An ‘Equitable’ system?
Civitas, 18 October 2010
It was reported over the weekend that the Comprehensive Spending Review would include a £1.5 billion compensation scheme for Equitable Life policy holders who have seen their policies decrease in value since the turmoil that engulfed the insurance company in 1999, writes Stephen Clarke. The scheme is larger than the £400 million recommended earlier this year by Sir John Chadwick who was appointed by the previous government to assess compensation; however, campaigners say that the scheme still only covers a third of the total amount owed to the victims, which is estimated to range between £4.8 and £6 billion.
The case of Equitable Life is long-running. It began in 1999, when the Equitable Life Assurance Society ran into financial difficulty and announced it was going to cut bonuses it paid to for-profit guaranteed annuity rate (GAR) policy holders. The decision was initially held up in court, but then later overturned by the Court of Appeals and the House of Lords. Equitable Life has since staggered on, winding down its operations by selling off assets and refusing to take on any more customers. The result, however, is that some policy holders have still suffered losses on their policies and have been demanding compensation in a sustained campaign. The Government is deemed to be partially liable for the losses because the legal decisions in the case found that failings by the regulators and government departments played a part in the company’s demise.
The Equitable Life case has thrown up a great deal of heated debate on both sides. Some have argued that the policy holders deserve compensation and that the proposed £1.5 billion is not enough. In contrast, others have replied that it is not for the tax payer to compensate people who lost money due to poor investment by a company that they freely chose to take out a policy with. The debate centres around the fact that many of the policy holders took out for-profit annuity policies that paid out bonuses based on the performance of the firm’s investments. Policy holders paid a premium so that Equitable Life could place such premiums in an investment fund that would generate high returns, benefitting policy holders and Equitable Life. This type of policy had been described as a conservative investment for people who want a taste of the stock market. In the case of Equitable Life, the difficulty lies in determining the degree to which the loss incurred on the policies was a result of governmental and regulatory failures, or due to the inherent risk in the policy.
Aside from this difficult and perhaps indeterminable question, the case has important implications for financial services in general. In particular, it highlights the fact that customers need to be aware of the financial implications of their decisions when purchasing financial products. Customers cannot expect the Government to bail them out if decisions they knowingly took result in losses that were always possible. This is an issue which is not limited to the insurance and assurance industries. In banking, customers demand a good interest rate on their savings, however an interest rate can only be generated for savers if banks are using deposits for productive investment. Banks theoretically use short-term deposits to fund long-term lending, and in doing so distribute credit in a manner that produces benefits for savers and borrowers alike. However, such activity is not without risk; defaults on loans, or mass withdrawals by savers can produce crises in the system. Such crises are far more prevalent than is perhaps appreciated, and evidence suggests that they affect developed and developing nations alike with the same frequency and severity. Such crises, and in particular the recent global financial crisis, have created calls by some for ‘narrow banking’. Such ‘narrow’ banks would simply take in deposits and hold them for savers, investing them in ‘safe’ assets such as government bonds. In return, savers would be guaranteed the safety of their deposits but would forego a high interest rate, savers may also have to pay the bank a holding fee for effectively storing their money. In essence, narrow banking would be attractive to savers who want security but a low rate of interest, other savers who wanted a higher rate could deposit money in banks who would engage in maturity transformation (turning short-term deposits into long-term lending) in order to generate increased returns for customers but with a greater level of risk.
As is probably apparent, this trade-off between security and profitability would occur in other financial services. Life assurance policies could be marketed to different customers depending on their appetite for risk. What is necessary, however, is that customers are aware that the trade-off between security and profitability exists and that they make decisions on financial products based on this knowledge. Currently, some customers seem to expect both high returns and security, and Equitable Life perhaps marketed some of their policies by promising both. This is unacceptable and financial services providers need to be held to account for accurate marketing of their products. The other side of the coin, however, is that customers need to be aware that such a trade-off is inevitable. Once this is firmly recognised, the implications for financial services may be dramatic: deposit insurance for banks could be deemed illegitimate if it allows banks to promise security and a high rate of return on savings; the era of expected interest rate returns on deposits could come to an end; more customers may choose to invest part of their money safely and part of their money on risky ventures such as through peer-to-peer lending systems.
Such developments would be dramatic, and it is far more likely that the current system will continue. However, the nagging implications of the security-profitability trade-off will remain. Perhaps it will take a few more banking or financial crises before customers realise that in financial services there is no such thing as a risk-free, high yield investment.