Examination of witnesses (Questions 180
THURSDAY 15 FEBRUARY 2001
Sir Michael Spicer
180. Sir Howard, in a letter to me dated 23
January this year, you said, "In the unlikely event of insolvency,
there is a scheme designed to assist with the transfer of policies
or arrange compensation". Does that mean that at the back
of your mind there really is a possibility of insolvency in the
(Sir Howard Davies) I think I was stating the factual
position in response to an inquiry. I think I have in the back
of my mind, in relation to all of the 10,000 companies I regulate,
the possibility that they might become insolvent or go bankrupt.
I hope, Sir Michael, you would think that I should have that in
the back of my mind. As to whether it is in the front of my mind
in relation to the Equitableno, it is not, because at the
moment the company is solvent and we can see a solvent way through
for it. I think, however, for completeness one has to say there
is a policyholder protection board which stands at the end of
181. Mr Sclater told us in answer to a question
that I put to him that what he called technical insolvency was
a possibility if the economic circumstances changed. Does that
(Sir Howard Davies) Yes, it is true and, as he explained,
there are two sorts of insolvency for life insurance companies.
There is insolvency in relation to the statutory returns which
is where we require companies to maintain a higher degree of reserves
and, if you like, a higher degree of solvencythat is probably
not the technical way of putting it but a higher cushion of solvencythan
would be required according to company law. We are operating,
therefore, above a cushion between our reserves and solvency law.
At the moment they are above that and, at the moment, satisfactorily
above that. Their solvency cushion above this minimum is not as
great as some other companies, and any company which is clearly
under some uncertaintyas the Equitable is with uncertainty
about the outcome of a vote, et ceteraone has to have under
particularly close watch. Indeed, we have a ratings system with
the Government Actuary's Department whereby companies are rated
according to the nervousness we have and the closeness with which
we look at their solvency and the speed with which we analyse
their returns, and the Equitable has moved appreciably up that
table in the last couple of years.
182. But both you and the Society representatives
before us have said that, if economic circumstances change, insolvencyboth
true and technicalwas a possibility, so does that not imply
that the reserves are still potentially inadequate?
(Sir Howard Davies) I do not think so because I think
that the answer given by the Equitable and the answer that I would
give would be that any life company could become insolvent in
a particular combination of circumstances. Our regime protectswe
hopeagainst most plausible economic circumstances but it
cannot protect against all possible eventualities. Were the stock
market to fall much further out of bed than it has at the moment
and were long term interest rates to remain low or, indeed, get
lower, then there could be circumstances in which the Equitableand,
indeed, other companieswould be in difficulty, but we do
not foresee that at the moment. What I was saying for completeness
in your letter was, were those unlikely set of circumstances to
be the case, then there is the policyholder protection board which
183. Asset value is obviously one economic circumstance
that could change; the other is that, for some reason not totally
predicted by the Society, the with-profit policyholders could
do a runner. That surely remains a risk, in your view?
(Sir Howard Davies) It does and we monitor the performance
of the fund very closely at the moment. We get regular figures
from the company about the number of surrenders and the impact
on the fund but at this point we are comfortable that that level
of surrenders is not running at a rate which would threaten the
solvency of the company, and we are content that the company meets
all its statutory requirements at this point.
184. Taking all your answers, do they not add
up to a sense of uncertainty about the future so far as the Society
is concerned? Is that perhaps not the real reason why you feel
it needs to be sold?
(Sir Howard Davies) Yes. There remains considerable
uncertainty and I think that, without a sale involving some strengthening
of the fund, that fund would, in order to maintain its solvency
have to take a defensive approach to its investment management.
I am certain it could maintain its solvency but it would have
to do so, to put it simply, by buying fewer equities and more
gilts in order to maintain the capital certainty of the fund and
its liquidity. Over time, therefore, although the year 2000 was,
of course, a notable exception, you could expect that that would
produce lower returns because, over time, equity returns are approximately
2.5 per cent higher than gilt returns. The fund could, therefore,
achieve a sustainable solvency but at the expense of future returns.
If the Halifax deal goes ahead and the policyholders vote for
a deal as put to them, then we think the fund could be solvent
with a normal investment strategy, a normal proportion of gilts,
and, therefore, it would be back on all fours with other closed
funds. It would not be the same as an open fund because it would
not be doing new business, but it would be back on all fours with
other closed funds.
185. Coming back to your duty as a regulator,
you are required to ensure that the company had prudent reserves.
(Sir Howard Davies) Well, we are required to ensure
that the company's reserving meets the standards in force at the
186. So you got it wrong.
(Sir Howard Davies) No, we did not.
187. If the company is put up for sale
(Sir Howard Davies) No. The company did maintain the
reserves in line with the rules in force at the time but the House
of Lords changed the circumstances, changed the interpretation
of the law, which meant that they needed higher reserves at that
point, at which point the company immediately put those reserves
in place by passing the bonus for the first seven months of that
year. So it remained consistent with our requirements, albeit
it was achieved in this rather dramatic fashion.
188. But why did you allow the Equitable to
hide behind its own interpretation of the legal position?
(Sir Howard Davies) We did not. As the Equitable themselves
have explained, the bonus policy is a commercial matter for companies.
Traditionally, regulators have not interfered in that. They took
that bonus policy in the light of legal advice that they took
at the time and therefore, from our point of view, we would check
that a company was operating with good legal advice, and it did
so. In addition to that, the letter that Martin Roberts wrote
in December did reflect the view which the Treasury held at the
time on the basis of its legal advice and which we continued to
hold. The Equitable's interpretation of the discretion available
to them was not inconsistent with our understanding of the law
as it was.
189. Once you were warned by insurance directorate
about the information and their concerns about the information
they had received, why did you not require the Equitable to ring-fence
the with-profits fund once it was clear to everybody that the
guarantees were going to be very costly?
(Sir Howard Davies) That was not clear at that point
because we were still operating on the basis that it was possible
for the Equitable to achieve an equalisation of returns by adjusting
the terminal bonus and the reinsurance policy was set in place
against that legal background. It was that legal background that
changed in July of the following year.
190. So you do not accept there has been a regulatory
(Sir Howard Davies) In answer to the Chairman, I said
that I think that it would have been better had a different reserving
approach been in place in the past for companies writing open
interest rate options and, therefore, if one could have one's
time over again, that is what you would do differently. In the
circumstances of 1998/1999, however, so far as I am aware, reasonable
decisions were taken. I have to tell you, however, Mr Fallon,
that this will be one of the core issues to be addressed in the
review which is currently being carried out, and I am sure that
that review team reporting to our full board will address that
question. I hope you will not misunderstand me, therefore, if
I give you my response to that, as I see it now, having lived
through the period but others looking at it independently may
reach a different view.
191. But it is not a wholly independent review,
is it? It is your own review.
(Sir Howard Davies) It is a review carried out by
a director of internal audit with external support from lawyers
and accountants and will be reported to our board which, as you
know, is dominated by non-executive members and will be published
and I believe that will give an independent view of the events
that took place.
192. In effect, the FSA is reviewing whether
or not its own position was reasonable. You are reviewing yourself,
are you not?
(Sir Howard Davies) We have set up procedures; we
have accountability procedures for the FSA including a board which
is dominated numerically by non-executive members; we have set
up an internal audit and a quality insurance function which was
partly in place in order to deal with questions where people raise
issues about our regulatory effectiveness and, therefore, the
board thought that was a reasonable response for us to take to
what we have or have not done.
193. Turning, finally, to the issue I raised
earlier, you required in effect a £1.5 billion liability
provision to be made against the guarantees in the returns. Why
did you not require the Equitable to inform its policyholders
directly of the position?
(Sir Howard Davies) The way this has worked in the
past, and I will at the end of my answer explain what I mean by
that slightly qualifying point, is that this was disclosed in
the statutory returns and therefore was, in the normal way, available
in the public domain. Those statutory returns were looked at extensively
by analysts, rating agencies, et cetera, and were the basis on
which people produce league tables of free asset ratios and so
on which are quite widely available in the public domain. This
was the normal way in which regulatory requirements in relation
to certain reserves would be made public and nothing different
was done in relation to the Equitable at all. I think there is
a question mark about whether there is sufficient clarity on the
position of with-profits funds for with-profits policyholders.
You may recall, Mr Fallon, that at my last appearance before this
Committee in November I said we were contemplating doing some
work on with-profits policies and a range of regulatory issues
surrounding them, and I think the issue of the transparency of
with-profits funds to policyholders and whether policyholders
are, under the existing regime which I inherit, given the kind
of information which is best suited to them and which most clearly
explains the risks to which they are open is an interesting question
and one at which we are actively looking. We are looking at whether
disclosure to policyholders is adequate and whether the funds
themselves are sufficiently clear, or not too opaque. There was
nothing different done about the Equitable and that is the way
it has always been done. Whether it is providing adequate information
to policyholders for the future is an open question and one which
we are actively looking at.
194. But what was different, surely, with the
Equitable was the difference in the amount? They were telling
you that potential liability was £1.5 billion, and you were
letting them tell their own policyholders that the maximum cost
was only £50 million?
(Sir Howard Davies) We have no control over the statutory
accounts. The way insurance regulation works is on the statutory
returns prepared according to insurance regulations, and they
have always been describing a different picture from the one put
out in the company accounts. I have to say this is the case for
many other forms of financial regulationthe kinds of returns
we require from banks and the kinds of reserving policy we require
are different from the ones they present in their company accounts.
Those returns have been well understood, however, by those who
analyse the industry in the past and this change would have been
well understood by the people looking at this closelynot
individual policyholders but the analysts.
195. But do you not have a duty not only to
ensure that companies have prudent reserves but also an obligation
to secure an appropriate degree of protection for consumers as
part of your mission statement? Knowing what you did, you could
have written to the Equitable requiring them to disclose this
£1.5 billion liability to all their policyholders?
(Sir Howard Davies) Technically I have to say that,
while we do include our statutory objectives in our mission statement
about our future ambitions, those have not yet come into effect.
The Financial Services and Markets Act remains not yet implemented
and, therefore, we are looking in this case, particularly if you
are looking at the events of 1998/1999 at the regulations that
were in force at the time and the duties on insurance regulators
at the time. Looking forward, we certainly believe that an integrated
approach to the regulation of life insurance companies incorporating
both the prudential and the conduct of business side is required
and, furthermore, that more and better information for policyholders
is certainly necessary. That is a regime that we are currently
working on; we have made some changes and improvements already
and will be making more.
196. But could you or could you not have required
the Equitable to inform their policyholders of the £1.5 billion
potential liability? You could have required them to do that had
you chosen to do so?
(Sir Howard Davies) Could we?
(Mr Roberts) I am not sure we could. If I may say
so, there are two separate points here: one is that we are requiring
a reserve to be established against the possibility that, in extreme
economic circumstances, the cushion of surplus assets over and
above the contractual liabilities might no longer be available
to pay out the guaranteed annuity rate. That was the potential
liability against which we required a reserve to be set up. I
think what the Equitable were saying in their accounts and what
they said to policyholders in correspondence was that their estimation
of the possible cost of losing their case on the GAR and non-GAR
issue was what they said. Those are quite separate issues and
I think there is quite a lot of confusion between them.
197. Following that, do you think there should
be a change so that statutory financial provisions that are required
in terms of yourselves are included in the accounts?
(Sir Howard Davies) I am not sure that change would
be possible because I think it would cut across the Companies
Act under which the accounts are prepared, so I am not sure whether
that could be achieved.
198. But surely you could make that recommendation
to government at least?
(Sir Howard Davies) I imagine that we could and I
think it is a point that we should look at. As far as the technical
legal position is concerned, however, if this is of interest to
the Committee I would be pleased to write to you about it. It
came up in previous evidence, and it might be helpful.
199. Thank you. Going on to your discussions
with Equitable before the House of Lords judgment was made, in
the memorandum you sent to the Committee you said, "In advance
of the House of Lords judgment, the implications of what subsequently
proved to be its findings was one of the possible scenarios the
FSA discussed with Equitable." How far in advance of the
House of Lords rulings did those discussions take place?
(Sir Howard Davies) They were between
the Court of Appeal and the House of Lords. I cannot remember
the precise date.
(Mr Roberts) I do not remember precisely
either. We did some internal work ourselves before the High Court
to look at what the likely outcome might be. After the Court of
Appeal, we got into quite a significant discussion with the Equitable
to ascertain what their scenario planning was so that we might
understand it so that there might be some arrangements already
contemplated against the various possibilities that might emerge.
(Sir Howard Davies) Our question to the Equitable
was, as you would hope, "What will you do in the various
circumstances, and then we can make a judgment as to whether that
would be acceptable?" What they said in advance was, "If
we go down in this unlikely event, we will announce that we are
going up for sale and we will strengthen our reserves by passing
the first seven months bonus".
Our role was then to say, "Will that be enough to meet your
solvency requirements and, in light of that, to allow you to carry
on trading", and the answer to that was, "Yes".
We regarded that as a response that was consistent with the regulations
and appropriate in the circumstances. It was not our decision
to do that but that was acceptable in regulatory terms and, therefore,
we agreed with them that that would be what they would do. They,
of course, did it immediately and so their regulatory requirements
2 See p. 44. Back
Footnote by the Witness: Prior to the House of Lords judgement
the Equitable told the FSA that, in the event of an unfavourable
outcome, it would put itself up for sale and suspend the bonus
payments on policies to ensure they were compliant. Back