The reduction of the discount rate by 0.5% to 2.5% can only strengthen the feeling of insurers that they are being used as a soft target for dealing with society's ills. The Lord Chancellor's decision has politics written all over it. After studying his arguments, it's clear the outcome is a compromise. He has chosen a rate halfway between the insurance industry on one side, which wanted no change, and Sir Michael Ogden himself, consumer groups and personal injury lawyers, which had been calling for a full 1% reduction. Like all compromises, it may end up satisfying no one.
The cut will cost insurers £350m on our estimates. Paying out more to accident victims in this way may be socially desirable, but anyone who thinks the money will be found by cutting into excessive profits is in for a rude shock.
Contrary to public perception, insurance companies are not awash with cash. It is probably the most complex industry in which to get the finances right. Doing so involves a fine balancing act – all the more difficult when the rules are constantly being changed to your disadvantage.
Despite the recent hike in motor and other rates, insurers are still barely charging enough to make an adequate return on capital. The only way to recoup the costs of this ruling – both retrospective and going forward – is to charge the public more. We estimate motor premiums will have to rise by an additional 2.3% to pay for the decision.
It's not just motor that will be affected, however. The liability market is especially fragile and we estimate premiums here will need to rise by 8%. This is particularly bad news for creditors of Independent, with its high exposure to liability claims.
Independent acts, of course, as a warning to any insurer that might be tempted to set uneconomic rates by absorbing the extra costs.
The decision was ultimately political rather than purely technical, and you could argue the merits either way. But the Lord Chancellor seems to have used questionable logic – the 2.5% figure is only slightly above what one could expect from tax-adjusted yields on government bonds. He acknow-ledges that it is unheard of for claimants who receive sums for personal injury damages to invest all their money in this way. Indeed, he says they "would not be advised to invest solely or even primarily in index-linked government securities".
Claimants opt instead for mixed portfolios, which generally include a substantial measure of investment in the equity markets. The Lord Chancellor says, furthermore, that they are right to do so, because of the much higher returns secured for only a small increase in risk. It would seem more logical and fairer to us, therefore, to have kept the discount rate at 3%.
Notwithstanding the debatable fairness of this decision, it is symptomatic of the unfriendly political, legal and social environment that the insurance industry inhabits. It's just the latest in a line of government or court actions to hit insurers, often retrospectively.
There are almost certain to be more. For example, pressure is building up from consumer groups and personal injury lawyers, among others, for a review upwards of last year's Court of Appeal decision on general damages. The current cap on NHS recoupment costs may be removed altogether. All this against a background of increased litigiousness which, as the Second UK Bodily Injury Awards Study demonstrated, is helping to keep claims escalation at around 13% per annum.
Like it or not, companies that wish to remain in business must reserve and price accordingly.
Industry to blame
In one sense, the insurance industry only has itself to blame. Its poor image can only have taken a battering as a result of recent insurance company failures, making it even more difficult for the Association of British Insurers (ABI) to argue for a more sympathetic approach by government. It is clear that someone must get a public debate going about the wider social and economic role of insurance.
If the government and consumer groups would only acknowledge that milking the insurance industry ultimately leads to higher costs for the public, then that would be a good start.