Equitable's Headdonistic approach to reinsurance

Wherever there is corporate collapse, there is nearly always incompetence, mismanagement and negligence. Quite a lot of the time there is outright fraud as well, and the Financial Services Authority yesterday came as close as its lawyers would allow in raising the spectre of it at Equitable Life. The more that becomes known about Equitable's slide into financial ruin, the more murky and shocking the whole affair becomes.

The latest disclosures are only the icing on the cake really after everything that's already happened, but they do show up in sharp relief what a shambles Equitable had become from way before it was forced to close its doors to new business. In order to satisfy the regulators that the company was still solvent, Equitable reinsured its liability to guaranteed annuity rate policyholders against a fall in the stock market for £700m. The regulator accepted that the sum should count towards reserves and rubber stamped the books accordingly.

It now transpires that the reinsurance contract was hardly worth the paper it was written on, since the then Appointed Actuary at Equitable, Christopher Headdon, had sent a letter of comfort to the reinsurers agreeing that Equitable would never claim the whole amount. The FSA insists it would not have vouched for Equitable's solvency had it known of the existence of the letter and, although it is not prepared to say so outright, the FSA plainly fears it had the wool pulled over its eyes.

For Mr Headdon, who is already threatened with legal action by the new Equitable board, the storm clouds just get darker and darker. Being negligently over optimistic is one thing, but to mislead the regulator is quite another. If Mr Headdon has offered any explanation of how this letter came to be written or why it wasn't disclosed to the regulator, nobody outside Equitable and his lawyers know about it. Since discovering the letter, which was appropriately dated April Fools Day, 1999, Equitable has renegotiated the reinsurance contract for a smaller sum, so something has been salvaged from the wreckage. But it won't come as much consolation to those who signed up for an Equitable Life policy after the letter was sent.

In any case, the whole Equitable débâcle might have been brought to a head at a much earlier date but for the non disclosure of Mr Headdon's "letter of understanding", with possibly less painful consequences for all. As an object lesson in the old adage, "when in a hole stop digging", they don't come much more clear cut than this one.

Apparently reinsurance contracts of the sort taken out by Equitable are "relatively common" for life assurers, though it took the Equitable fiasco to make the outside world aware of the practice. The whole episode raises further questions about the efficacy of regulation for life assurers. Most policyholders would reasonably assume that where reinsurance contract forms a crucial part of a company's overall solvency, the FSA would have taken steps to ensure that the contract held water. Obviously it didn't and although the FSA says it will be reforming regulation "with a view to eradicating market practices that are no more than window dressing", it's a bit late now.

You might have thought that with all the adverse publicity "the with-profits" form of saving has suffered in recent times it would by now have been seriously on the wane. First there was pensions mis-selling, then there was the mortgage endowment débâcle, then came the whole GAR fiasco, and now Equitable. And yet it is not; the with-profits life fund remains far and away the most popular savings product.

Nor is this just because life funds are good at marketing themselves. In many instances, the with-profits life fund remains an exceptionally attractive means of saving, not just because of the way it "smoothes" returns so that the investor is not disadvantaged by a sudden fall in the stock market when he comes to cash in, but also because returns are buttressed by a reserve pool of capital built up by others.

The main drawback is plainly the industry's lack of transparency. Both solvency and performance differ widely but the saver has little way of assessing either of them. Rules that split the assets and profits of the life fund 90 per cent to the members and 10 per cent to the managing company further confuses an already impenetrable picture.

Recent erosion in the stock market value of most life funds has made the issue of how to divide up orphan asset estates almost wholly irrelevant. After Equitable, the FSA wouldn't allow any such raid on capital reserves. In such circumstances, the 10 per cent rule becomes meaningless. Most life funds would benefit substantially from being put on arms length contracts with managers, so that policyholders own all the assets and profits of the fund and pay the life company a fee for managing it. More vigorous regulation of life assurance is only a part the problem. Structural reform and greater transparency must go with it.

Japanese misery

As commentators fret over how much scope Gordon Brown, the Chancellor, has or hasn't got for loosening the purse strings in today's Pre-Budget Report, spare a thought for poor old Junichiro Koizumi, Japan's beleaguered Prime Minister. The dashing Mr Koizumi was swept to power six months ago on a platform of root and branch economic reform, but he's since delivered virtually nothing. Meanwhile, Japan's economy continues to slip unchecked into the surrounding sea.

Set against our own little economic slowdown in Europe and the US, Japan's economic difficulties are of truly epic proportions. Twenty years ago, Japan was the country that was going to conquer the world with its economic, managerial and technological superiority. Whole libraries were written on Japan's apparently unassailable brand of communitarian capitalism, and long nights were spent worrying about how the West would soon be eclipsed by the land of the rising sun.

Today the position is almost wholly reversed. Public debt is fast approaching 150 per cent of GDP, leaving worries about whether Mr Brown can keep within 40 per cent looking like a complete irrelevance by comparison, the country is heading for its third year of recession, and with a few notable exceptions Japanese companies are thought among the worst managed and most overmanned in the developed world. Meanwhile unemployment is rising and prices are deflating.

Late as ever, the credit rating agencies have begun downgrading Japan's creditworthiness. At the weekend, Fitch downgraded from AA+ to AA, which might not sound like very much, but puts the world's second largest economy on a lower credit rating than everyone else in the G7 other than Italy. If Japan doesn't managed to haul itself out of its malaise soon, warns Fitch, then debt will hit 200 per cent of GDP by 2007. It scarcely needs saying that any developing economy which allowed itself to get into such a position would by now have been so seriously hammered by the capital markets that it would barely have a currency left at all, let alone be able to avail itself of the services of international bond markets.

Despite all Mr Koizumi's promises, he looks more and more like a rabbit paralysed in the headlights of an oncoming car. The really worrying thing is that if even a radical reformer is incapable of doing anything to address Japan's burgeoning economic difficulties, just who is?

j.warner@independent.co.uk