Memorandum by the Financial Services Authority
1. The FSA welcomes the opportunity to contribute
to the Committee's inquiry into regulation and management of risk
in the life assurance sector. This memorandum:
outlines the FSA's role in the regulation
of Equitable Life from January 1999 to December 2000
summarises the FSA's work since Equitable
Life's closure to new business.
outlines the FSA's plans to improve
insurance regulation for the future.
B. FSA'S ROLE
B1 The FSA's Report on its supervision of
2. Attached at Annex A is a timetable of
the main events over recent years. The Committee will be aware
that on 22 December 2000 the FSA announced that it will produce
a Report on its role in the supervision of the Equitable Life
Assurance Society ("Equitable"). The Report will be
prepared by a team led by Ronnie Baird, Director of the FSA's
Internal Audit Department, with the support of legal and accountancy
advice from Norton Rose and PricewaterhouseCoopers respectively.
The Report team is accountable directly to the Board of the FSA,
which is made up predominately of non-executive directors. The
Report will be published. It is likely to take some months to
3. The FSA expects to learn lessons from
these events. It wishes to be as helpful to the Committee as it
can at this stage, including by outlining the steps it already
has in hand to improve insurance regulation for the future. However,
in advance of the Report referred to above it would not be appropriate
for the FSA to draw any final conclusions about the lessons to
be learned or otherwise to pre-empt the findings of the Report.
B2 The FSA's responsibilities for the regulation
of Insurance Companies
4. Following the Government's announcement
in May 1997 of its plan to reform the structure of financial services
supervision, Ministers decided that prudential supervision of
insurance companies should be transferred from Government to a
new single regulatory authority. In preparation for this, responsibility
passed from the Department of Trade and Industry to the Treasury
in January 1998. With the agreement of the FSA, Martin Roberts
was appointed as Head of the Treasury's Insurance Division, with
a view to leading the eventual transfer of the Division to the
FSA. The Treasury and the FSA subsequently decided that, in order
to facilitate the eventual full integration of supervisory functions
within the FSA, the day to day task of prudential insurance supervision
should be transferred to the FSA, ahead of the implementation
of the Financial Services and Markets Act 2000 (FSMA).
5. Accordingly, from 1 January 1999 the
Treasury's role in the prudential supervision of insurance companies
was contracted out to the FSA, by order under the deregulation
and Contracting Out Act 1994. Under the Order the majority, but
not all, of the Treasury's powers under the Insurance Companies
Act 1982 became exercisable by the FSA. Relevant Insurance Division
officials, including Martin Roberts and Roger Allen, Head of the
Department responsible for the supervision of life insurance companies,
transferred to the FSA at that time. Throughout the months leading
up to the transfer, Treasury officials had kept the FSA informed
about significant developments in the insurance industry which
were likely to be relevant to the functions which were to be transferred
6. Following the transfer, and until FSMA
is implemented, the FSA remains accountable to the Treasury for
prudential insurance supervision.
7. The Government Actuary's Department (GAD)
provides actuarial advice to the FSA to assist in this supervision
in the same way as it previously advised the Treasury and the
8. The Personal Investment Authority retains
legal responsibility for regulating the marketing of investment
products by insurance companies including Equitable. Its requirements
include standards for advertising and advice given to consumers
at the point of sale. Whilst the work is carried out by the FSA
staff under a service level agreement, the PIA continues to discharge
its own functions.
B3 Guaranteed Annuities
9. When the FSA took on prudential supervision
of insurance companies in January 1999, work was on-going on the
guaranteed annuity rate (GAR) issue. A survey of GAR exposures
across the insurance industry had been conducted by GAD in the
summer of 1998.
10. This survey was conducted in order to
establish which companies had an exposure to GAR contracts, as
the transition to a low inflation environment led to these having
greater significance. Equitable's response indicated that, although
it had a substantial exposure to GAR contracts, no specific reserves
were held to cover the costs of the guarantees. The Equitable
explained this on the basis of its practice of paying different
levels of bonus to GAR policyholders, depending on whether or
not they exercised their right to the guaranteed annuity rate.
Equitable had decided to pay those exercising the guarantee a
lower terminal bonus, to the extent necessary to make the value
of the guaranteed annuity no greater than the benefits that could
be bought if the guarantee were not exercised.
11. Discussions between the regulators and
the Equitable about the level of reserves required for its GAR
exposure and the acceptability of its bonus practice in respect
of GAR contracts were in train when regulation was transferred
to the FSA in January 1999. Equitable established additional reserves
of some £1.6 billion for its GAR contracts from the end of
12. The GAD survey and subsequent discussions
with insurance companies highlighted uncertainty within the industry
about two issues: first, how the costs of GAR contracts should
be met by companies and, second, the standard of reserving that
was expected by the regulator.
13. In December 1998 Martin Roberts, then
still Head of the Treasury's Insurance Division, issued a guidance
letter to Managing Directors of insurance companies on the first
issue. That letter was drafted on the basis of actuarial and legal
advice at the time. The guidance was suspended in July 2000 following
the House of Lords judgement.
14. In January 1999 the Government Actuary,
in conjunction with the FSA, issued guidance to companies and
their Appointed Actuaries on the second issuethe standard
of reserving expected for GAR contracts.
15. During 1999 the FSA and GAD monitored
companies' compliance with the guidance on reserving, primarily
by review of their Annual Returns for 1998 (the bulk of which
were received in June 1999). At the FSA's request, the Government
Actuary issued further clarification of the reserving guidance
in December 1999, as it was apparent from analysis of the Returns
that there was some inconsistency in companies' interpretation
of the January 1999 guidance.
B4 The Court Decisions
16. Throughout 1999 and 2000, the FSA followed
closely the progress of the court case relating to Equitable's
bonus practice in respect of GAR contracts. The FSA considered
the implications of a range of possible outcomes of the case,
including what was the eventual decision of the House of Lords,
and encouraged the Equitable to develop plans for addressing these
17. The judgement at first instance supported
Equitable's bonus practicethe Court held that Equitable
could pay different levels of bonus to GAR policyholders according
to whether or not a guaranteed annuity was taken up. As such the
judgement had no financial implications for the company.
18. The Court of Appeal found that the Equitable
could not pay different levels of bonus according to whether or
not a guaranteed annuity was taken up. But it did not rule out
the possibility that different levels of bonus could be awarded
to different types of policyholder. One judge, Lord Justice Waller,
said: "I see no reason why different bonuses may not be awarded
to different types of policyholder and . . . why, for example,
the board cannot in deciding what final bonus to award to GAR
policyholders, keep that bonus at a level which does not deprive
different with-profits policyholders of their equivalent asset
share." Thus Equitable took the view, at the stage, that
it could ringfence the costs of GARs amongst just the GAR policyholders,
by reducing their bonuses as a class, and leaving the benefits
payable to non-GAR policyholders unchanged.
19. The House of Lords judgement went further
than merely upholding the Court of Appeal judgement. It ruled
that when setting final bonuses the Equitable was not entitled
to differentiate between policyholders depending on whether or
not their policies contained GARs, or on the form in which benefits
B5 Implications of the House of Lords judgement
20. In advance of the House of Lords judgement,
the implications of what subsequently proved to be its findings
was one of the possible scenarios the FSA discussed with Equitable.
The Equitable took the view that at current annuity values, the
effect of this would be to increase the value of benefits taken
in GAR form, and that these could only be paid at the expense
of other policyholders. Moreover, the effect would be to require
more funds to be set aside as reserves. As Equitable's policy
had been to operate with relatively few spares assets, the company's
scope to manage this without adversely affecting policyholders
was limited. The FSA envisaged that in such an outcome Equitable
would remain solvent and able to meet the statutory requirements,
but it would be left in a relatively weak financial position and
might need to seek a buyer. This proved in the event to be the
B6 Supervision of Equitable after the House
of Lords Judgement
21. As a mutual, Equitable had limited options
for rebuilding its financial strength in the wake of the House
of Lords judgement. The company's response was to cut to zero
the investment return paid to all policyholders for the first
part of 2000 and, as discussed with the FSA prior to the judgement,
to put itself up for sale. The FSA concluded that immediate regulatory
action was not appropriate and, as indicated to the company prior
to the judgement, the FSA allowed the sale to be pursued as a
means of addressing the need to increase the company's financial
strength. The FSA maintained close contact with Equitable during
its search for a buyer so that any regulatory issues raised by
potential bids for the company could be addressed at an early
stage. The FSA also monitored the financial position of the company
closely during this period.
22. In the summer of 2000 Equitable received
15 expressions of interest from potential purchasers and there
was every expectation that a sale would be achieved. In December
2000, when it became apparent to the FSA that the prospects of
a successful sale of the whole business were diminishing, the
FSA held further discussions with Equitable. The company concluded
that if no buyer was forthcoming it should close to new business.
Accordingly, when the last potential bidder withdrew the FSA worked
with Equitable to ensure that the decision to close to new business
was announced in a co-ordinated way.
C. THE FSA'S
23. Since Equitable's announcement that
it was closing to new business, the FSA has focused on six areas:
monitoring Equitable's financial
participating in sale discussions
to address any regulatory issues arising;
monitoring the terms on which policyholders
can withdraw their funds;
monitoring disclosure and advice
by Equitable to potential and actual policyholders;
monitoring the activities of other
firms offering advice to Equitable policyholders;
ensuring that policyholders have
access to the information they need.
C1 Monitoring Equitable's financial position
24. It is not uncommon for insurance companies
to close to new business. Currently there are 25 companies, other
than Equitable, that have with profits funds which are closed
to new business. Following its closure to new business Equitable
has remained solvent and able to meet its liabilities to policyholders.
However, the relative weakness of its financial position has resulted
in a reduction in its investment freedom, and the company has
begun to move to a more conservative investment strategy (which
is normal for a closed fund). In December 2000 Equitable estimated
that investment returns might be reduced by 0.5-1 per cent per
year, once the change in investment strategy was fully implemented.
25. With GAD's assistance, the FSA continues
to scrutinise the latest financial information provided by Equitable
to ensure that prudent reserves are being maintained and that
appropriate steps are taken to ensure that the funds of the Equitable
are not exposed to undue risk. Insurance companies are required
to maintain assets that exceed their liabilities by a specified
margin, commonly referred to as the solvency margin. The FSA has
regularly confirmed that Equitable continues to meet this requirement.
C2 Sales and other negotiations
26. Equitable made clear in the statement
announcing its decision to close to new business that in order
to secure maximum value for the policyholders, it would be looking
to dispose of certain assets and business units that were not
relevant to its continuing operations. Discussions with policyholders
have also been taking place. Negotiations of this kind are primarily
matters for parties concerned but the FSA participated in some
discussions so that any regulatory concerns could be identified
and considered at an early stage.
27. After holding detailed discussions with
a number of potential bidders. Equitable announced on 5 February
2001 that it had concluded a sale of its operating business to
the Halifax Group plc, in a deal worth up to £1 billion.
The sale covered the sales force, the administration services,
the management of the fund management business and the economic
interest in the unit-linked and non-profit business (mainly term
assurance) which will move to companies in the Halifax group.
The sale does not cover the Equitable's with-profits fund which
remains within a self-standing mutual, with the fund significantly
strengthened by the proceeds from the sale. This element of the
transaction is worth £500 million.
28. As a second part of the deal, Halifax
has committed to make a further payment into the mutual, in respect
of goodwill, of up to £500 million. This payment is conditional
on a deal being struck between Equitable's policyholders that
will enable it to cap the liabilities to GAR policyholders. Equitable
intends to put to policyholders a GAR compromise scheme which,
if accepted, would have the effect of further strengthening the
fund and improving investment freedom and likely returns to policyholders.
The scheme to buy out the GAR rights will need to be made on a
basis that secures by vote the agreement of the different classes
of policyholder. Court approval will be required.
29. The FSA has welcomed this deal as being
in the interests of policyholders. Equitable is still working
on the detail of the terms of the GAR/non-GAR compromise and the
FSA will consider the detailed proposals in due course.
C3 Withdrawal of funds by policyholders
30. The FSA is carefully monitoring consumer
reaction to Equitable's closure to new business and the basis
on which policyholders are able to withdraw their funds.
31. As a matter of practice, life insurance
companies typically reduce the amounts paid when a policy is surrendered
other than on contractual dates. This is done be deducting some
money from the funds being withdrawn. Life offices calculate surrender
values in different ways. But in effect, each company sets the
amount of the deduction, often referred to as a Market Value Adjuster
(MVA), according to what it thinks is fair in the circumstances.
Policyholders withdrawing funds on contractual dates (including
retirement or other dates specified in the contract) are not affected
by the adjustments.
32. The considerations that a life office
takes into account depend on the particular circumstances of the
company, the policies and the need to balance the interests of
policyholders leaving the fund and those remaining. Other considerations
the fact that the notional value
of the policyholder's fund at the time of surrender may be higher
than is actually justified by the investment underlying the policy;
the need to recover expenses incurred
when the policy was sold or set up on the company's administration
systems. These expenses would otherwise have been recouped in
the need to prevent sales of the
fund's assets at disadvantageous priceswhich would lead
to a poorer deal for policyholders staying in the fund.
33. Equitable announced on 8 December that
following its closure it would increase the MVA to 10 per cent
from its previous level of an average 5 per cent. At the time
of writing this memorandum, the FSA understands that Equitable
has no plans to change the level of the adjustment. On the basis
of information provided to the FSA by GAD, it appears that even
following the increase to 10 per cent, Equitable's surrender values
are roughly in line with the industry average. The FSA is also
satisfied that the level of MVA has been set in accordance with
the criteria described in the previous paragraph. The FSA will
continue to monitor the adjustments made by Equitable and has
powers to intervene at any time, if it considers the adjustment
to be unreasonable.
C4 The FSA's assessment of Equitable's disclosure
and advice to policyholders during the period up to the closure
to new business
34. Firms are under a regulatory obligation,
imposed by the PIA rules, to ensure that information disclosed
to consumers is clear, fair and not misleading. Advisers should
use their best endeavours to enable consumers to understand the
nature of any risks involved in an investment. During the period
from the Court of Appeal decision in January 2000 to its closure
to new business Equitable continued to advertise and advise consumers
to invest in its with profits fund.
35. The FSA is carrying out work to assess
the steps taken by Equitable to meet its regulatory obligations,
in order to establish whether consumers were misled and have incurred
loss as a result, and whether they should receive compensation.
The rights of individual consumers will depend on the information
and advice they were given at the time of sale. The FSA's work
continues and includes an assessment of Equitable's handling of
complaints by policyholders during this period.
C5 Monitoring advice to Equitable policyholders
following the closure to new business
36. A key part of the FSA's work since the
Equitable's closure to new business has been ensuring that policyholders
have access to proper, clear information and advice. The FSA has
worked with Equitable to make sure its own salesforce is available
to advise clients appropriately.
37. The PIA has reminded advisers that all
advice needs to be given on the basis of sufficient knowledge
of the client's position and that all the relevant advantages
and disadvantages of any recommendation need to be disclosed to
clients and confirmed in writing. The PIA is examining approaches
being made by other firms to Equitable policyholders and the advice
they are receiving. This work includes the commissioning of a
"mystery shopping" exercise involving Equitable policyholders
seeking advice on what they should do. This will help the FSA
understand whether advisers are meeting their regulatory obligations.
If they are not, the PIA will consider action against the firms
or individual advisers concerned where appropriate.
C6 Information for policyholders
38. The FSA has sought to ensure that Equitable
policyholders have access to the information they need, including
after the recent announcement of the sale to Halifax. The FSA
produced an initial fact sheet on
the company's announcement of its closure to new businessalso
available on its websitewith information for policyholders
who were considering whether they needed to take any action;
provided information to policyholdersalso
available on the websiteabout the sale of the operating
business to Halifax;
handled Equitable-related enquiries
through its Consumer Helpline;
dealt with a substantial volume of
written enquiries from policyholders;
sought to reassure policyholders
that Equitable is solvent and continues to meet the relevant statutory
requirements for insurance companies;
encouraged policyholders to seek
financial advice before taking action;
worked with Equitable to monitor
the information it has made available at different times and to
ensure that its communications to policyholders are written in
monitored the adequacy of Equitable's
enquiry handling arrangements.
39. This section describes a number of projects
currently in hand which the FSA believes will, taken together,
improve insurance regulation in the future. These steps reflect
our general intention to move to a more proactive approach to
regulation, focusing on the key risks to our statutory objectives.
D1 Supervision Resources
40. When the FSA took on the prudential
supervision of insurance companies on 1 January 1999, the relevant
officials from the Treasury's Insurance Division transferred to
contracts of employment with the FSA. These included, in addition
to the Head of Division, three Departmental Heads, nine managers,
31 associates and 17 support staff (secretaries and administrators)
directly involved in supervisory work. These staff, with support
from two advisers and 19 actuaries in GAD, carried out supervision
of some 760 insurance companies.
41. Resources devoted to insurance supervision
had increased significantly during the 1990s. Since 1 January
1999, the FSA has increased resource by a further 15 per cent.
Nonetheless, we recognise that this area of the FSA's work is
still comparatively under-resourced (by contrast, the FSA has
some 21 managers and 114 associates who, with support from about
50 further staff in specialist teams, are responsible for the
supervision of 398 authorised banks, building societies and UK
branches of non-EEA banks). As indicated in the FSA Plan and Budget
2001-02, some further rebalancing of resources is planned in favour
of insurance supervision, as well as significant changes in its
organisation and the way staff work. These plans were made in
the light of an assessment of the potential risk to the FSA's
objectives posed by different classes of firm, which suggests
that insurance supervision was relatively under-resourced, and
is not specifically related to the circumstances of Equitable.
D2 Insurance Supervision
42. Historically, prudential insurance supervision
has been based on:
(a) Public disclosure by companies of detailed,
audited, financial information in annual statutory returns;
(b) For life insurance business, oversight
of each company's financial condition, and control over the distribution
of surplus, by the company's appointed actuary. The appointed
actuary's functions are determined by statute, and are significantly
buttressed by professional guidance and discipline;
(c) Desk based review (prioritised on a risk
based basis) of the statutory returns by insurance supervisors
(or, in the case of life insurance companies, by GAD actuaries);
(d) Discussions between insurance supervisors,
GAD actuaries and companies as issues arise;
(e) Readiness to use statutory powers where
43. As resources increased during the 1990s
these activities were supplemented by more regular meetings between
insurance supervisors and the senior management of leading companies,
or of companies causing particular concern. By the time FSA took
on prudential insurance supervision those visits were running
at the rate of approximately 140 per year, of which about one
third were focused on life companies. Our aim is to increase the
frequency of such visits.
D3 Risk Based Supervision
44. In order to adjust to a rapidly changing
(and increasingly competitive) insurance market and to prepare
for the transfer of supervision from the Treasury to the FSA,
supervisors have developed a more formal approach to risk-based
assessment. This is now in use and encourages supervisors to consider
a range of risks to insurance companies and their policyholders:
financial risksarising from
capital adequacy and the valuation of assets and liabilities;
external environmental risksarising
from economic and other developments;
control riskshow firms organise
and manage risks. (This has received relatively modest supervisory
attention in the past.)
This approach builds on the model developed
over recent years for banking supervision and foreshadows the
risk assessment framework described in the FSA publication, "A
new regulator for the New Millennium" on which development
work is continuing.
D4 Organisation of insurance supervision
45. As explained in the FSA's Plan and Budget
for 2001-02, starting in April this year the FSA plans to integrate
conduct of business (CoB) and prudential supervision of life assurance
business. This will lead to a number of synergies between CoB
and prudential regulation. The supervisory teams already need
to consult each other extensively. This has been easier since
co-location; full integration will help eliminate most of the
remaining inefficiencies in this communication process. It will
bring together both types of supervisor in the same team. It will
be easier to share information between supervisors, and information
requests made of firms will be tailored to suit the needs of both
sets of supervisors. This will make the FSA's supervision of this
sector more efficient.
D5 Actuarial Advice
46. Operational efficiency and flexibility
will be further improved by the transfer in April 2001 of those
GAD staff who currently provide the FSA with actuarial advice.
D6 Reviewing the prudential regime for all
47. The FSA's further thinking on assessing
the adequacy of firms' financial resources will be set out in
the Integrated Prudential Sourcebook, which the FSA expects to
issue for consultation during the second quarter of this year.
This will impose a duty on insurers to make and justify their
own assessment of the adequacy of their financial resources using
appropriate modelling and other techniques including scenario
and stress testing.
D7 Treating retail customers fairly after
the point of sale
48. As part of implementing the new risk-based
approach, the FSA announced last year that it would carry out
a number of "thematic projects", reviewing major issues
which cut across industry sectors and consumer groups and have
wide-ranging implications for the FSA's ability to pursue its
statutory objectives. One such theme is "Treating retail
customers fairly after the point of sale".
49. This project is considering aspects
what powers and responsibilities
the FSA has under FSMA relevant to treating customers fairly;
how "fairness" should be
interpreted for these purposes;
circumstances in which unfairness
current industry standards in this
proposals for FSA workin addition
to projects already in handto address the risks identified.
50. The FSA is discussing its thinking with
industry experts, consumer bodies, financial journalists and the
Financial Ombudsman Service and expect to publish its conclusions
in Spring this year.
D8 Improving the information available to
51. In pursuit of its statutory objective
to promote public understanding of the financial system, the FSA
has a number of projects in hand to improve the information available
to consumers, to help them make better informed investment decisions.
In the summer of 2001 the FSA will
launch a new Comparative Information service. This will provide
an on-line service to consumers, giving them the opportunity to
compare the features of financial products of specified types.
A telephone helpline will offer this information to those without
access to the Internet. The initial material will concentrate
on long-term investment products.
The FSA has published, both on its
website and consumer booklets, a comprehensive range of generic
information on financial matters such as FSA guides to pensions,
financial advice and making a complaint. Over the coming year
the FSA will be working, for example through post offices, to
raise awareness of this FSA material.
Following on from the FSA's discussion
paper, "Informing Consumers", published last November,
the FSA may consult later this year on proposed changes to the
rules and guidance to firms on the information they must provide
to consumers on packaged products. The aim is to assess the impact
which the various disclosures currently required have on consumers,
the burden which they impose on firms, and to consider how the
disclosures might be expressed in a more meaningful way.
At a more general level, the FSA
plans to publish a statement "defining the regime" describing
what consumers can expect from the regulator and from firms, and
what will remain their responsibility.
D9 The implications of a low-inflation environment
52. A further thematic project on which
the FSA is currently working concerns the implications of a low-inflation
environment. In recent decades individuals and businesses in the
UK have been accustomed to living in an environment of relatively
high inflation. The long-term trend of falling inflation and falling
investment returns has important general consequences for firms,
markets and consumers. This development has been behind a number
of policy initiatives across the FSA and is also an important
backdrop to the Equitable case.
53. The FSA will publish its conclusions
in a Paper in the Spring; this will highlight the risks the FSA
sees arisingespecially during the transition to a low-inflation
environmentto its statutory objectives of protecting consumers,
promoting consumer understanding and maintaining market confidence.
D10 With-profits review
54. A number of recent cases, including
the Equitable, have raised important questions about with-profits
products. In evidence to the Committee last autumn, the FSA indicated
that it was minded to conduct a review of with-profits business.
This work now forms one of the FSA's priorities for 2001-02.
55. With-profits products entail the exercise
by companies of very wide discretion (for example of the way in
which with-profits funds work, how bonus rates are set, how charges
and expenses operate, how surrender values are calculated, and
how "smoothing" works). The FSA wishes to examine the
nature and extent of this discretion; and also whether with-profits
products can be made more transparent to consumers, and if so
how can this be achieved.
56. The FSA has already had preliminary
discussions with representatives of consumers, the industry and
the actuarial profession. These groups are generally supportive,
and keen to contribute to the debate; the FSA wants to work closely
with them in conducting the review.
9 February 2001