David Worsfold
The dark clouds of the shock reduction in the discount rate which is used by the courts in England and Wales to calculate personal injury damages awards – the Ogden rate – are set to deepen further.
The cut in the rate in February from the 2.5% it was set at in 2001 to -0.75% shocked insurers. Most had already priced in a reduction but nowhere near on that scale. AIG had assumed a cut to 1% and QBE was working on a more modest assumption of 1.5%. Now, both are among several major insurers to announce significant increases in reserves in the light of Lord Chancellor Liz Truss ‘s February announcement.
AIG said last week that its Q1 pre-tax profits would be down by £78m, while QBE has upped its reserves by £129m. Their personal injury claims are mainly in employers and public liability accounts. The biggest pain is being felt by motor insurers with Direct Line adding £230m and Admiral £129m. At the top end of the announcements that have been made so far is Aviva which with big liability and motor accounts has boosted reserves by £385m.
The total impact on reserves across the industry could be as high as £3bn, according to Deloitte.
These figures merely cover the immediate reassessment of the likely uplift in the costs of claims that will arise on the current and past year policies. There is more pain to come as reinsurance contracts come up for renewal, with PwC among the experts forecasting premiums on the lower layers of motor policies rising by between 50% and 75%.
Motor insurance premiums are already on the rise – 8% up in the last year – and liability premiums will soon start to follow, but that isn’t where the impact will stop.
The dark cloud is casting a lengthy shadow across insurers’ investments too.
Reserving for these multi-million pound payments is placing additional strains on investment strategies already struggling to cope with Solvency II, low returns and increasing scrutiny by boards hoping investment returns will bolster the bottom line as the seemingly endless soft market drags on.
The change to the discount rate puts many general insurers in an especially difficult position, as they are already struggling to cope with the burden of rising catastrophic personal injury claims. Con Keating, head of research at Brighton Rock, flagged up this challenge at last September’s Insurance Investment Exchange seminar. He warned that motor insurers’ liability profile was being fundamentally altered by periodic payments for catastrophic personal injury cases: “They effectively turn the balance sheet of a motor insurer into a life assurance book. In some cases, this now represents up to 50% of the balance sheet”.
That could be set to get worse and presents a real dilemma at the heart of insurers’ response to the change in the discount rate.
James Dalton, the Association of British Insurers’ director of general insurance policy, has made a case for periodic payments as part of the ABI’s response to the Lord Chancellor’s announcement:
“We need certainty on a formula that: delivers full and fair compensation to claimants; takes account of how claimants actually invest their money; recognises that claimants generally have a low-risk not no-risk appetite, and that periodical payment orders are available to them if they want a ‘no-risk’ option; is not tied to only one class of investment; and is set through an open process with proper consultation of experts, including both insurers and personal injury lawyers.
Many of its members will shudder at the prospect of taking on more large periodic payment schemes as it will accelerate that transition from managing investments as a general insurer to thinking more like an annuity provider.
The prospects for persuading the government to ease back from the -0.75% rate are not high and have certainly been at best delayed by the General Election.
There is a consultation and a review of the methodology – promised at the same time as the February announcement – and this offers some hope of a modest easing back on the discount rate but with the Bank of England long-term forecasts still showing negative returns (see below) and the powerful claimant lobby already fighting hard to keep the rate at -0.75% the industry would be unwise to raise its hopes too much.
The ABI feels it has logic on its side, especially when it comes to arguing against basing the discount rate on a single asset class: “A discount rate that assumes that claimants invest 100% of their compensation in Index Linked Government Securities bears no resemblance to what prudent claimants do in practice, and ignores the most basic of investment advice not to put all eggs into one basket”, says Dalton.
The implication of that argument is that any new formula should take other investment options into account. This is appealing to the industry but likely to be treated with caution by the government. It will not want to expose itself to accusations of giving investment advice that might, over the 25 plus years many catastrophic injury victims require treatment and care, turn out to be flawed.
The Ministry of Justice is more likely to pass that one back to the insurers and suggest they manage the investment themselves – through periodic payments.
The dark discount rate cloud is set to cast its long shadows across the industry for some time to come: insurers and investment managers will need to re-think their strategies to operate in this changed climate.