Memorandum from Ernst & Young
1.1 This paper is in response to the invitation
to submit written evidence to the Committee dated 19 January 2001.
We have been asked, as auditors of Equitable Life Assurance Society
(the "Society"), to comment on our role in the recent
events surrounding the Society.
1.2 Ernst & Young and its predecessor
firms have acted as auditors to the Society for many years. Until
the last two years, our services to the Society have been predominantly
carrying out the audit. More recently, we have been asked to help
the Society in a number of other areas, and brief details of other
assignments can be found in section 5.
1.3 The recent events surrounding the Society
have centred on the treatment of policyholders' rights in relation
to policies containing Guaranteed Annuity Rate Options ("GAR").
This issue was the subject of a representative action, funded
by the Society, which culminated in the judgment of the House
of Lords in July 2000 in Equitable Life v Hyman.
1.4 In addition to providing a summary of
the regulatory background as it applies to both directors and
auditors, this paper addresses the manner in which GARs were reported
and accounted for in the accounts and the regulatory returns of
the Society for 1998 and 1999. We have not included a detailed
analysis of how the Society's GAR contracts operate. If the Committee
requires information on this or any other matter, we would be
happy to submit further evidence as requested.
2.1 A UK life assurance company is required
by statute to prepare two sets of financial reports:
the annual accounts (the "statutory
accounts") required by the Companies Act 1985; and
the regulatory return required by
the Insurance Companies Act 1982.
2.2 The basis for the preparation of each
set of financial reports is different and auditors have different
responsibilities in relation to each set of reports. We explain
this further below.
Statutory accounts of life assurance companies
2.3 The directors are required by section
226 of the Companies Act 1985 to prepare accounts which give a
true and fair view of the state of affairs of the company as at
the end of the financial year and of the profit or loss for the
financial year and which comply with the detailed provisions of
the Act. There is no set definition of what constitutes a "true
and fair view". For working purposes, however, it is important
to note that this does not mean wholly accurate. What is involved
is a judgment to ensure that the accounts as a whole do not present
a materially misleading picture of the state of affairs of the
2.4 Detailed requirements and guidelines
for the preparation of the statutory accounts are set out, in
Schedule 9A of the Companies Act
the Statement of Recommended Practice
on accounting for insurance business published by the Association
of British Insurers in December 1998 ("ABI SORP") which
sets out details of the Modified Statutory Solvency Basis of accounting
Financial Reporting Standards published
by the Accounting Standards Board.
2.5 The regulatory return is required under
the Insurance Companies Act 1982 and has to be prepared in accordance
with the Insurance Companies (Accounts and Statements) Regulations
1996 (the "1996 Regulations"). The return is prepared
by the company and is submitted annually to the company's prudential
regulator, currently the Financial Services Authority (the "FSA")
and formerly HM Treasury and, before that, the DTI.
2.6 The regulatory return is significantly
longer and more detailed than a company's statutory accounts.
The Society's return for 1999, for instance, ran to 420 pages.
The contents of the return are prescribed by the 1996 Regulations
but the regulator can modify the requirements for a particular
company by issuing an order under section 68 of the Insurance
Companies Act 1982.
Valuation differences between statutory accounts
and the regulatory return
2.7 The method of valuation of assets and
liabilities in regulatory returns is prescribed by the Insurance
Companies Regulations of 1994, and requires the use of detailed
rules, the application of which is more pessimistic than the prudently
realistic basis used for statutory accounts.
2.8 The valuation rules, for instance, require
that certain assets contained in the statutory accounts be disallowed
from inclusion in the regulatory return and also that liabilities
be increased for the purposes of the regulatory return in order
to include substantial resilience and contingency reserves. The
MSSB, in particular, sets out significant adjustments that may
be made, when preparing statutory accounts, to the basis used
for preparing the regulatory returns.
2.9 The statutory accounts and the regulatory
return are, therefore, very different reports which reflect their
different objectives. The statutory accounts provide information
on the overall performance of the company whereas the regulatory
return is intended to provide the regulator with a wide range
of information to facilitate its monitoring functions.
3. THE ROLE
3.1 As indicated in paragraph 2.3 above,
the responsibility to draw up the statutory accounts is that of
the directors of a company. The responsibility of the auditors
is to form an independent opinion, based on their audit, as to
whether the statutory accounts prepared by the directors give
a true and fair view of the state of affairs of the company as
at the balance sheet date, and of the profit or loss for the financial
year. An audit is planned and performed such that the auditors
obtain sufficient evidence to give reasonable assurance that the
accounts are free from material misstatements.
3.2 While the role of the auditors with
regard to the regulatory return is also to express an independent
opinion, there are some significant differences as a result of
the requirements of the 1996 Regulations. The 1996 Regulations
provide that only specific parts of the regulatory return are
covered by the opinion expressed by the auditors. In respect of
the Society's 1999 regulatory return, for instance, the auditors'
report only covered 28 out of the 420 pages. In particular, the
auditors do not report on Schedule 4, which is the part of the
Society's regulatory return that contains the reserves in respect
of GARs. In addition, the report that has to be provided is not
an opinion on a "true and fair view" but is a report
on whether the particular parts of the regulatory return subject
to audit have been "properly prepared" in accordance
with the 1996 Regulations and any modifications specific to that
3.3 In conducting audits of assurance companies,
the latest specific guidance is given in Practice Note (PN) 20
"The audit of insurers in the UK" issued by the Auditing
Practices Board in 1999. PN20 superseded earlier guidance from
the Auditing Practices Board which was extant at the time of the
1998 audit, including the Auditing Guideline on life insurers
in the United Kingdom and Bulletin 1998/3"Auditors'
reports on regulatory returns made under the Insurance Companies
3.4 In addition to the specific responsibilities
to review the regulatory return, the auditors have a right under
the Insurance Companies Act 1982 to report to the regulator any
information or opinion which is relevant to the regulator's functions.
There is a duty to report to the regulator in respect of the matters
set out in The Auditors (Insurance Companies Act 1982) Regulations
1994; in essence, these cover matters that would be of material
significance to the regulator in determining whether to exercise
its powers of intervention.
4. THE ROLE
& YOUNG IN
4.1 Our audit work, both on the statutory
accounts and the regulatory returns, was carried out in accordance
with the applicable UK auditing standards and using relevant accounting
guidelines. The audit team was primarily staffed from a specialist
insurance group within the firm and used methodologies and support
tools that have been adapted specifically for the life assurance
1998 Statutory Accounts
4.2 In determining the required level of
provisions to be included in the statutory accounts for the year
ended 31 December 1998, the Society had to consider the challenges
raised by some policyholders to the Society's treatment of GAR
policies and also new guidance on GARs issued by HM Treasury Insurance
Directorate on 18 December 1998.
4.3 The Society increased the relevant provision
in the 1998 accounts (the long-term business provision) by £200
million to £21.9 billion in order to reflect the additional
cost of the GARs. The increase was made on the basis that the
approach then being adopted by the Society to award differential
terminal bonuses was wholly within the wide discretion conferred
on the Board by the Society's Articles of Association. This approach
was supported by a joint opinion from two senior Counsel.
4.4 Actual experience of the take up of
GARs in 1998 indicated that a much smaller amount (£50 million)
would probably be required but on the grounds of prudence, the
increase in the provision was set at £200 million.
4.5 As auditors, we reviewed the calculations
prepared by the Society and discussed them with the actuarial
staff and the Appointed Actuary and the Audit Committee. We also
discussed with the Society the legal advice it had received and
we formed the view that the action the Society had taken and the
provisions made were reasonable.
1998 Regulatory Return
4.6 The Society calculated the additional
reserves for the 1998 regulatory return in respect of GARs in
the light of the guidance from HM Treasury referred to in paragraph
4.2 above and specific guidance on regulatory returns issued by
the Government Actuary's Department ("GAD") on 13 January
1999. The calculations required an assumption that the take up
rate of GARs would be greatly in excess of the Society's actual
experience. The calculations provided a figure of £1.59 billion
for inclusion in the reserves in respect of GARs.
4.7 The Society also negotiated a reassurance
treaty in order to mitigate the impact of these additional reserves
on the excess of the available assets over the required solvency
margin. One of our life actuarial specialists (who was not part
of the audit team) assisted the Society in reviewing the terms
of the reassurance treaty and the terms of the policy were discussed
with and accepted by the regulator and the GAD prior to its inception.
The net figure for the additional reserves, after taking into
account the reassurance, was £784 million.
4.8 Details of the reserves and the level
of reassurance were set out in Schedule 4 of the regulatory return.
The 1996 Regulations do not require an audit of Schedule 4 and
it was not, therefore, included in our report on the regulatory
return. We were, however, aware of the contents of Schedule 4
and that the regulator had been consulted specifically in respect
of the reassurance.
4.9 It is important to note that the reassurance
had no impact on the additional provision for GARs made by the
Society in its statutory accounts. It was only taken into account
in connection with the reserves in Schedule 4 of the regulatory
return. The provision in the statutory accounts was based on assumptions
as to the take up rate of GARs that would not have triggered the
right to make a claim under the reassurance treaty; it would,
therefore, have been inappropriate to adjust the provision.
1999 Statutory Accounts
4.10 At the time that the company was finalising
its accounts for the year ended 31 December 1999, the state of
the court proceedings was as follows. In September 1999, judgment
had been given in the High Court confirming that the Society was
entitled to award differential terminal bonuses to GAR policyholders.
In January 2000, the Court of Appeal had given judgment in which
the majority of the court had held that there should not be differential
terminal bonuses. Leave was granted to take the case to the House
of Lords. A detailed report on the state of the case was included
in the Society's 1999 Annual Report which was sent to policyholders
at the same time as the statutory accounts.
4.11 One of the main issues in preparing
the 1999 accounts was, therefore, to determine what provision
and disclosure should be included in relation to GARs following
the Court of Appeal judgment.
4.12 Whilst the Court of Appeal had ruled
that the Society should not award differential terminal bonuses
depending on whether a GAR policyholder exercised his rights to
take a guaranteed annuity, the Society concluded that the detailed
reasoning of the court allowed the Society to "ring fence"
assets of GAR policyholders so that, as a class, their terminal
bonuses were not paid from the asset share of other policyholders.
This approach was consistent with the HM Treasury guidance referred
to in paragraph 4.2. It was also consistent with the Position
Statement issued in March 1999 by the Life Board of the Faculty
and Institute of Actuaries to assist its staff in responding to
questions from members of the actuarial profession and the public
on this issue. We were also aware that the Board had taken independent
4.13 Specific consideration was given by
the Board to whether the outcome in the House of Lords would be
significantly more adverse than the Court of Appeal judgment.
The Board concluded that, having considered the legal advice received,
such an outcome was no more than a remote possibility.
4.14 The approach adopted by the Society
to meet the requirement to prepare accounts to a "true and
fair view" standard in accordance with the MSSB, was to select
a provision that was realistically prudent and not excessive.
In line with this approach and given its conclusion that the likelihood
of a significantly more adverse judgment was remote, the Board
considered that it was not necessary to make an additional provision
for this eventuality or to make any more detailed reference to
the matter in the notes to the accounts.
4.15 We discussed at length the issue of
the GARs, both with the management of the Society and with the
Audit Committee. We reviewed the Society's calculation of the
provision which, in the light of the Court of Appeal judgment,
was prepared on different assumptions from those used in 1998
and we concluded that the Society was acting reasonably in maintaining
a provision of £200 million for the GAR liabilities. This
provision formed part of the total long-term business provision
of £23.9 billion which was included in the 1999 statutory
accounts for the Society.
4.16 We also considered whether there was
a requirement to disclose contingent liabilities under the Companies
Act 1985 and the relevant accounting standards. In our view, no
such additional disclosure was necessary as the risk of the House
of Lords producing a judgment more adverse than the Court of Appeal
was seen as remote.
1999 Regulatory Return
4.17 For the 1999 regulatory return, updated
guidance on reserving had been issued on 22 December 1999 by the
GAD and the reserves were established in the light of that guidance.
The calculation of the additional reserves in respect of GARs
produced a figure of £1.66 billion.
4.18 Following the Court of Appeal decision,
it was necessary to amend the reassurance treaty and the Society
renegotiated the treaty with the reassurer and informed the FSA
of the revision. Taking into account the reassurance, the net
reserves in respect of GARs came to £565 million. Details
of the reserves and the level of reassurance were disclosed in
Schedule 4 of the regulatory return which, as indicated above,
was not subject to an auditors' report under the 1996 Regulations.
Once again, it should be noted that the amended reassurance had
no impact on the provisions made by the Society in the statutory
Auditors' general duty to report to the regulator
4.19 For the sake of completeness, we would
note that no report was made by us to the FSA under the general
duty to report referred to in paragraph 3.4. The FSA was already
actively reviewing the issue of GARs in the industry generally
and the Society was specifically discussing its position with
the FSA throughout the period, as well as providing the standard,
detailed information required in its regulatory returns.
5. ERNST &
5.1 In addition to our audit appointment,
Ernst & Young has carried out other non-audit work for Equitable
Life. Most recently, this has included:
Provision of actuarial advice. This
has involved providing assistance on a number of matters but predominantly
relates to the potential sale of the Society's business. As indicated
above, we also assisted the Society in the arrangement of the
reassurance effected in 1998 in relation to GAR policies.
Assistance in the enhancement of
the Society's risk management processes in order that it could
achieve voluntary compliance with the requirements of the Turnbull
Assisting the Society in a tax review
on part of its business and in the preparation of tax computations
for part of its business.
6 February 2001