"Ambiguity of Contracts: Lessons learned from Equitable Life"
HIGH LEVEL NARRATIVE OUTLINE
Introduction
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
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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 pay 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
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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 withprofits 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.
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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 nondiscretionary 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 covert that gain to a realised
gain. I am no expert on non-UK forms of life insurance but this
strikes 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
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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 a
solution. For many but not all life insurance companies the
discretionary profit sharing term itself included one important nondiscretionary 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
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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
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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
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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 that 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.
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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
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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 the 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
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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 panacea for the
problems 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
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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 that 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
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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
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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
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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 withprofits 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
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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 withprofits 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
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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.
(word count 5022)
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