The Equitable Life Assurance Society Collapse

1. The Equitable Life Assurance Society Collapse Veronica Marchetti Muhammad Naeem 4 May 2012

2. The underlyingreasons of the crisis

3. 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.

4. 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 July1988, Equitablesoldpoliciesto itspolicyholders with an option to selecteither a GuaranteedAnnuity Rate (GAR) or the CurrentAnnuity Rate (CAR). Theseitemsreflected the anticipatedinvestmentreturn on the lump sum over the annuityholder'slifetime and theycouldchange with interestrates 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.

5. Financial engineeringanalisys 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 GAR

6. GAR>CAR GAR<CAR

7. GAR issuetimeline • 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.

8. 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.

9. TOWARDS THE COLLAPSE • The Board, before the 1993 drop of CARs, awarded annual bonuses and all members’ policy values to increase at the samecurrentrate, notconsidering the potential extra costsconnected with the Garrisk. • In an effort to correct the adversemovements of current market annuityratesthe Board corrected for the extra cost of the GARs through a ‘differential final bonus policy’ first introduced in 1993. • When in 1990’s market currentannuityrates 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 GARsand 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 ‘differentialfinal bonus’ policy rendered the GAR option totally valueless, neutralizing the policyholders’ guarantees. The difference in interests between the two kinds of policyholders overcomesthat between an insurance provider and an insurance buyer, this because of the different appropriate investment policies for the with profit fund.

10. Some causes of ELAS crisis and the reasons why it was forced to put itself for sale can be summarized as follows:

11. Main ELSA distinctiveness with respect to othersLife Assurance Societies OTHERS ELAS

12. OTHERS ELAS

13. Lessons to be learnt