A nodding acquaintance with modern finance theory tells you that the strategy of Equitable Life was the financial equivalent of alchemy or perpetual motion. Yet, Lord Penrose is wrong to believe that tighter regulation is the best solution – the only answer is higher standards of both ethics and competence in the whole financial services industry.
Lord Hutton, whose report on the death of David Kelly, the weapons scientist, came out in January, did the reputation of the British judiciary few favours. But Lord Penrose, whose report on Equitable Life was published on Monday, demonstrates how a fine legal mind can cut through jargon and special pleading and give a coherent and even compelling account of events.
Equitable Life is a very British scandal. The near-collapse of the company made headlines because the business was at the centre of the country’s professional life. Lawyers and academics, politicians and accountants, looked to Equitable to provide their retirement incomes. Its main product line was with-profit policies. The pragmatic character of these products was itself very British. You paid fixed sums of money to an insurance company for many years, and they paid back whatever they felt was appropriate at the time.
Readers elsewhere may wonder why anyone in their right mind would take out such a contract, far less put most of their savings into one. But the results were generally fine. The insurance business was governed by actuaries, who claimed to have discovered the secret of smoothing, a mechanism that offered the high returns obtained from investment in risky assets, without the volatility.
A nodding acquaintance with modern finance theory tells you that this is the financial equivalent of alchemy or perpetual motion: you do not need to look at the detail to know it will not work. But many actuaries have resisted the incursion of modern finance theory: Equitable’s actuary even published a guide to the philosopher’s stone under the title “With Profits Without Mystery”.
The reality of with-profits is that for a long time businesses did not compete much on price or performance and the products were sold by smooth-talking salespeople with their foot in the door. Providers paid out less than the investment returns they earned. They used the difference to build reserves and to expand.
More recently, retail financial services became more competitive. Providers vied for new business by increasing payouts. Ultimately, they paid out more than came in and nemesis was inevitable. Equitable closed its doors and told its policyholders that they would not receive the full sums they had been expecting. With the retrenchment of Standard Life this year, the era of with-profits is well and truly over.
We should judge the severity of financial scandals by the venality of the participants, the financial consequences for those directly affected and the broader economic effects. By these criteria, the Equitable Life fiasco barely registers. The company’s management, justly and roundly criticised by Lord Penrose, made mistakes, was arrogant and tried to cover up when things went wrong. But there, but for the grace of God, go you and I. Most policyholders got a reasonable return, even if it was lower than they had expected. Even with hindsight, I do not much regret having had an Equitable policy myself. And there were no wider consequences of any significance at all.
The minor wrongdoings at Equitable emerged in 1999-2000, while infinitely more serious malfeasance was taking place. Bankers and consultants puffed stocks that they knew were worthless, or ought to have known were worthless. They placed securities at a low price with their friends, while the public bought them at a higher one. Those responsible were far more cynical than at Equitable Life and far better paid; in most cases punters lost their whole investment; the resultant misallocation of capital was extensive.
It suits everyone to search for lightning conductors through which public anger can be narrowly discharged while the broader edifice remains intact. But – as often seems to be true in modern financial scandals – the main difference between people at Equitable and many others in the industry is that Equitable was unlucky. Lord Penrose is wrong to believe that tighter regulation is the answer, and his description of the junior officials who supposedly supervised Equitable explains why. The only answer is higher standards of both ethics and competence in the whole financial services industry. That will be achieved only if naming and shaming extend far beyond Equitable’s board and management.