MIT Sloan School of Management Mini-Case
© Anna Pavlova and Dimitri Vayanos

February 23, 2004

Equitable Life
Ever since the celebrated House of Lords’ ruling against the company in July 2000, life appeared awfully inequitable to policyholders of Equitable Life Assurance Company. Equitable Life, the staple of Britain’s pension industry, with over a million policyholders, including a plethora of the biggest British companies, the parliamentary pension fund, the Personal Investment Authority, had no choice left but to announce that it was up for sale. To be able to cover the liability worth about £1.5 billion, it froze the value of all current with-profit policies and imposed an exit penalty of 5% on withdrawals. Fifteen prospective purchasers looked at the books of the company, but all but one – Prudential – walked away from a deal. The final straw came in December 2000, when Prudential reached the decision not to buy Equitable Life. Following the decision, Equitable doubled the exit penalty for withdrawals to 10% and closed the fund for new investors. Numerous legal actions, investigations, and reports followed. Yet the debacle is still far from over, and new inquiries into this perhaps the most shocking collapse in the insurance industry keep pouring. Equitable Life’s growing problems and policyholders’ growing despair grab headlines in British press almost daily. On December 12, 2003, BBC News ran an article on Ann Berry, 65, a former physiotherapist from West Sussex, who should have been enjoying her retirement. Ann saw her £6,000 pension slashed by nearly a quarter in the past 18 months. "It is very worrying, I did everything the government asked me to do - I saved hard for my retirement," Ann told BBC News Online. "Now my pension is being used by Equitable as a cash cow to pay for promises it couldn't keep." It doesn’t appear things are going to get any better for Ann and many other British retirees: “I have to forgo life's treats - holidays, meals out, even presents for the grandchildren.” “I'm convinced things are going to get worse; the Equitable is still in a mess and I thoroughly expect to have my pension cut again and again," she said. Equitable Life is the world oldest mutual life insurer. It was founded in 1762, inventing “scientific life insurance.” “From mature consideration”, the company wrote in its deed of settlement, “it appeared that many advantages and great benefits may arise and be secured to great numbers of persons from the establishment of a society, to be composed of such persons as shall be qualified and willing to become mutually contributors for Equitable assurances on lives and survivorships.” If there were one life insurer one could trust to honor its pledges – and to make pledges that could be honored – that would be Equitable Life. But it turned out Equitable did neither. It started making these pledges in 1957, 1

together with many other providers, in the form of Guaranteed Annuity Rate (GAR) contracts on pension policies. These promises were made to around 90,000 policyholders, who were entitled to receive a lump-sum payment at retirement, which, if desired by the policyholder, could be converted into a stream of guaranteed monthly payments, for the life of the policyholder. These promises were not worth much at the time they were made: the guaranteed payments were too low; one could top them easily by simply purchasing an annuity at the time of retirement at a prevailing market price. The promised retirementtime lump-sum payments also didn’t seem particularly daunting -- should the inflation remain as high as it was in the late 1970s and early 1980s, when the bulk of the policies were sold. No one could possibly imagine that the guaranteed annuity payments would ever become attractive. Until, in October 1993, the unthinkable happened: inflation was barely there, and falling interest rates made annuity prices jump sky-high. All of a sudden, the guaranteed streams of payments on the annuities looked remarkably desirable, and, sadly, the market value of Equitable’s liabilities became more than it could bear.

Various attempts have been made by Equitable Life to avoid insolvency, primarily at the expense of policyholders, but it was too late. The liability, worth £1.5 billion at the time it froze the value of all current with-profit policies, was going to swell even more if interest rate were to fall further, and nothing could possibly stop this from happening. There is still a lot of debate about the adequacy of regulation, and possible measures the Financial Services Authority (FSA) should have imposed on Equitable Life and other life insurers when it formally took over responsibility for the regulation of insurance in January 1999. There are also many fingers pointed at regulators who did not express any concern over the liabilities of Equitable Life in the early 1990s, when there was possibly still enough time to reverse the misfortune. One thing for sure: by failing to properly hedge its liabilities, Equitable robbed its policyholders of their peaceful retirement, and mistakes of such an enormous scale should never happen again. On 2/12/00, The Times published a

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letter, entitled “Guaranteed Annuities - no excuse for not managing risk.” Here is a quote from that letter: … insurance company management should face up to the responsibility for failing to manage the inherent interest rate risk through the use of derivatives techniques explicitly or implicitly by lengthening the duration of their investments. The mismanagement of derivatives on a considerably smaller scale led to a spell at Changi jail for Baring's Nick Leeson and dismissals or resignations elsewhere. The insurance companies rightly say that interest rates fell unexpectedly. But the problem arose not because of the fall in rates; but as a result of the collective failure to manage the embedded risks in the insurance policies sold to annuity policyholders. Instead of effectively saying: "You can't collect on your insurance policy because we did not know that you were going to claim on it", they should have been busy managing or laying off the risks. If that's the attitude of the insurance industry than I had better read the small print of my buildings policy in relation to floods and earthquakes! As it happens, insurance companies have large holdings of fixed rate UK government bonds (gilts). The "unexpected" fall in interest rates has therefore led to substantial gains in these gilt portfolios. Given the "unexpected" nature of this fall, is the UK Treasury entitled to reduce the rates on the long term gilts held by these insurance companies? Of course not! When a bank provides a fixed rate mortgage to a borrower, it immediately goes into the derivatives market to protect itself against a rise in interest rates and therefore a rise in its funding costs. If rates rise, the bank will not tear up the fixed rate guarantee. If rates fall, there is a penalty imposed on borrowers who wish to get out of the deal. Derivatives are not new. It is over two decades since futures and options arrived in the UK. And it is worth noting that a US Appeal Court has held directors liable for not hedging. It declared that "directors breached their duty in failing to .. become aware of essentials of hedging ... the primary cause of the gross loss was the failure to hedge." Sources: BBC News, 12/12/2003; The Economist, 12/23/2000; The Times, 2/12/2000; various press releases.

Discussion questions: The objective of the questions below is to understand the nature of the risk faced by Equitable Life, and how this risk could be hedged. For this, we need to take a closer look at Equitable Life’s insurance policies. Under these policies, an individual would pay a premium during his/her working life in exchange for a fixed lump-sum payment at retirement. Moreover, the individual would be given the option to convert the lump-sum payment into a stream of guaranteed monthly payments for the rest of his/her life. (This option was the Guaranteed Annuity Rate (GAR) contract.) Thus, the policy involved two guarantees: (I) a guaranteed lump-sum payment at retirement, regardless of the level of interest rates between now and retirement, and (II) a guaranteed monthly payment during retirement, regardless of the level of interest rates at retirement. For simplicity, we will ignore the second element, and consider policies guaranteeing only a fixed lump-sum payment at retirement. (These policies are referred to as Guaranteed Income Contracts 3

(GIC), and are quite common in practice.) The additional element (i.e., the option to convert the lump-sum payment into a stream of guaranteed monthly payments) can be viewed as a call option on an annuity: a right but not an obligation to buy an annuity at a pre-specified price. This call option can be valued using tools covered later in this class. Taking the call option into account would, in fact, further increase the liability of the insurance company and the sensitivity of this liability to interest-rate movements. Consider a hypothetical insurance company that has been selling GICs for many years. A year from today, you expect the aggregate payment for the maturing GICs to be £20 million. Thereafter, you project payments for maturing GICs to grow forever at an annual rate of 1%. The term structure is flat at 9%, and the current assets of the company consist of £300 million in cash. Rates are with annual compounding. (a) What is the present value of the company's GIC liabilities? company’s net worth? What is the

(b) Suppose the company keeps its assets in cash. Explain why this is a dangerous choice. To provide an example, consider a parallel shift in the term structure to 5% (the term structure remains flat). (c) Quantify the company’s interest-rate risk by calculating Macaulay duration and modified duration of the GIC liabilities. Show that the Macaulay duration is 13.625 years. Hint 1: Use the formula for the present value of a growing perpetuity, and the fact that modified duration is related to the derivative of the present value. Hint 2: Alternatively, you can assume that payments do not continue forever, but end at some very distant future date. Take this date to by 20 years, 50 years, 100 years,… Use Excel to show that the ensuing duration approaches 13.625 years. (d) Explain why the company cannot exactly offset interest-rate risk (say, by purchasing finite-maturity bonds that exactly replicate the present value of the GIC liabilities). How can the company reduce interest-rate risk? (e) You consider two government bonds for your analysis. The first is a zerocoupon bond that matures in 18 years, and the second is a 10% coupon bond that also matures in 18 years. Both bonds have a face value of $100, and coupon payments are annual. Calculate the price, Macaulay duration, and modified duration, for each of these bonds. (f) Set up a portfolio of the two bonds that has the same price and approximate price changes as the GIC liabilities. Use only modified duration to obtain the approximate price changes. Does the company currently have enough assets to purchase this portfolio?

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