Select Committee on Treasury Minutes of Evidence

Exmination of Witnesses (Questions 180-199)



  180. You said earlier that the relationship with Equitable Life was not the way you liked to operate; and you said you were encouraged that a number of insurance companies were pursuing a closer relationship. I think many policyholders will be worried by this approach, which seems to be based on building up a friendly network. They will feel that the ones who potentially are going to cause problems are the ones who do not have a close relationship with you. Do you not feel that this kind of voluntary approach is actually inadequate?
  (Sir Howard Davies) I think it would be wrong to characterise it as a "voluntary approach". The approach that we will be taking in the future is a rigorously risk-based approach to regulation. That is built on an assessment of what we perceive to be the riskiness of this company to our objectives in other words, principally the protection of the policyholders. The assessment that we create of the riskiness of the companies is a combination of the inherent riskiness of their business (and some insurance companies and some banks are inherently in riskier areas of the market than others) and the nature of the customers that they have (and our bias is clearly to be more interested in companies who have a relationship with a large number of policyholders, rather than purely inter-professional business, if you like), and also the strengths of the risk management systems within the company and of its management. We have a clear architecture where we assess that. A company that was operating in a way where we did not feel that we were confident we were always getting a true bill from the management, where we had a record of being surprised by the management and not being told things, scores higher on that element of the risk model and, therefore, attracts a higher degree of attention. What you see in the Baird Report in the reference to a note that was actually produced in 1999 about Equitable (in fact the source of the phrase "arrogant superiority") was, in fact, the first stage of that—where we were asking our people to assess each company in the light of the risks it posed to our objectives, and to include in that assessment a view of the management and the kind of relationship that we have with the management. Any company that is seeking not to be cooperative scores more highly and attracts more of our attention.

Mr Fallon

  181. We established two weeks ago, did we not, that Equitable was the only company whose problems were subject to the pre-handover note to the FSA back in 1998. You then told us you pursued a rigorous approach to lack of reserves at Equitable. What is the evidence of the additional scrutiny you subjected Equitable to?
  (Sir Howard Davies) Yes, it was true that it was the only insurance company that was particularly drawn to our attention. The insurance staff from the Treasury were, as you know, about 5 per cent of the organisation as it came together in early 1999. Of course, there were a lot of other companies which were similarly in our sights as companies that we had to look carefully at.

  182. Compared to other life assurance companies, what was the additional scrutiny?
  (Sir Howard Davies) The attention paid within the insurance division to Equitable Life was greater because it was scoring more highly on our risk assessment than other companies would have done. There were regular board reports about Equitable; and regular reports to Michael Foot in particular.

  183. When other life offices were making extra reserves for guaranteed annuity options during the 1990s, why was Equitable allowed to be an exception to the rule?
  (Sir Howard Davies) Some companies did, as you say, put in particular reserves within their portfolios. I could not answer why Equitable was allowed to be an exception to it, because I was not responsible for the regulation at the time.

  184. You have told us that since 1998 you were pursuing a rigorous approach?
  (Sir Howard Davies) Indeed, that is what we were doing precisely. We had identified, as a result of the Government Actuary's survey which took place in the middle of 1998, Treasury regulators had identified at that time that Equitable was in an unusual position. It had an unusually large number of guarantees and it did not have reserves in place to back those guarantees. They had identified in the latter part of 1998 the need to put in place reserves; and we pursued that and ensured that the company did put in place reserves, and we overrode the threat that they would take us to judicial review. That was the approach we pursued which I believe was resolute at the time. As for why that had not been done earlier—that goes back to the earlier period for which I cannot answer.

  185. It was rigorous from the moment you took over?
  (Sir Howard Davies) I believe it was.

  186. Let us look at the implicit future profits item. Under the Contracting Out statutory instrument, the Treasury retained responsibility for Section 68 Orders. However, the Minister told us a fortnight ago that the Treasury were "wholly dependent" on FSA advice. Were you aware of that?
  (Sir Howard Davies) I was certainly aware of the fact that the argumentation in relation to Section 68 waivers was put to the Treasury by us; but I presumed that the Treasury looked at the integrity of the argumentation we put forward and performed some due diligence on that.

  187. It would not be right that the Treasury were wholly dependent on your views?
  (Sir Howard Davies) They were wholly dependent on our advice in the sense that we were the people who put forward the propositions to them. If they were unhappy with them then they could challenge them in the way that anyone with a proposition they did not like the look of could do.

  188. The responsibility for signing the Section 68 Orders rested with the Treasury, and not with the FSA?
  (Sir Howard Davies) Yes, it did, and still does.

  189. After the Lords' judgment in September 2000 the Insurance Supervisory Committee was then allowed to rejig Equitable's balance sheet to the tune of £1.1 billion so far as the implicit profits were concerned. Baird picks out that this was done on the old resilience test and not on the new resilience test, and it was done on Government Actuaries' advice and was delivered before the Lords' judgment. Was that acceptable?
  (Sir Howard Davies) I believe it was at the time.
  (Mr Tiner) My understanding is that it was done on the basis of the rules in place at that time. I was not here to oversee that but that is my understanding.

  190. Were you briefed on the operation of the Insurance Supervisory Committee? Sir Howard, were you a member of that committee?
  (Sir Howard Davies) No.

  191. Were you aware it was not even a proper meeting, it was simply a telephone call?
  (Sir Howard Davies) I was not aware of that until the Baird Report was produced.

  192. This was the only life insurance company which was subject to a pre-handover warning notice that you claim to have been rigorously regulating; and you were not aware that it was allowed to rejig its balance sheet by £1.1 billion by your own committee on the basis of a telephone meeting?
  (Sir Howard Davies) I do not think I would necessarily need to be aware of that if it was done consistently with the rules. We have a system of delegation and delegated authority which is necessary in an organisation which regulates 10,000 different firms. I would also point out, once again in relation to this idea of a handover note and a handover warning, the people who were warning about Equitable Life were the people who were there. It was not that there was a warning that was given by people who did not come across. The briefing note that we received from the team of insurance regulators was from the same people who came across. There was no warning note delivered from anyone else in the Treasury. Those people previously reported to senior management in the Treasury and they came to us and they had within themselves a view that Equitable Life was a company we ought particularly to watch. This was not in any sense a communication from the Treasury to the FSA. It was a communication within the regulatory system by people who remained within the regulatory system. I had no reason to think I had been warned by people outside my regulatory department that there was a concern which they were not taking seriously. They were the people who put up a warning and, therefore, I had confidence that they acting in a way that was consistent with that view of the company.

  193. By 2000 I think a lot more people knew what was going on. Baird reports to us that the chairman of the Insurance Supervisory Committee simply sent an e-mail to the other members stating: "Did not have time to put questions to individual supervisors bilaterally". You are the Chief Executive of this Authority, is that rigorous regulation?
  (Sir Howard Davies) I do not attach a huge significance to that. There is an enormous amount of business to transact within the Authority. What I believe he was saying at the time was that it was difficult to assemble a meeting with everybody, and what was being done was consistent with the rules and, therefore, it was acceptable it should be allowed to proceed.

  194. On your major insurance worry the balance sheet can be rejigged to the tune of £1.1 billion on the basis of a telephone call from the chairman of one of your committees and you are not even aware of it?
  (Sir Howard Davies) The work was done based on actuarial advice and an analysis of the position and representations from the company. Yes, that kind of thing can happen and it can happen all the time. As I say, in an organisation where we regulate 10,000 companies, I have to say, that will go on without the Chairman's knowledge. It is quite unrealistic to think that all of those decisions could be put up to the Chairman of the Board of the Authority; that simply is not practical.

  195. You are Chief Executive as well as the Chairman?
  (Sir Howard Davies) Indeed, and I would say exactly the same thing.

Mr Nigel Beard

  196. Sir Howard, in a memorandum from Mr Ned Cazalet, which is Appendix 5 of our previous report on Equitable, [1]he says: "As a group, life offices began to make extra reserves for guaranteed annuity options 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". Why, when other life assurance companies were making provisions for potential GAR liabilities, was Equitable Life allowed to be an exception to that rule?
  (Sir Howard Davies) Once again, Mr Beard, I think we are talking about a period before I took over responsibility for the company. The story that we can tell from the Baird Report was that, by early 1998, the supervisors were concerned about the position of guaranteed annuities across the industry and, therefore, decided to undertake a specific survey to ascertain what the position was of a variety of different companies and that led to the identification of Equitable Life. As to why that identification was not made earlier, I am afraid I could not answer that question.

  197. Going to the Baird Report, paragraph 6.10.1, page 212, he says: "During the Review Period, [that is January 1999 to December 2000] GAD was aware of the existence of entitlements in GAO policies to pay additional premiums (or `top-up' the policies) . . . However, the prudential regulator did not question the reserving basis for these, despite information received from Equitable Life in response to the GAD survey in 1998 that such entitlements were available . . . neither IFSD [your own department monitoring this] nor the GAD appear to have appreciated the significance of the fact that the exposure could neither be reliably quantified nor capped". Why did the FSA not appreciate that the findings of the GAD survey indicated a potential black hole, because the liability could not be capped?
  (Sir Howard Davies) I cannot answer, Mr Beard, as to why that did not happen. I simply have to accept the Baird Review's view that that was not done, and the consequences which flow from it in the following paragraph.

  198. Was there any attempt made to make an assessment of what the GAR liability might be?
  (Sir Howard Davies) Yes, there was an attempt, because that was the basis on which we were requiring the company to increase its reserves in 1999. There was certainly an attempt to assess what the liabilities would be. This is a particular dimension of that, which is that the policies did have the possibility for top-up in them. That, of course, is extremely difficult to assess, because it depends on the individual tax position, and financial position indeed, of the policyholder. It is not something you can see from the face of the policy; because typically these policies would allow you to make a contribution to the Inland Revenue rules in relation to your income; and since you do not know what the income level of the individual who owns the policy is, you cannot be sure how much they would be entitled from an Inland Revenue point of view to put into the policy. It was inherently very difficult to assess; and that may have been part of the reason why no attempt was made to assess it because we did not have (and indeed I do not think Equitable Life would have) the information available to make an accurate assessment; but clearly there was a liability, albeit unquantifiable.

  199. How important was this black hole liability when Equitable Life was trying to find a buyer after the House of Lords' judgment?
  (Sir Howard Davies) It was undoubtedly a relevant factor. When we talked to companies who were considering buying Equitable Life, or indeed who had considered and rejected buying Equitable Life, the unquantifiable nature of these was certainly a factor. There were, however, other factors related to the fit between the company, potential acquirer and the Equitable's business. There was also considerable concern in the industry, which developed during the course of 2000, that the future profitability of the life industry would be lower than it had been in the past, influenced by the 1 per cent cap on advice in relation to stakeholder pensions; and that looking forward, given that a proportion of the market would move into stakeholders with a 1 per cent cap, the overall profitability of the kind of business mix that Equitable would have had was going to be lower. That was a very important factor certainly drawn to our attention. This was one factor, but I could not say that it was a decisive factor in any of the negotiations of which I am aware; but there were, of course, 15 or so companies who began, and I could not tell you in relation to all of them whether this was a decisive factor for them.

1   HC 272-II p. 62. Back

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