In his Report to Parliament in 2004 , Lord Penrose described how Equitable had increased the share of returns to ‘with profit’ policyholders paid as discretionary terminal bonuses. This had “the intended effect” of reducing future benefits required to be reserved for and recognised as liabilities in the statutory accounts and regulatory returns, which only captured contractual liabilities. In this way, Equitable over-allocated to policyholders from the late 1980s onwards, weakening its underlying - although not its reported - solvency position. The regulatory solvency position was also bolstered by consistent adoption of the weakest valuation basis for reserves and by use of valuation practices “of dubious actuarial merit”. Following Equitable, the FSA supplemented the existing regulatory reporting with ‘realistic’ reporting, defined as the present value of expected contractual and ‘fair’ discretionary bonus payments plus a realistic capital margin. That realistic capital margin was based on stress testing, taking account of all key risks – for example, in the case of life insurers, market, credit, longevity and lapse risks. The Equitable case, along with several failures in the London Market in the preceding 20 years, showed why robust prudential regulation is necessary. Firm failure or even near-failure can bring significant costs for policyholders, particularly when it disrupts the provision of core insurance services. It also showed the importance of effective, forward-looking supervision. Although the board and managers bear first responsibility for the safety and soundness of their firms, we cannot rely entirely on firms’ own judgements about risk, reserves and capital adequacy.

Although application of the Matching Adjustment is subject to a number of asset and liability eligibility criteria, it has much in common with a similar feature of the previous UK ICAS framework – the ‘liquidity premium’. Within the EU, the main users are UK life companies. Indeed the only countries with firms currently using the Matching Adjustment are Spain (15 companies) and the UK (23 from the UK). 3  2  Under Solvency II, the scope of internal models is comprehensive and firm-wide. A typical insurance group internal model might take 1 day to run 500,000 scenarios with key processes requiring multiple model runs. A diversified insurance group internal model may use around 150 risk drivers, separated into over 10 different risk categories (e.g. credit, market, mortality, lapse, operational). By contrast, under Basel standards and the EU Capital Requirements Regulation, bank internal models are separate and limited to particular risks eg credit and market, with capital requirements from them added up at the firm level. 3 Long Term Guarantee Report, EIOPA, December 2016. 3  All speeches are available online at www.bankofengland.co.uk/speeches  3  In its Financial Stability Report in November 2016, the Financial Policy Committee concluded that the matching adjustment “is beneficial from a macroprudential perspective by reducing potential instability across the financial system”. 4  This combination of internal models and the matching adjustment has created strong incentives for UK life firms to invest in long-term illiquid assets, such as commercial property, equity release mortgages and infrastructure financing.