Equitable Life Assurance Society is a life insurance company founded in 1762 in the United Kingdom and headquartered in London. This company offered in addiction to standard pensions also a lump sum, which consisted of sum assured, reversionary bounces and larger terminal bounces. The main problem leading to the Equitable Society collapse in 2000 was the fact that Equitable changed some of the assumptions used to calculate its figures in order to have the effect of reducing liabilities and its policy of leaving its liabilities unhedged.
LIFE ANNUITY An insurance product that features a predetermined periodic payout amount until the death of the annuitant. These products are most frequently used to help retirees budget their money after retirement. Between 1957 and July 1988, Equitable sold policies to its policyholders with an option to select either a Guaranteed Annuity Rate (GAR) or the Current Annuity Rate (CAR). These items reflected the anticipated investment return on the lump sum over the annuity holder's lifetime and they could change with interest rates or longevity. As the interest rate increased and the policies were less expensive to buy, therefore they were become demanding and there was a rapid growth in 1980s to 1990s and the amount of policyholders was significantly increased.
Financial engineering analisys of the crisis and collapse Between 1957 and 1988 ELAS offered Guaranteed Annuity Rates (GARs) to its with-profit policyholders, where these GARs were applied to single-life fixed annuities only. A Guaranteed Annuity can be interpreted in a financial engineering context as an interest rate put option on a stream of payments. The holder of the option has the right to a stream of payments, the pension annuity, calculated with reference to a guaranteed interest rate, the exercise price of the option. ELAS position Policyholder position CAR GAR
For the policyholder this option has no intrinsic value -out of the money-if the market interest rate is above the guaranteed rate although it will still have a time value since there is always a possibility that the market interest rate will fall below the guaranteed rate at some future date. The options begins to have an intrinsic value and it becomes in the money as well as having time value when that the market interest rate will fall below the guaranteed rate. GARCAR
GAR issue timeline 1957 Equitable Life began selling with-profits pension annuities with guaranteed rates (GARs). GAR policies were sold until 1988; with-profits policies offering 'guaranteed interest rates' (GIRs) were sold until 1996. 1970-1982 UK high-inflation years (retail inflation rate 10-22% p.a.) 1990 UK inflation drops significantly, with long-term gilt yields falling accordingly. Insurers with large books of GAR policies saw their liabilities increase dramatically: ELAS, holding minimum reserves and giving maximum payouts. 1993 Market current annuity rates fell below the GAR annuity rates, raising substantially the cost to ELAS of providing GAR pensions. Differential Bonus Policy are applied. 1998 GARs and Differential Bonus Policy formally became an issue. 8 December 2000 ELAS closed its doors to new business, having failed to find a buyer.
POLICYHOLDER POSITION ELAS POSITION For the whole period these guarantees had no intrinsic value since the GARs were much lower than current market annuity rates; it was only after 1993 that the GARs began to have an intrinsic value as CARs fell below GARs. The two risks ELAS had to face were interest rate and mortality risks, which the Society didn’t explicitly hedge but which it believed it could manage by “discretion”. In addiction the GARs policies had a time vale that Equitable Life Assurance Society was unable to price.
The Board, before the 1993 drop of CARs, awarded annual bonuses and all members’ policy values to increase at the same current rate, not considering the potential extra costs connected with the Gar risk. In an effort to correct the adverse movements of current market annuity rates the Board corrected for the extra cost of the GARs through a ‘differential final bonus policy’ first introduced in 1993. When in 1990’s market current annuity rates fell very sharply, this fact caused there to be a sharp increase in the extent to which policyholders were "in the money" with regard to GARs and life offices were in trouble. In practice the ELSA “discretion” took the form of this ‘differential final bonus’ between GARs policyholders who took their pensions when they retired and those policyholders who, despite having a GAR option, elected to take their pension benefits in a different form but at the lower market rate ruling at the time. The Society confined the effect of the GAR risk to the GAR policyholders by reducing the final bonuses of all such policyholders The ‘differential final bonus’ policy rendered the GAR option totally valueless, neutralizing the policyholders’ guarantees. The difference in interests between the two kinds of policyholders overcomes that between an insurance provider and an insurance buyer, this because of the different appropriate investment policies for the with profit fund. TOWARDS THE COLLAPSE
Some causes of ELAS crisis and the reasons why it was forced to put itself for sale can be summarized as follows: ELAS offered to policyholders financial instruments that it was not able to correctly pirice. Actuarial techniques were not appropriate just showing surplus which was actually loss. The use of financial reinsurance to get the liabilities off its balance sheet. There was a wrong calculation in smoothing future profits and losses. GAR problem was compounded by the fact that historically the Society had operated a policy of maximizing bonuses and not building up a reserve.
Main ELSA distinctiveness with respect to others Life Assurance Societies The nature of the guarantees contained within the Societies’ products, because the level premium policy structure of those other companies normally meant that only future premiums paid at the initial level would benefit from guarantees in the original policy. The pension savings products they sold were generally less flexible than those provided by Equitable. The Society operated a policy of maximizing bonuses not building up a reserve. When ELAS recognized it could not afford to honour its guaranteed annuity it sought to construct its bonus rate regime so that theguarantees would be worthless. ELASOTHERS
A common requirement for Life Assurance Societies is to hedge the risk of the financial instruments they offer, by entering into option hedging strategies and by accomulating an adequate excess of capital to cover potential risks. Equitable thus did not maintain assets in excess of the amount needed to meet policyholder benefits, including terminal bonus. Apart from maintaining what was sometimes referred to as a ‘revolving estate’ to provide some working capital, the Society said that it made a full distribution to its participating policyholders. OTHERSELAS
EL failed to react to market developments by not providing any consistent hedging or cover against the risk of GAR. Leaving liabilities unhedged is potentially very risky and violates one of the main insurance principles, namely that assets and liabilities should be matched as closely as possible. The Equitable decision to change assumptions by moving money out of equities and into fixed interest, which payed a higher income, was totally devoted to a discounting purpose.