Running on empty
The troubles at the UK mutual life office Equitable Life have sent shock waves throughout the market. That this once proud and respected society now finds itself in a deep hole is all the more ironic given that Equitable created, nearly 250 years ago, the actuarial principles that have underpinned life assurance ever since.
The difficulties stem from individual with-profit pension savings plans that guarantee annuity rates on retirement. These policies were issued during the 1970s and 1980s, when inflation and interest rates were sky-high. Even though the guarantees do not fully reflect interest rates prevailing at the time, they comfortably exceed annuity terms available on the open market now. Equitable stopped selling guaranteed annuity rate (GAR) policies in 1988, but not before 90,000 customers bought individual plans and a further 100,000 topped up their company pensions via additional voluntary contribution plans with the guarantee.
The fall in interest rates over the last 10 or more years has made funding the GAR policies increasingly difficult. But Equitable had a solution hinging on the way bonuses are added to with-profit policies. There are two types of bonus. Reversionary bonuses are added year-by-year at the actuary’s discretion; once allocated, their payment on maturity is a contractual obligation. Terminal bonuses, on the other hand, are allocated on maturity, again at the actuary’s discretion, at a rate that applies to all similar policies terminating in that year. For many years terminal bonuses have formed the bulk of bonus additions.
Faced with funding annuity terms that cannot be sustained by modern investment conditions, Equitable’s plan was to reduce the terminal bonus payments to GAR policyholders, to put them on a par with non-GAR customers. The GAR would still apply, but to a lower cash payout. The company won a test case in the High Court brought by an action group of GAR policyholders angered by the prospect of diminished returns, but an appeal overturned the decision. The case went to appeal once more, heard this time in the House of Lords, which upheld the Appeal Court’s decision. Equitable Life suddenly found itself with far bigger liabilities than it had bargained for.
The society put itself up for sale in July last year, although it continued to write new business. It took £1.5bn (e2.4bn) from the with-profit funds of non-GAR policyholders to shore up the GAR liabilities. In December, Equitable sold its subsidiary Permanent Insurance for £150m, soon after announcing that it had closed to new business.
Since July a succession of companies invited to bid, including Prudential, AMP and Aegon, have walked away. The true extent of the GAR liabilities is the stumbling block. Estimates of between £3bn and £5bn have been made but ultimately the figure depends on economic conditions and policyholder longevity. But aside from the GAR liabilities, as time has marched on Equitable has looked less and less a desirable catch. The Equitable brand has been blackened, the customer base is haemorrhaging (surrenders are running at four times the normal rate, despite a 10% penalty to discourage withdrawals) and the sales force is eroding.
What a terrible fate for one of the UK’s most respected life assurance brands. That brand was founded on trust, fairness and value for money. The society made much of its salary-only sales force (“We cut out commission-hungry middlemen,” it said). It has one of the lowest expense ratios in the industry and attracted large volumes of quality business from professional and other upmarket groups. How could Equitable find itself so deep in the mire?
Fingers have pointed to management incompetence. It was unwise to give such generous annuity guarantees given that the high interest rates when the GAR policies were issued were merely a blip in long-term rate trends. Equitable’s lean efficiency means there are no surplus assets for meeting the GAR obligations. The society believed in distributing surplus to policyholders; unlike many other companies, its pockets are empty. And, being a mutual, it has no shareholders from whom to raise cash.
Although Equitable still meets UK Treasury requirements for solvency, prospects for all policyholders have been damaged, especially those of with-profit customers: the need now to invest in more bonds and gilts means lower overall returns. The effectiveness of financial regulation in the UK is under the microscope. Should the developing GAR issue and Equitable’s solution have been tackled earlier by the regulators? Should regulation extend so far into a company’s commercial decision-making? The society’s auditing will be scrutinised too.
While the causes of Equitable’s downfall are grave, the consequences are no less so. A likely upshot will be a general tightening of reserving requirements, placing yet more strain on life companies’ already delicate finances and hastening the process of industry consolidation. The concept of mutuality is a casualty. While mutual companies have been declining in number, the remainder have been defending their status, pointing to the virtues of working solely for policyholders and not being answerable to shareholders. But events have shown how exposed the members of a mutual can be, and that a company and its customers can have different interpretations of mutuality.
Once again the integrity of the financial services industry has been called severely into question. With-profits policies are supposed to be a way of minimising risk by smoothing potentially volatile investment returns. But events have shown that Equitable’s with-profit policyholders were vulnerable. They have highlighted how much trust is placed in a life company’s actuary to get the sums right and how arcane the process of bonus distribution is. The case for with-profits policies has been irreparably harmed; consumers, with some justification, will want much more transparency.
The issue of trustworthiness has cropped up time and time again over the last decade or so. The trustworthiness of companies and of advisers – indeed the whole UK industry – has been called into question as news of mis-selling, underhand dealing and poor value for money has broken with almost predictable regularity. Consumers have come to suspect the industry is rotten to the core. More recently, things looked as though they were starting to get better, but now Equitable, of all companies, has seriously let its customers down. This is a huge blow for the industry and its credibility.
Now there seems to be more than a glimmer of light for Equitable, ending what turned into a two-horse race for the beleaguered society. The Halifax group has pipped GE Capital at the post by offering a deal worth £1bn: £500,000 for the sales force, fund management and administration, and two further injections of £250,000 into the with-profits fund, which will close. These are conditional on:
q concessions by GAR policyholders to limit the GAR liabilities, and
q tough sales targets for 2003/04 being met.
Investment responsibility for fund management will be transferred to Clerical Medical, which manages the assets of the Halifax group.
The Halifax deal needs to be agreed by all Equitable’s members and, crucially, by the GAR policyholders. Whatever the final outcome, the aftermath of this affair will reverberate through the UK life industry for some time yet.