Memorandum by Professor Richard Dale
FAILURES AT EQUITABLE LIFE
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
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
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