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9 September 2004
Speech by John Tiner

1. I have been asked today to say a few words under the title "Ambiguity of Contracts: Lessons from Equitable Life". The title refers to one particular UK life insurance company, the Equitable Life, but except where I specifically note otherwise, I shall frame my remarks in the context of the UK life insurance sector more generally and so they should not be taken as necessarily referring to Equitable Life.
   
   
2. In my talk I shall first describe the nature of with-profits contracts within the UK both as they were originally perceived and as they are now perceived following the recent court ruling. I shall then briefly describe business, regulatory and legal changes that have resulted in and resulted from the change in the nature of with profits contracts. My remarks refer to life insurance in the UK. I am no expert on how life insurance is structured outside the UK, but I shall attempt to make a couple of remarks during my talk comparing UK practice and that on the Continent of Europe and to discuss to what extent the lessons we have learnt in the UK might be of wider application.
   
   
3. Turning now to the UK, first I shall briefly describe how contractual ambiguity in with-profits policies first arose. The Equitable Life when it was established in the 18th Century was the first insurance company successfully to sell life insurance based on actuarial principles. That is its premium rates depended on an actuarial estimate of life expectancy based on age at the time the contract was taken out and once set remained constant throughout the life of the contract. In the preceding decades several other companies had attempted to do the same but after apparent initial success became insolvent because the initial premium rates were set too low. Too little was known about human life expectancy. The Equitable Life determined to avoid the fate of similar companies by putting in place three risk mitigation strategies - although that is not of course what they would have called them in the language of the time.
   
   
   • First it put in place systematic methods for collecting life mortality data – and thus actuarial science was born.
   • Second it deliberately set premium rates well in excess of those it anticipated would be needed.
   • Third it put in place profit sharing. The purpose of the profit sharing was to allow the return of those excess premiums (with interest) to policyholders as and when it was deemed safe to do so. Discretion as to when, and by how much, profit would be payed out was vested in the Equitable Life's senior management as advised by the actuary.
     
     
4. I mention this because, as I shall illustrate in a moment, a primary cause of the perceived ambiguity in life insurance contracts is that contractual terms that were designed for one purpose end up being used for another purpose. Over the following decades and centuries actuarial science proved to be far more successful than anyone had anticipated. One might have thought that as uncertainty as to mortality rates receded as a problem, life insurers would cease to set premiums well in excess of those needed. Life insurers would exchange a fixed promise to pay a guaranteed amount on death – without any addition for profits – for a fixed single or regular premium. In other words there would be a switch solely to non-profits life insurance. In fact this did not typically happen. Non-profits life insurance did indeed come into existence but it did not replace with-profits insurance. The feature of with-profits policies that was invented to deal with mortality risk proved also to be a highly effective way of dealing with other risks especially investment risk. As premiums were set in excess of the amount anticipated as needed to meet guaranteed benefits insurers had freedom to invest in higher yielding – and therefore higher risk – investments. By the late 19th century with profits life insurance had become a flexible savings product.
   
   
5. Initially – i.e. the first century or two – actuaries were cautious. Investing in higher yield investments meant merely investing in government loans and other fixed interest securities rather than leaving all the funds on short term deposit. Investment return was in the form of interest on those loans and securities. Actuaries were also cautious in how they distributed the investment return. At the end of each year they would allocate a bonus – an increase in the guaranteed amount under the policy – that passed on to policyholders most, but not usually all, of interest earned during the year. They kept a little back to help build up reserves for future contingencies. Also when interest rates rose or fell the actuaries were reluctant to believe that the increase was permanent and would at least initially keep policyholder bonuses at their previous levels. They reasoned that short term fluctuations in interest rates would near enough even out over the life of the policy. And so – almost as it were by accident – bonus "smoothing" became a key aspect of the with profits insurance product.
   
   
6. From the 1950's onward life insurers started investing in equities in significant amounts. This of course coincided with a period of significant capital gains. This posed a dilemma for actuaries. They were reluctant to believe that these gains were permanent especially where they were as yet unrealised. However it became increasingly clear that it would be unfair not to find some way to allow policyholders to share at least some of these gains. Actuaries resolved this dilemma in different ways in the UK and in many other European countries. Within the UK they invented the terminal bonus. That is at the maturity of the policy they paid out more than the amount guaranteed under the annual bonuses. Once again discretionary profit sharing, the feature of the with profits product that was invented to deal with mortality risk, proved also to be a highly effective way of dealing with a new risk. With some other European countries as I understand it a different approach was taken. There was a non-discretionary rule that all realised gains would be distributed, but of course there was discretion as to when to sell investments which had accumulated an unrealised gain and so convert that gain to a realised gain. I am no expert on non-UK forms of life insurance but this strikes me as involving nearly as much discretion as the approach preferred by UK actuaries of using discretionary profit sharing.
   
   
7. At this stage one might have been forgiven for thinking that discretionary profit sharing would be a panacea to solve all future problems. That this proved not to be the case is the subject of my remarks here today. In the 1990's two serious problems arose. These were the questions of who owns the "inherited estates" that had accumulated over the preceding decades and of how life offices should pay for the increasing cost of guaranteed annuity options. I shall turn first to "inherited estates". As I have already mentioned actuaries typically did not even over time distribute all profits to policyholders. They held some back to create a reserve to help cope with future contingencies. By the early 1990's three factors converged to make the question of who "owned" these surpluses a critical business and regulatory issue. First the surplus had grown significantly in size especially due to the significant rises in equity values over the preceding decades not all of which had been passed on to policyholders. Second, actuarial science and computing power had progressed sufficiently to allow more accurate estimate of the resources that were actually needed and so to allow clearer identification of surplus assets. Third within the UK the management of life insurers began to focus on shareholder value.
   
   
8. Faced with this problem actuaries naturally enough turned to their tried and trusted solution to many previous problems, the discretion that life insurance companies had as to how to distribute profits. However here there was a problem and so some of them thought up a solution. For many but not all life insurance companies the discretionary profit sharing term itself included one important non-discretionary condition. Profits, as and when they were shared, must be shared in the ratio of at least 9 to 1 in favour of the policyholders. There was discretion as to by how much and when to distribute profits but not – at least for many life insurance policies – as to in what proportion to allocate the amount that was distributed. The solution – as some life insurers say it – was that this distribution ratio itself was in the rules of the with profits fund which themselves were alterable at the discretion of the company either because those rules were set out in the company's articles of association or because they were set out in a resolution by the company's board of directors. In contractual terms – absent perhaps the application of the Unfair Terms in Consumer Contracts Directive of which more later – there was perhaps little to fault this analysis. However from a regulatory point of view this proposed practice led to fears that "policyholders reasonable expectations" would not be met. The regulatory regime which was operated in the UK by the predecessor regulator to the FSA gave that regulator the power to intervene to prevent or correct conduct by insurance companies that would lead to policyholders reasonable expectations not being met. This power was used to require life insurers to demonstrate to the regulator that from an objective point of view it was treating policies fairly when re-attributing or distributing inherited estate. In particular in considering whether and to whom inherited estate should be attributed or distributed the regulator required life insurance companies to consider how the inherited surplus arose, what had been previously said to policyholders as to how the surplus would be used and what were the likely future needs of the with-profits fund in terms of working capital and contingency reserves for possible future problems. This regulatory approach has now been taken forward with renewed vigour by the FSA with its new and better regulatory powers that are now based explicitly on the requirement for insurance companies to treat policyholders fairly.
   
   
9. I shall now turn from the "inherited estates" issue to the other significant with-profits life insurance issue that crystallised in the 1990s. From 1958 to 1986 life insurance companies incorporated within some with profits policies a guaranteed annuity option. This was a guarantee at the termination of the policy – which was the retirement date of the policyholder – to convert the lump sum proceeds of the policy into an annuity at a rate that was set at the time of the inception of the policy. It was an option as the policyholder was not obliged to use this pre-set annuity rate and until the 1990's policyholders did not choose to do so because the market rates for annuities were more favourable than the guaranteed rates. However in the 1990's interest rates began to fall with the move to a low inflation environment. This coincided with a longer term trend of increasing human longevity. The combination of the interest rate falls and the longevity increases reduced market annuity rates to below the guaranteed amounts. Policyholders therefore began to take up the guaranteed annuity options, but not all had these options and – because some of the conditions in the options where quite specific – not all who had them were able to take them up. This gave actuaries a new problem. The take up of the options was imposing significant costs on life insurers. How was this cost to be fairly allocated? Not surprisingly actuaries again turned to their old friend, discretionary profit sharing.
   
   
10. The problem of guaranteed annuity options was by far most acute at Equitable Life. The actuary at this company recommended the introduction of differential terminal bonuses for policyholders depending on whether or not they chose to take up their guaranteed annuity options. The effect was to neutralise the economic value of the option as, if the option were taken up, the policyholder would receive a terminal bonus that was lower by the exact amount of the value of the option. The legal argument at the time that this was acceptable based on the belief that the life insurance company had a wide discretion as to how it set future discretionary bonuses. The policyholder's right to convert the proceeds of his policy on maturity into an annuity at a pre-determined right was a contractual right that could not be denied, but the actual amount of the proceeds at maturity depended on how the company used its discretion under the discretionary profit sharing term in the with-profits contract. Equitable Life's use of its discretion in this way was litigated through the UK court system ultimately reaching the highest court in the UK, the House of Lords. At the level of more junior courts the Equitable found some support for their view, but when the court reached the House of Lords the judges unanimously held that Equitable Life's discretion in setting terminal bonus was not unfettered. It needed to be exercised fairly and for a proper purpose. Using that discretion to defeat the purpose of another contractual term, the guaranteed annuity option, was not a proper purpose.
    
    
11. So why did discretionary profit sharing not provide a solution for the "inherited estates" and guaranteed annuity options problems? Before answering this question I shall spend a few minutes answering a logically prior question. Why prior to the 1990's was an apparently ambiguous and unilateral contract term – discretionary profit sharing – such a successful feature, at least apparently, of with-profits life insurance contracts. I would suggest there are three reasons for this.
    
    
12. First, the legal environment was more accepting of the idea that the management of life insurance companies needed flexibility to manage the risks of life insurance. I do not intend to try your patience by reciting in detail the relevant UK case-law. However by way of example I shall briefly describe one leading case that was decided in the early 20th century, British Equitable Assurance Co. Ltd v Bailey. British Equitable (by the way not the same company as Equitable Life) had advertised that as a company capitalised by shareholders it did not need, in contrast to mutual insurance companies, to hold back any of its profits to build up a reserve for future contingencies. However the policy documents merely referred to the right that the company's directors had to distribute profits "according to their practice for the time being". After some years of following the practice, as advertised, of full distribution of profits the company's directors decided to change their practice. From now on they would hold back a proportion of profits to set up a contingency reserve. Bailey, a policyholder who had taken out his policy at the time the company advertised that this was not its practice sued. Upholding the company's right to change its practice, the House of Lords, the UK's highest court, held that "nobody would effect an insurance in the belief that the laws and regulations of the [life insurance company] which he selects are immutable". The only test that the directors need to pass in deciding to change practice was that they exercise this power bona fide that is to say they do so in a way that is "fair, honest and businesslike, and will, in the opinion of the directors and shareholders of the company, be beneficial to the policyholders as well as shareholders". It is hard to believe that if a case with similar facts were to present itself today it would be decided in the same way.
    
    
13. The second reason is that – as Lord Penrose in his independent report on Equitable Life has made clear – the focus of regulation prior to the FSA's reforms was on ensuring that the guaranteed amounts, rather than discretionary profit bonuses in addition to the guaranteed amount, were adequately secured. I shall give two brief quotes from Lord Penrose's report. "Up to the end of the inquiry's period of interest the assessment of regulatory solvency was geared in practice to the assessment of regulatory solvency almost exclusively by reference to contractual or guaranteed liabilities". "At no time during the reference period, and indeed at no time until the new regulatory regime under the Financial Services & Markets Act 2000 was instituted, did regulators devise amendments to, or propose to modify, the regulatory requirements so as to require [Equitable] to account, for regulatory purposes, for the characteristic transactions of the business". By which Lord Penrose meant the with-profits policy under which a significant proportion of the eventual payout to policyholders took the form of discretionary bonus allocations of profits.
    
    
14. The third reason I shall give is that policyholders expectations at least as to the transparency with which discretionary profit sharing needed to be explained were arguably less acute. This in turn was probably due in part to the long bull market in the second half of the 20th century. When profits are high external scrutiny from policyholders and, where they were present, shareholders tends to lessen. Also important was the culture of deference towards the professions that existed in the UK prior to the 1980's. This was not unique to the actuarial profession. From the 1980's onward all professions have found the exercise of their professional judgment has come under scrutiny. New standards of transparency have been demanded from accountants, doctors, engineers, scientists among others and these professions have had to learn new communication skills with the emphasis on explaining, persuading and listening to lay people as much as to other members of their profession. I have heard one commentator in the UK refer to the actuarial profession as the last of the professions. By which I think he meant the last profession to feel sufficiently self-confident to set its own technical and ethical standards without significant help and scrutiny for lay persons. I do not know whether this is precisely true, but I do know that reform of the actuarial profession commenced much later than reform in several other professions and indeed is at present far from complete. The Penrose Inquiry into the circumstances surrounding Equitable Life helped start this process. This is now being followed by a separate government-sponsored review, the Morris Review, which specifically focuses on the actuarial profession.
    
    
15. This now brings us to the question of why from the 1990's onward the discretionary profit sharing no longer proved to be the panacea for the new problems that arose for life insurers that had sold with-profits policies. The reasons for the post 1990's failures of discretionary profit sharing are the same as for the pre-1990's successes.
    
    
16. First, the legal environment had changed. I have already described the ruling of the House of Lords in respect of Equitable Life's guaranteed annuity options. This ruling was some 90 years later than the British Equitable ruling that I also described and illustrates how judicial attitudes had changed. In addition there have been some important statutory or legislative changes that have been made to contract law. From a contract lawyer's point of view I am told that the story of the last few decades has been one of increasing legislative intervention in how contract terms are interpreted and the terms on which they are permitted to be made, especially for contracts made between a business and a consumer. Within the UK this change has affected insurance contracts somewhat later than other contracts. Domestic legislation, entitled the Unfair Contract Terms Act, was enacted in the UK in 1967. However this expressly excluded insurance contracts from its scope. It was not until 1996 with the implementation in the EU Unfair Terms in Consumer Contracts Directive into UK law that an objective statutory standard of fairness was applied to insurance contracts. This Directive provided that written contract terms must always be drafted in plain, intelligible language and that they must in addition be fair. However the Directive provided that the fairness standard did not apply to "the definition of the main subject matter of the contract" or to "the adequacy of the price and remuneration ". There has been some debate in the UK – and I would expect also in Denmark – as to whether and to what extent this exemption might be said to apply to some of the terms typically occurring in life insurance contracts that give wide discretion to the life insurance company, including the discretionary profit sharing term. This is important as the Directive sets out a non-exhaustive "indicative" list of terms that typically might be considered unfair and that list includes terms that allow a firm to alter the terms of a contract or any characteristics of the service provided under the contract if done so "unilaterally without a valid reason". For changes in the terms of the contract the valid reason must itself have been specified in the contract. As I have said within the UK there is some debate – but as far as I am aware few if any actual decided cases – as to how, if at all, this applies in general to the discretionary profit sharing term in with profits contract and in particular to revisions of the details of that contractual term that are often needed when a with profits life insurance company apportions or distributes its orphan estate. However given the "main subject matter" exclusion in the Directive we in the UK have chosen – as I shall explain more fully in a few moments – to establish more detailed regulatory rules that require fair treatment of policyholders and that apply unequivocally even to the arguably core "main subject matter" discretionary profit sharing term in with profits life insurance contracts.
    
    
17. This brings me back to the question I posed a few minutes ago of why discretionary profit sharing was no longer a panacea and brings me to my second reason which is that the standard, scope and focus of regulation has changed profoundly. When I joined the FSA in 2001, initially as a Managing Director responsible for insurance regulation I set up a fundamental review of the regulation of life insurance. This review had three aims: first securing a fair deal for consumers, second firms that are soundly managed and have adequate resources and third smarter regulation of insurance. I shall briefly explain how we are now pursing the first two of these aims as they are relevant to my subject matter here today of the regulatory response to ambiguity of contracts. All I would say today on the third aim is that it is also as you would expect essential if progress on first two aims is to be achieved in practice.
    
    
18. We are pursuing the aim of securing a fair deal for consumers in the particular context of the discretionary and, if left unchecked, unilateral power which with-profits life insurance companies have to set future bonus distributions of profit. Our approach has three main aspects to it. First we are introducing a new regime of enhanced disclosure for with-profits life insurance companies of the principles and practice they propose to follow in the management of their with profits business. The purpose of this disclosure is to inform policyholders and those who advise policyholders of how an insurance company proposes to use the discretion that it has under the terms of the with profits life insurance contract. That main aspect of that discretion is of course discretionary profits sharing, but there are other important aspects including the discretion to set the investment policy of the with profits fund. Second we are consulting on rules and guidance that would govern and limit the ways in which a life insurance company may use its discretion. These would set objective standards of fair treatment of policyholders including in respect of how discretionary bonus distributions are set. Third we have established a new regime to protect policyholders when with profits funds are restructured or closed to new business or when inherited estates within with profits funds are allocated between or distributed to policyholders and shareholders. The life insurance company must submit plans for pre-approval when these changes are made. Before an insurer may allocate or distribute an inherited estate it must appoint a policyholder advocate. The role of this advocate is to ensure that the interests of policyholders are properly represented to senior management when they draw up their allocation or distribution proposals. Those proposals are then subject to regulatory approval either by the FSA or, depending on the precise legal form of the proposals, by a judicial process.
    
    
19. The next aim of the review that I established was, as I have explained, that firms that should be soundly managed and have adequate resources. There are two aspects to this. First on sound management we have we have repositioned the roles of senior management, the actuary, the auditor and, in the exceptional circumstances of an inherited estate attribution, created a new role of policyholder advocate. The FSA's approach to regulation in all financial services sectors emphasises the role of senior management. When the FSA imposes regulatory duties on regulated firms it is the FSA's intention that the primary responsibility to ensure that the firm performs those duties rest with the senior management of the firm. Under the regime for the regulation that the FSA inherited the roles of senior management and of the actuary had, arguably, become conflated and confused. There was the widespread suspicion that in some life insurance companies the board of directors would rely without sufficient understanding on the advice of the appointed actuary on the question of how fairly to determine the allocation of discretionary bonus distributions of profit. It is now clearly the responsibility of the board of directors after taking appropriate actuarial advice to ensure that with-profits policyholders are treated fairly.
    
    
20. On the issue of adequate resources, we have established a new capital adequacy standard for with-profits life insurance, called realistic capital. We apply the realistic capital requirement as well as the more traditional statutory capital requirement that is based on the EU directives. A with-profits life insurance company must calculate its capital requirement under both standards and hold actual capital to meet the higher of the two. There are three main differences between realistic capital adequacy requirement and the statutory capital requirement. Within the realistic quantification of liabilities a with-profits life insurance company must include a fair estimate of future discretionary bonuses, must include an amount for options and guarantees calculated using modern market-consistent methods and must estimate liabilities on a best estimate basis that is without hidden margins. A realistic capital requirement is then explicitly added to the realistic quantification of liabilities. This is calculated by estimating the financial effect of pre-determined equity, real-estate, interest rates and persistency stress tests on the life insurer. The introduction of this realistic capital adequacy regime reflects our view that it is part of our prudential regulatory aim to protect not only policyholder benefits that are contractually guaranteed but also policyholder's expectation to receive fair future discretionary benefits.
    
    
21. This brings me once again back to the question of why discretionary profit sharing is no longer a panacea and brings me to my third reason which is that policyholder attitudes have changes. Consumers and consumer-interest groups first focused increased scrutiny on the with-profits life insurance sector in the 1990's when life insurance companies began putting forward proposals to allocate or distribute their "inherited estates". They then increased scrutiny further as a result of the cuts in policy bonuses and policy values arising from the bull market in equities and from the increased costs of guaranteed annuity options. The FSA welcomes the increased scrutiny of consumers and consumer-interest groups and especially their emphasis on demanding – and supporting the FSA's demands – that insurance companies give clearer and more timely explanations of how they are using and proposing to use discretion and then of subjecting those explanations to scrutiny. The FSA has as one its statutory objectives promoting consumer education. Our aim therefore is to improve the quality and timeliness of the information that insurance companies provide to policyholders and also to improve policyholders' ability to understand that information.
    
    
22. I have now briefly reviewed three reasons why discretionary profit sharing in particular – and contractual ambiguity or discretion in general – is more difficult for with-profits life insurance in the new environment of increased legal, regulatory and policyholder scrutiny. As I have mentioned already I am not of course an expert in life insurance as it is practised outside the UK, but I believe that the trends which I have described in the UK for increased legal, regulatory and policyholder scrutiny are to some extent matched by similar trends in the rest of the EU. This, I know in the UK and I suspect elsewhere in the EU, has raised the question in the minds of some commentators as to whether profit-sharing life insurance has a future as a flexible saving vehicle and if so what changes need to be made to ensure it continues to meet policyholder needs and wants and legal and regulatory requirements and constraints. I am of the view that there is a niche within the saving market place for a flexible saving vehicle that allows consumers to invest in equities, real estate and similar investments but also provides some smoothing. It is not of course for the FSA or I would suggest other regulators elsewhere in the EU, to redesign the with-profits product to equip it to continue to occupy that niche. That responsibility rightly falls to the industry in consultation with other stakeholders including regulators and policyholders. However it is responsibility of the regulators including the FSA to help create the climate in which this re-design of the with-profits product may occur including setting out clearly – which we believe we are doing – the regulatory and transparency standards to which such products will be held.