Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum by Professor Richard Dale


  The following comments seek to identify the major management, auditing and regulatory failures that combined to bring about Equitable Life's downfall.


  1.  In the high inflation era of the 1970s and early 1980s Equitable offered guaranteed annuities on a large scale. At the time these transactions were equivalent to writing "out-of-the-money" options which Equitable did not expect to move into the money (ie the guarantees were thought to be worthless). However, writing very long-term options (20 years plus) on this scale was reckless, given that it is impossible to forecast market interest rates over such a timescale with any reliability.

  2.  When interest rates fell in the 1990s and the guarantees began to move "into the money", Equitable should have ring-fenced the with-profits fund so that new policy holders were not exposed to the risk of having to fund the guarantees. This was not done.

  3.  Equitable failed to set aside reserves to cover the potential cost of meeting the guarantees, evidently preferring to gamble on an interpretation of the law that had not been tested in the courts.

  4.  There was no disclosure to existing or prospective policy holders of the potentially catastrophic contingents liability that was building up within the with-profits fund. Even when Equitable was forced to recognise the possibility of an adverse legal outcome the 1999 company accounts merely stated that the cost of meeting the guarantees was "unlikely to exceed £50 million in total over the coming years".


  It is difficult to see how the auditors could have approved Equitable's company accounts without giving any indication of the scale of the contingent liability within the with-profits fund. In the event the accounts as reported to policy holders proved to be virtually meaningless. This failure to disclose or alert is all the more surprising given that the statutory prudential returns to the regulator showed in 1999 a £1.5 billion provision to cover potential liabilities arising from the guarantees. In other words, policy holders were being sent a dangerously misleading set of accounts while the regulator (alone) was being informed of the true risks facing the policy holders.


  It is widely accepted that regulation of life insurance and pension products is necessary in part because coverage extends over a long period during which time the management and prudential practices of companies might change to the detriment of policy holders. In this context the current insurance regulator(the FSA) has been charged with ensuring "that consumers receive clear and adequate information about services, products and risks", and to this end must "set out and enforce high standards in this area [and] should take action where such standards are inadequate or are ineffectively enforced".

  Against this background the effectiveness of official regulation as applied to Equitable Life must be considered woefully inadequate. Why was Equitable allowed to issue open-ended annuity guarantees in the first place without regard to proper provisioning against the potential cost and without disclosure to prospective policy holders? Why was Equitable not required to ring-fence the with-profits fund once it had become clear that the guarantees were likely to prove costly? Why was Equitable allowed to hide behind its own interpretation of the legal position without regard to the possibility of an adverse court decision? Why, when the regulator required a £1.5 billion provision to be made against the guarantees, did the regulator not also require Equitable and its auditors to inform policy holders (present and prospective) of the risks to the with-profits fund? (This last failure was in flat contradiction of the FSA's current mission statement.)

  Once the House of Lords decision had been handed down the FSA was put in a difficult position. Clearly it wished to maximise the value of the company to potential bidders by keeping the business going, although that meant in effect subordinating the interests of new policy holders (who were not aware of the risks) to existing policy holders. It seems unreasonable to criticise the regulator on these grounds.

  In summary, the risks involved on annuity guarantees should never have been taken; having been taken, they should have been provisioned against; having been taken and not provisioned against, they should have been ring-fenced; and the risks having been taken, not provisioned against and not ring-fenced, they should at least have been disclosed to policy-holders (existing and prospective).

  In conclusion, the events that led up to the House of Lords decision suggest a complete break-down of regulation under the FSA's predecessor organisations, although it is much less clear that the FSA's handling of the crisis it inherited was flawed. One may even argue that it would have been better had there been no regulation of Equitable Life rather than the ineffective regulation to which it was subject under the Department of Trade and Industry and the Treasury. At least present and prospective policy holders would then have been alerted to the need to take special care, and market mechanisms (such as specialist insurance ratings provided by, for example, AM Best) would have been developed to fill the regulatory gap.

2 February 2001

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