaking down the expense ratio
total for 1998 into its underlying components that respectively
represent the expense ratios relating to the acquisition of new
business and the maintenance of in-force business and, secondly,
by comparing those ratios to the rest of the UK life industry
(we have used Equitable's 1998 data for this as, at the time of
preparing this evidence, we did not have to hand comparable industry-wide
data for the 1999 year end).
EQUITABLE LIFE: EXPENSE RATIOS (PER CENT)
Source: Equitable Life; Cazalet Financial Consulting.
The breakdown of Equitable's expense experience set out in
the table immediately above shows that Equitable was away ahead
of its nearest competitors in terms of the financial efficiency
of its new business and administration functions, being almost
five times more efficient than the UK life industry as a whole
when it came to writing new business, and nearly seven times more
efficient in terms of the cost of administering in-force business.
To reiterate, Equitable's systems and cost controls have
been brilliant. The systems are very much worth acquiring by a
bidder. The Equitable policy book administered on those systems,
however, is "profit-lite" and unlikely (even under more
favourable circumstances than currently persist) to provide a
filling repast for a profit-oriented shareholder (rather like
dining at Old Mother Hubbard's bistro).
We are aware that, in recent times, officers of Equitable
Life have been referred to by the media as "arrogant"
and wonder whether it was the case that the Society's stupendous
successes in terms of its operating efficiency caused its leaders
to think that they could repeat the walking on water trick when
it came to defying gravity in terms of financial strength.
The GAO problem
The origins of the life industry's guaranteed annuity problem
might best be summarised by the words of the song: "I know
an old lady who swallowed a fly. I don't know why. Perhaps she'll
Much has been said and written over the years on the subject
of the madness of crowds and popular delusion. To the South Sea
Bubble, Dutch tulip mania and the recent dotty dotcom boom and
bust must surely be added the widespread granting by life offices
of guaranteed annuity options on pensions contracts written in
the high inflation 1970s and 1980s.
During times when inflation was at 20 per cent and yields
on government securities were seemingly perpetually to be in double
digits, the giving of a promise that, come what may, the interest
rate applied to your annuity once you cash in your retirement
savings would be at least 7, 8 or 9 per cent (terms and conditions
applying to guaranteed annuity options vary considerably from
insurer to insurer) probably seemed a safe bet on the grounds
that, viewed from the high 20 per cent+ uplands, it would never
Well, fifty years ago, you might have said (and truly believed)
that a man would never walk on the moon, a woman would never be
prime minister (or your local vicar) or that you could telephone
home from on board an aeroplane flying direct from London to Tokyo.
The "we thought it would never happen" lament now
looks somewhat pathetic, especially given that the devising and
monitoring of these guaranteed annuity options was and is the
responsibility of that army of mathematical Mystic Megs known
as the actuarial profession. From where we stand today, it is
hard to conceive that, during the period when guaranteed annuity
options were being handed out with indiscriminate abandon like
flyers for an Ibiza night club, anyone actually worked out the
precise nature of the guarantees/options they were granting. For,
if they had reflected on the nature of the promises given, they
would have realised that it was impossible to hedge out their
components (comprising interest rate and mortality risk) and,
further, that exposure to such risks was highly volatile and practically
limitless. (Pensions annuity rates are calculated by life companies
on the basis of the amount of the capital sum deployed to purchase
the annuity and the rate of return available from government securities
spread over the likely lifespan of the person taking out the annuity.)
Let us deal with the interest rate problem first. It can
be seen from the chart below that, as we have moved into a lower
inflation environment, long term interest rates have fallen. The
fall in long term gilt yields was so great during the 1990s as
to cause guaranteed annuity options written on interest rate assumptions
based on single figure gilt yields to progress from being a no-chance
non-event to a horrific reality.
The farther gilt yields fall the greater the reserving problem
for life offices as policyholders' guaranteed annuity options
become more and more "in the money" as the returns that
such policyholders could achieve by buying their annuity income
in the open market (and life offices could finance from purchases
of gilts) is outstripped by the guaranteed rate incorporated in
their pension contracts (which cannot be financed sufficiently
from the returns attainable from gilts).
What is more, once the guaranteed annuity iceberg began to
emerge in the 1990s there was no way of hedging the problem. Leaving
aside the deficiency between the gilt yields required to finance
guaranteed annuities and the actual yields available in the markets,
many of the pension contracts containing guaranteed annuity options
were (and are) still a long way from being converted into annuities,
following which, such annuities could be expected to be in-payment
for perhaps 20 years or more on average.
In other words, a 40 year old man who took out a policy incorporating
guaranteed annuity terms in 1985 (when he was 25) might retire
at 65 and then live and draw annuity income for a further 20 years
until he dies at, say, 85. Even if, as a life office, you are
prepared to take the "hit" on the gap (as it currently
stands) between the gilt yield required to finance the guarantee
and the actual, much lower yield currently available in the market,
the problem is that our 40 year old pension saver is likely to
be drawing pension annuity income up to 45 years from now, and
there simply are not any 45 year gilts for you to buy!
The second element of the GAO problem is mortality. The guaranteed
annuity options granted by life offices mostly also have a mortality
component (rather than just having an interest rate promise).
The problem here is that longevity has increased dramatically
in recent years.
The table immediately below illustrates how, over the course
of the past few decades, mortality has improved to the extent
that between the commencement of a deferred annuity plan and its
vesting, the holder might have seen his life expectancy increase
by two or three years.
EXPECTATION OF LIFE (REMAINING YEARS) AT SELECTED AGES
|Year||Male Aged 60
||Aged 70||Female Aged 60
Such increases in life expectancy might seem innocuous but,
in reality, can serve to reduce annuity payments sharply. As the
next table illustrates, the improvement in mortality for a male
at age 60, which took place in the 25 year span under examination
is such to boost remaining life expectancy by one-fifth.
IMPROVEMENT IN REMAINING LIFE EXPECTANCY (PER CENT) 1971-95
Source: ONS; Cazalet Financial.
The net impact on pension annuity rates is illustrated by
the chart immediately below, from which it can be seen that a
pension annuity compulsorily purchased by a 65 year old man in
spring 1999 bought an income for life of less than 60 per cent
of the income for life that could have been secured by a man of
the same age in the autumn of 1990.
Given the above, it is a no-brainer to conclude that persons
contributing to personal pension contracts incorporating guaranteed
pension annuity rate options would be increasingly likely to exercise
such options on retirement in view of the declining value to be
had from the alternative of buying an annuity in the open market.
Impact on the life industry
The significance of all this from an actuarial reporting
perspective is that, in the era of high inflation, high bond yields,
lower longevity and higher open market annuity rates, it was extremely
unlikely that anyone would elect to take what was then a relatively
very low guaranteed rate of annuity when a much higher level of
retirement income could be secured in the open market. Once this
operating background started to shift adversely (from a life office
standpoint), it became clear that more and more people would elect
to exercise their guarantee options. In the days when the guaranteed
annuity options were very unlikely to be exercised, it perhaps
was not unreasonable for life offices to disregard such possibility
when preparing their accounts. Once such guarantees became valuable
from a policyholder viewpoint ("in the money") and were
likely to be exercised, it became imperative that life offices
should increase their reserves to provide for the uptake of GAOs.
As a group, life offices began to make extra reserves for
GAOs during the 1990s, tending to increase reserving as gilt yields
came down and longevity improved. Such reserving was ad hoc
and subject to a great deal of actuarial discretion. Between
1997 and end 1998, long gilt yields fell very sharply indeed,
causing there to be a very sharp increase in the extent to which
policyholders were "in the money" (and life offices
were in trouble) with regard to GAOs. This market movement caused
the Government Actuary's Department ("GAD") to survey
life offices to determine their exposures to GAOs, which in turn
led to the issue of guidance as to the basis of provisioning for
GAOs. The Committee doubtless will have access to the detail of
the activity of GAD in this area, but it can be summarised as
meaning that, when calculating their GAO reserves, life offices
were required to move to a position based on the assumption that
the substantial majority (80 per cent+) of policyholders with
pensions savings contracts incorporating GAOs would be likely
to exercise such options.
When, in the early 1990s, the GAO problem began to lap at
Equitable's shores, the Society (unlike the generality of its
competitors) seemingly decided not to make reserves, but chose
to deal with the problem in an entirely different way, with the
intention of seeing to it that practically none of its customers
would opt to take the annuity on the terms guaranteed in their
contracts, but, instead, decide to purchase a pension annuity
at the prices prevailing (whether from the Society itself or from
another provider on the open market).
Equitable sought to influence its customers to refrain from
exercising the (reserving-heavy) guaranteed form of annuity by
the simple expedient of manipulating its bonus rates so that a
lower rate of final bonus would emerge on contracts where the
policyholder had elected to take the guarantee, meaning that a
smaller pension pot would be available to purchase the (higher)
guaranteed form of annuity, and a higher pension pot would be
available to purchase the (lower) open-market form of annuity.
The bias usually would be sufficient to ensure that, compared
side by side, the lower fund/higher guaranteed rate option would
be seen to generate less in pension income than the higher fund/lower
Equitable's conduct would appear to have been the result
of its philosophy of not holding substantial excess capital. Quite
simply, the Society knew it could not afford to honour its guaranteed
annuity promises and, accordingly, sought to construct its bonus
rate regime so that the guarantees would be worthless (in terms
of their attraction relative to the alternative of buying an annuity
on open-market terms).
Equitable's evasion of its annuity promises was threatened
by GAD's requirement that life offices reserve on the basis that
the substantial majority of their in-force pension savings contracts
would result in the exercise of annuities on the guaranteed basis.
At first blush, Equitable's payout strategy was scuppered
as, notwithstanding its seeming ability to manipulate payouts
so as to ensure that its policyholders would find the guaranteed
form of annuity (conveniently) unattractive, GAD's insistence
that Equitable should reserve on the basis that its policyholders
would in fact tend to elect to exercise such guarantees meant
that it would have to make extra reserves for the thick end of
£1.5 billion. The problem was that Equitable's thin solvency
meant that this was £1.5 billion that it really did not have
With one bound he was free
In the manner of a Bruce Willis or younger Harrison Ford,
however, Equitable contrived to break free from GAD's tight strictures
in a single, cunningly calculated leap that took it all the way
across the sea to Ireland.
The GAD-inspired accounting treatment required to be applied
to Equitable's book of GAO-embedded pensions was the problem.
The solution was for the Society to divest itself of this book
of business (or at least the potential claims arising from it)
through the magic of reinsurance. In effect, Equitable managed
to park its book of GAO liabilities with a Dublin-based reinsurer
(out of the reach of the UK's GAD) so that (bingo, jingo!) there
simply was nothing left to reserve for in the UK.
The reinsurer, a subsidiary of GE Capital, was no fool, however.
The deal was simply a case of sophisticated regulatory arbitrage.
It was Equitable's apparent belief that GAD's reserving requirement
was unreasonable given that none (or, at best, hardly any) of
its pension customers would want to exercise their GAOs and that,
accordingly, GAD's requirement to reserve on the basis of an 80
per cent+ take up was unrealistic.
The basis of the reinsurance was that, as pension contracts
vested and (non-guaranteed basis) annuities were purchased by
policyholders, such claims would be dealt with by the reinsurer,
which would make recovery from Equitable on a drip-feed basis
(effectively acting as a paying agent).
Again, Equitable's motivation in resorting to pension provisioning
prestidigitation would appear to have been its fundamental lack
of spare capital with which to absorb the cost of making the reserves
resulting from GAD's guidance.
The required reserving for the entire UK life industry would
appear to be something in the order of £10 billion+. With
a couple of minor exceptions, all other life offices chose to
take their GAO hits squarely on the chin, using their excess capital
to meet the cost of their emergent liabilities.
HMT letter re GAOs
In carrying out its maturity value/annuity strategy, Equitable
appeared to have the explicit backing of the Insurance Directorate
of HM Treasury.
Members of the Committee doubtless will have access to the
letter written, on 18 December 1998, to all life offices by Mr
Martin Roberts of HM Treasury's Insurance Directorate. The key
phrases of Mr Roberts' letter might be said to be the following:
"As you will know the Government Actuary's Department
undertook a survey of life offices' exposure to . . . GAOs . .
. earlier this year [which] indicated that the exposure to GAOs
was relatively widespread . . . and had the potential to have
a significant financial impact on a number of companies . . .
one issue to be addressed by all companies was how the concept
of policyholders' reasonable expectations (PRE) should be interpreted
in the context of GAOs. The purpose of this letter is to provide
some guidance to companies on the Treasury's interpretation of
PRE in these circumstances.
As a starting point, we take the view that policyholders
entitled to some form of annuity guarantee or option on guaranteed
annuity terms could reasonably be expected to pay some premium,
or charge, towards the cost of their option or guarantee.
Charging for the cost of providing a guarantee or annuity
. . . In the case of participating [ie with profits] policies,
any charge could be deemed to be met out of each premium received
(or the investment return to be credited by way of bonus), and
hence would impact on the assessment of bonuses, including in
particular any terminal bonus that would normally be payable to
the policyholders. Generally we consider that it would be appropriate
for the level of the charge deemed to be payable by participating
policyholders for their guarantee (or annuity option) to reflect
the perceived value of that guarantee (or option) over the duration
of the contract. This could be achieved in some cases through
some reduction in the terminal bonus that would be payable if
there were no such guarantee (or option) attached to the policy
. . .
. . . it would appear possible, depending on the particular
circumstances relating to the contract, that any terminal bonus
added at maturity could be somewhat lower than for contracts without
such options or guarantees, and that this terminal bonus could
in some cases be applied at current annuity rates . . .
This is the Treasury's considered view, and is without
prejudice to any decision of the courts which may effect it .
Not so fast, buster
Equitable's Nemesis came in the form of an independent financial
adviser, a Mr Bayliss who, being a specialist in the retirement
annuity sector, was instrumental in spreading the word that Equitable,
in his opinion, had been treating its pension policyholders unfairly
by juggling pension maturity values and annuity rates so as to
deprive policyholders of the true value of their guaranteed annuity
The agitation of Mr Bayliss and others led to the litigation
that eventually saw the Society defeated in the House of Lords.
When faced with litigation, Equitable seemed to adopt a sophisticated
tone in addressing its policyholders, perhaps finding it inconceivable
that the Court would ever judge other than that the Society was
in the right.
With hindsight, it might have been better if the Society
had been franker with its members by being clear about why it
has resorted to fast footwork on annuity rates. Let us suppose
the Society had addressed its members as follows:
"Look now, this is a mutual Society and, as such,
we have very limited recourse to outside capital. These guaranteed
annuities are a blessed nuisance; we wrote them some time ago
and now sincerely wish that we had not. At that time, all of our
competitors were doing the same thing and we got caught up in
the market vogue, little believing that we ever would be called
upon to deliver.
As you all know, it has been a cornerstone of our philosophy
not to retain relatively large amounts of surplus capital. Over
the years, we have chosen, with your seeming approval, to use
our resources to pay relatively high claims values on surrender
and on maturity, often substantially more than our competitors.
This belief in making as generous as possible a return of profits
to our membership means that we do not have the resources to take
the GAO hit on the chin in the manner of other life offices that
have been less generous in their payouts in the past. Accordingly,
something has to give. We are Equitable by name and by nature
and, in arranging our maturity values and annuity rates as we
now do, we simply are trying to be as fair as possible to all
parties within the constraints of our modest solvency position.
We can understand why some of you may feel hard done by, but assure
you that we simply are endeavouring to make the best and fairest
use of the Society's resources in the circumstances in which we
now find ourselves. To those of you considering legal action against
the Society, we would ask that you consider where the resources
would come from to finance any success you may achieve in pressing
your claim and urge you to refrain from such proposed action in
the interest of the common good."
Upon hearing such address, we estimate that there might well
have continued to be discontent among Equitable's pension policyholders,
but that this would have been tempered by a realistic understanding
of the Society's true financial position and the motivation of
its managers and directors in embarking upon the complained of
GAO avoidance strategy.
Instead, however, the Society's seemingly sophisticated approach
and its dismissal of the GAO issue as being relatively trivial
and having an impact of no more than £50 million (or, take
your pick, £200 million) probably served to irritate Equitable's
policyholders rather than soothe them and, when the House of Lords
balloon went up, caused them to be mightily concerned to learn
that a "£50 million" bagatelle was, in fact, a
£1.5 billion terminal disaster.
It is not as if Equitable's true position ahead of the commencement
of litigation was not known or discernible. The following is taken
from our work, LIFE 1999:
EXTRACTS FROM "LIFE 1999" (Published February
The guaranteed annuity option issue is now a matter for the
Court. However, it is to be wondered whether some of those
pressing to have their cake and eat it have considered where the
money would come from to pay a "full" rate of TB [terminal
bonus] and meet the guaranteed annuity cost, as the potential
sum at issue would appear to be of such magnitude as to require
terminal bonuses to be reduced in any event (there's no free lunch).
Perhaps the annuity agitators are hoping to drive Equitable
to demutualise. The problem would seem to be that acquiring Equitable
might be like catching a snowflake in the palm of your hand. Leaving
aside the guaranteed annuity option furore, what would be the
industrial logic? A bidder could hardly expect to squeeze out
significant savings from cost inefficiencies (unless the acquisition
was effectively a reverse takeover). Further, it is not as if
Equitable is or would be capable of generating sufficient profits
such as to reward a proprietor keen to show a healthy return on
When Equitable lost its case in the House of Lords, we were
struck by the widespread policyholder astonishment at the revelation
that the GAO problem should have emerged to be £1.5 billion
in size. This outcome had been familiar to us for some timewe
had discussed the matter of the size of the potential liability
and Equitable's resorting to reinsurance with senior officials
of the Society and reported on this in a document entitled "The
Wolf's at the Door", which was published in October 1999
and, again, as set out below, in "LIFE 2000".
EXTRACTS FROM "LIFE 2000" (Published March 2000)
Equitable's approach to guaranteed annuity options has been
that it seeks to pay the same actual money benefits whether the
cash or GAO basis is selected by the policyholder, and it has
stated that the cost to it of such options is unlikely to exceed
£50 million. Paragraph 16 of its 1998 valuation statement
contains the following advice: "If the contract guarantees
minimum rates for annuity purchase the aggregate final bonus otherwise
applicable is reduced when benefits are taken by the amount, if
any, necessary such that the annuity secured by applying the appropriate
guaranteed annuity rate after such reduction, is equal to the
annuity which would be secured by applying the Society's annuity
rate for an equivalent annuity in force at the time benefits are
taken to the cash fund value of the benefits before that reduction,
subject to a minimum value for the final bonus after such reduction
Equitable has advised that its experience is that GAOs have
been exercised in about no more than 2 per cent of cases and that
its experience "has been consistent with an outcome significantly
lower than even the £50m figure". In the light of the
foregoing experience, Equitable has determined to adopt what it
regards as a belt and braces approach to the matter, and that
it would be prudent to structure its reserves on the basis that
25 per cent of benefits are taken in guaranteed form and 75 per
cent in cash and, accordingly, made a provision of £200m.
Notwithstanding Equitable's own experience and view as to
prudential reserving, the Government Actuary promulgated reserving
guidance for guaranteed annuity options to be followed by all
The Government Actuary indicated that he expected life offices
to reserve on the basis that substantially all of the benefits
were taken in guaranteed annuity form, irrespective of actual
experience, with only relatively modest allowance for cash commutation,
the exercise of open market options or the selection of different
post-vesting contracts such as unit-linked and with-profits annuities
As a result of the Government Actuary's guidance, Equitable
found it necessary to establish reserves on the assumption that
c 80 per cent of the benefits were taken in guaranteed form and
20 per cent in cash. As was noted above, given Equitable's determination
that the money benefits should be the same whether the guaranteed
or cash option was selected, reserving in accordance with the
wishes of the Government Actuary makes no pound-in-your-pocket
difference to the policyholder. There is, however, a marked impact
on the appearance of solvency.
The effective requirement of the Government Actuary for Equitable
to assume that 80 per cent of benefits will be taken in guaranteed
form has led to a significant shift across Equitable's balance
sheet divide, with an additional £1.5bn reserve being shown
in the 1998 returns (with consequent matching diminution on the
In order to mitigate the financial impact of having to assume
that 80 per cent of benefits are taken as a result of the exercise
of GAOs and to achieve a financial presentation that Equitable
claims is somewhat closer to the underlying reality, the Society
has entered into a reinsurance arrangement (with a Dublin-based
subsidiary of ERC Frankona).
The purpose of the reinsurance effectively is to enable Equitable
to assume that the composition of the relevant pension benefits
taken is 25 per cent in guaranteed form and 75 per cent in cash.
The financial effect of the reinsurance is such as to enable
Equitable to release part of the additional £1.5bn reserves
for final bonus back to the free assets (ie back from the liability
to the asset side of the balance sheet), thereby arriving at what
Equitable regards as being a presentation closer to the true underlying
The amount of the reinsurance offset is £800m and this
has been secured for a premium of £150,000. In the opinion
of Equitable, such a relatively small premium indicates that there
is little risk passing to the reinsurer and, therefore, that the
risk of the actual take up of guaranteed annuity options beyond
25 per cent is "very remote".
Should a claim be made by Equitable pursuant to the reinsurance
treaty, the reinsurer would make recovery over time from the future
surplus arising within Equitable's long-term fund.
Effectively, the reinsurance enables Equitable to "park"
its reserving problem (perceived by it as being unrealistic) with
another institution and, if things turn out worse than expected
(ie the take up of GAOs rises beyond 25 per cent), to drip feed
the hit onto its balance sheet.
It is also Equitable's contention that, even after allowing
for the effects of the reinsurance, there is still "effective
substantial reserving" for terminal bonus. On that basis,
the Society has felt it appropriate to make greater use of the
future profits implicit item to give a "more realistic"
position since, as future profits arise, they will fund terminal
The contingent capital gains tax liability was estimated as
being not greater than £98m as at end 1998 and a reserve
of £100m was held. A mismatching provision of £600m
was also held (equivalent to £1,236m if the Society had accounted
on a net premium basis).
Equitable continues to be talked of as a bid candidate (such
chatter inspired by the controversy surrounding the Society's
treatment of guaranteed annuity options, which has seen it be
transformed in the eyes of the media from the Muhammad Ali to
the Mike Tyson of the industry). As we observed last year, the
problem still would seem to be that acquiring Equitable might
be like catching a snowflake in the palm of your hand. Leaving
aside the guaranteed annuity option furore, what would be the
industrial logic? A bidder could hardly expect to squeeze out
significant savings from cost inefficiencies (unless the acquisition
was effectively a reverse takeover). Further, it is tricky to
see how Equitable's current business model would be capable of
generating sufficient profits so as to reward a proprietor keen
to show a healthy return on capital employed. All of this would
make for a relatively slim offer from any bidder.
In reviewing what we wrote in the second extract above (from
"LIFE 2000") we are struck by the disparity between
what we knew about Equitable's financial condition vis-a-vis
the GAOs (ie that there was a potential £1.5bn liability
that was too hot to handle and which needed to be placed in the
safe, asbestos-gloved hands of an offshore reinsurer) and the
gloss put on the situation in the Society's widely-circulated
annual report and accounts and the statements made at its last
annual general meeting (in which the £50m/£200m scenario
was played up). As we remarked above, it might have been much
better for all concerned for some brutal frankness to have been
deployed in spelling out to its members the reality of Equitable's
finances and the true, worst-case impact of a (then) potential
defeat in the Courts on the matter of the GAO litigation. It seems
to us that it was only after Equitable was defeated in the House
of Lords that it started using the £1.5bn figure in its communications
with its members who, not unsurprisingly, were confused and angry
at learning of such exposure when, only a few months previously,
in written and spoken communications, Equitable had been referring
to a £50m/200m problem.
How big was the "hole"?
Press coverage on Equitable, post the House of Lords defeat,
relating to Equitable's financial condition and the Society's
own statements on the matter have consistently referred to the
£1.5bn number as if that were the size of the problem that
needed to be overcome by a bidder for the Society as a whole (for
which, eventually, there was none).
In fact, the level of financial restoration that would have
been required by an outright bidder (which would have taken on
the long term liabilities of the Society by means of a demutualisation
and transfer of such business) was probably more like £4bn.
The reason for such a higher number is that, if we disregard
the GAO issue, Equitable was running on thin solvency anyway.
This already thin solvency in our estimation would have been significantly
eroded by the poor investment market conditions of 2000 (in which
UK equities produced negative returns and gilt investments generated
only modest income) on the one hand and, on the other, liability
escalation (excluding the impact of the addition reserving required
for the GAOs) arising from reserving for bonus additions and other,
technical issues including the impact of new, more stringent actuarial
valuation regulations in May 2000.
The asset and liability scenarios would have acted like a
pincer (for all with profits life offices, not just Equitable)
in the 2000 calendar year, causing significant erosion of solvency
across the UK life industry. Equitable's skimpy excess capital
meant that (excluding GAOs) it was going to be more adversely
affected by these circumstances than pretty well any other insurer.
To return to the specific matter of the GAO liabilities,
it is crucial to note that, although the figure of "£1.5bn"
has been bandied about, the true total, being based on ever-changing
mortality and interest rate factors, is highly volatile and, if
longevity were to continue to improve and/or if long term interest
rates were to decline further, the actual amount would be set
to increasepossibly substantially. For that reason, any
acquirer of the long term business of Equitable (which there was
none) would have been well advised to take a very conservative
view of the potential ultimate value of the Society's GAO liabilitiesthis
could have been done by reserving on the basis that long term
interest rates would turn out over time to be lower than they
are at present and by ensuring that the mortality bases used incorporated
an allowance for significant improvement in annuitant life expectancy.
On the basis of such justifiably cautious and prudent approach
to reserving, it would not be surprising if a potential bidder
looked at Equitable and factored in a GAO liability figure of
£2bn or perhaps even £2.5bn, making the Society an even
more eye-watering nettle to grasp. (Incidentally, if in such circumstances
a buyer did make reserves of, say, £2.5bn and the actual
outcome was £1.5bn, it would be expected that the demutualisation
would have been constructed on the basis that the £1bn of
over-provisioning be released gradually for the benefit of the
pre-demutualisation with profits policyholders rather than constitute
a windfall profit for the purchaser.)
Why no outright buyer?
The value of a life office has three components: the amount
of its capital base; its embedded value (ie the present value
of the future profits predicted to arise over time from its in-force
business); and the goodwill element (which reflects the value
of the brand name and its distribution capability).
As for its capital base, Equitable practically had none once
the impact of the poor markets, general liability inflation and
the impact of the GAOs had been factored together. Indeed, it
might be argued that, using very conservative assumptions (actuaries
have some degree of discretion over how conservative or otherwise
they choose to be in putting a present day value on future liabilities),
Equitable's capital position was negative as at end 2000.
Equitable's embedded value would have been very small relative
to the size of its in-force book of business. As we noted above,
this outcome would have resulted from the fact that it ran its
business on a very low cost base that left very little meat on
the bone as far as profit to be shared with a prospective proprietor
was concerned. The embedded value of Equitable's in-force book
was probably not very much more than £1bn.
As for the goodwill element, how long is a piece of string?
Equitable's image had already been tarnished but, before the announcement
that it had failed to find a bidder, probably not terminally so.
In conducting a valuation on a behalf of a prospective purchaser,
we would tend to have made some allowance for the value of the
distribution channel (in the context of Equitable's prior to 8
December 2000 reputation) and have made some calculation of the
value to an acquirer of Equitable's systems (which had had a very
good reputation among insurance industry back office anoraks).
Adding all this together, we are talking about a fundamental
value of Equitable (pre 8 December 2000) of perhaps £2bn
at best. This had to be set against the estimated £4bn of
required financial repair, however. Even allowing for the fact
that part of the financial repair might have been effected by
means of debt finance and financial reinsurance arrangements (ie
by non-equity financing), it always seemed impossible to breach
the very wide chasm between Equitable's intrinsic value and the
required rescue finance.
A LITTLE XTRA
Contrary to what has been reported in some newspapers and
newswires, Equitable Life Assurance Society most certainly has
not been "bought" by Halifax plc. The arrangements entered
into with Halifax are in respect of certain of the operations
of the Society and do not involve the demutualisation of Equitable
and/or the transfer of its long term business to any person. Accordingly,
Equitable will remain a mutual life office owned by its members.
The Halifax deal is effectively in three parts, and may be
summarised as follows:
An initial certain £500m
Of this amount, £200m is by way of consideration for
Equitable's administration systems (which thereafter will be exploited
by Halifax for its own benefit, subject to the provision of administration
services to Equitable on a not-for-profit basis), a contract to
manage (on a fully commercial basis) Equitable's c £30bn
of funds (formerly managed in-house by Equitable), and the Equitable
Life sales force (which will transfer to Halifax and be deployed
to sell Halifax products to the Equitable customer base).
The remaining £300m does not, in fact, represent "new"
money introduced into Equitable, but arises from the financing
by Halifax of part of Equitable's book of business. By way of
background, about 75 per cent of Equitable's in-force business
is with profits, with the remaining 25 per cent being made up
of a £7bn tranche of unit-linked and other non-participating
business (such as term assurance and annuities-in-payment). This
£7bn book of non-participating business is a source of profit
for Equitable's with profits policyholders and is estimated (in
present value terms) to be likely to generate profits of £300m
spread over many years in the future. Halifax, via a reinsurance
arrangement, will advance Equitable the £300m up front and,
over time, recoup this amount (together with appropriate margins
for the provision of the financing) by collecting in the profits
from this tranche of business as they gradually emerge.
A payment of up to £250m
As mentioned above, Halifax has acquired the Equitable sales
force (believed to be c 350 in number), which will be re-branded
as "Halifax Equitable" and be deployed to sell Halifax
products to the Equitable customer base. Halifax appears to have
taken a pretty cautious approach to this element of the deal in
that, aside from the seemingly nominal consideration for the sales
force forming part of the £200m payment for Equitable's operating
assets described above, Halifax will only put its hand in its
pocket if the re-branded sales force comes up trumps in terms
of new business production. The amount eventually paid by Halifax
for the sales force is capped at £250m and could, in an ultra-worst
case scenario, be zero.
Although the Equitable sales force was the hottest act in
town when it came to selling bucket loads of life and pensions
policies badged with the (then) untarnished Equitable name, it
remains to be seen what sort of reception (a handshake and a cup
of tea, or a jab in the posterior with a sharp stick, perhaps)
the typical Equitable customer will give to Johnny Salesman when
he comes a-knocking at the door with a smile and a cheery "It's
A £250m peace dividend
It clearly would be in the interest of the Society as a whole
for it to resolve the guaranteed annuity option problem by having
policyholders with pensions in deferment relinquish their options.
We are some way away from seeing detailed proposals on this matter,
but it does appear that the GAO policyholders will be asked to
accept an up-front sum by way of an addition to the value of their
policies in return for giving up the guarantee option.
Will this find favour with the policyholders? Any such proposal
is likely to require the consent of the majority of both those
policyholders not having policies with GAOs and, separately, those
with policies incorporating GAOs. As those policyholders without
GAOs have nothing to lose and something to gain, we should expect
that they would be overwhelmingly in favour.
However, it is not at all clear that the GAO policyholders
will vote for such a scheme, as it appears that the likely proposal
will see the value of the GAO group's policies enhanced by 20
per cent as a result of the up-front capital boost but that, on
the basis of current market conditions, the subsequent loss of
the GAO would cause a concomitant 28 per cent fall in annuity
income in retirement. In short, the GAO policyholders (who only
a few months ago were being encouraged to rejoice in the splendid
victory achieved on their behalf in the House of Lords) are being
asked to take a haircut.
A further problem in persuading GAO policyholders to vote
for the deal would appear likely to arise if, as suggested, the
GAO policyholders' vote is subject to weighting according to size
of policy. Given that, in aggregate, we would expect those policyholders
nearest retirement to have the largest accumulated pension funds
and that the losses of value from taking the haircut would be
more immediate and certain for such persons having greater voting
weight, it would seem a "hard ask" to expect there to
be a rush to sacrifice soon-to-be-enjoyed retirement benefits
for the good of the Society as a whole.
If Equitable did succeed in persuading its policyholders
to vote for what it calls the "compromise" (a reasonable-sounding
euphemism, much less challenging than "haircut", "sacrifice"
or "potential loss" do you not think?), this would not
strengthen its financial situation considerably, notwithstanding
the £250m kicker from Halifax, as the Society would incur
substantial expenditure in buying out the GAOs. The real benefit
would not be the modest improvement in Equitable's solvency position,
but the fact that the fundamentally unstable GAO problem would
be eliminated. (Remember that GAOs have interest rate and mortality
components, making for a very tricky-to-manage volatile liability
position as: (a) mortality experience changes, usually negatively;
and (b) long term interest rates fluctuate, each slight fall causing
the liability to increase. The combination of these factors means
that the £1.5bn GAO liability could quite easily turn into
£2bn or more over a short period of time or, were long term
interest rates to rise appreciably, decline to £1bn or less.)
15 February 2001