The little man trying in vain to battle the unstoppable monster is a staple of the horror movie genre. But insurers could be about to face their own nightmare: claims inflation
The monster plaguing the insurance industry is claims inflation – and the bad news is that it is getting bigger.
Recently published research by the Actuarial Profession shows a dramatic increase in the number of claimants opting for staggered periodic payment awards instead of lump sum settlements. This rise follows a landmark court ruling in 2008, which allowed such payments to be linked with wage instead of price inflation, pushing up the overall cost of awards. Increasingly, insurers are facing the spectre of liabilities that could stretch across a lifetime.
And if this wasn’t enough cause for worry, companies have little idea of the total value of the claim or when payments will cease.
Courts have been able to award periodic payment orders (PPOs) instead of lump sums in large bodily injury cases since 2005 (see box, ‘PPOs: no solution for insurers’). Before the creation of PPOs, courts awarded lump sums that were intended to provide enough money for individuals to pay for care for the rest of their lives. These lump-sum payments, which can still be issued, are calculated based on for the individual’s future life expectancy and future investment returns using a set of actuarial tables known as Ogden tables.
The big worry for insurers is that PPOs replace the certainty of a single lump sum with the uncertainty of index-linked payments to claimants for the rest of their lives. Under PPOs individuals receive a payment, normally annually, which increases in line with a prescribed index.
Originally, these payments were inflated each year in line with the retail prices index (RPI), which measures price inflation. However, 2008’s judgment in Thompstone v Tameside marked a turning point. This stated that PPOs could be linked to carers’ wages instead of RPI. Because wages usually increase faster than prices, this makes PPOs more desirable for claimants.
The result of these changes has been an increase in the number of PPOs over the past three years. According to the Actuarial Profession’s report, the number of PPOs jumped from a handful in 2007 to 25 in 2008 and then to 44 in 2009. Furthermore, according to the EMB, the growing trend towards periodic payments has fuelled a rise in the number of claims exceeding £5m.
The long-tail nature of PPO awards also exposes insurers to the risk of underpricing.
RSA’s UK personal lines underwriting director Nathan Williams believes that the uncertainty around these payments will be hugely challenging for insurers.
“The rate of future inflation is unknown – you don’t know by how much earnings are going to go up by,” Williams says. “You don’t know when a person could die. The person could die tomorrow or they could live for another 50 years. So that is a huge uncertainty. Under Ogden, you paid £5m and at least you knew that was it.”
From a claimant’s point of view, however, PPOs are ideal because they remove the risks that their investment returns will decline in value. What’s more, the government is keen on PPOs because they lessen the risk of individuals running out of money and falling back on the welfare state. Instead, PPOs transfer the risk of uncertainty from the claimant and the state to the insurer, which presents real challenges to both insurers and reinsurers of casualty classes, particularly those in the beleaguered motor market.
The biggest fear is the question mark over the total cost of the compensation awarded. LCP partner Laura McMaster suggests that PPOs
could end up costing insurers up to 30% more per claim than a lump sum settlement. “PPOs are something the insurance industry is struggling with at the moment,” she says.
“They are a new type of liability and insurance companies typically settle claims over a short time and now they are potentially getting liabilities for 60 or 70 years. Although they don’t have to pay the amount of money out immediately, generally they are costing the insurance sector more than settling on a lump sum basis.”
Ideally, insurers would transfer these risks to the life assurance market, which traditionally deals with the risks surrounding longevity, inflation, and investment through the purchase of an annuity.
However, solicitors Barlow Lyde & Gilbert partner Charles Brown points out the annuity market has failed to create products that specifically match the liabilities created by
PPOs. “No insurance company in the market provides an annuity that would escalate in line with wage inflation,” he explains.
He adds that the companies that do try to tailor existing annuities to these liabilities are charging exorbitant amounts. “This means it becomes not just a little bit more expensive than providing a lump sum, it becomes a huge amount more expensive.”
Furthermore, if insurers try to fund the liability themselves rather than buying an annuity, it means they will have to keep the claim open for the rest of the claimant’s life. This in turn will put enormous pressure on insurers’ reserves. “Under FSA rules, insurers have to cross match assets to ensure they have enough reserved to be able to meet what they are likely to be asked for over potentially 60 years. This is difficult because they are trying to match an outgoing that is not predictable because nobody knows how wages are going to increase over that period of time,” Brown says.
Legal experts warn that the increasing popularity of PPOs could also spell trouble for insurers when it comes to their reinsurance. They argue that many contracts between insurers and reinsurers are not designed to cover these types of long-tailed liabilities, which didn’t even exist before 2003.
Under existing arrangements, insurers are unable to recover from reinsurers until they have paid out their share of the loss (the deductible). With lump sum settlements, the whole loss, including the deductible, would be paid at once, triggering the payment from the reinsurer at the same time. But because PPO payments are spread over time, insurers will be unable to make recoveries until the deductible is fully paid. But there is no guarantee of when this will be.
In addition, insurers could face the constant worry that their reinsurers may not be in a position to meet these costs. “There is always the uncertainty about the creditworthiness of reinsurers and whether they are going to be around in 20 years to pay,” Williams says.
There is no doubt of the scale of the challenges ahead for insurers. “The fact that there isn’t an annuity provider out there does cause some issues,” Groupama’s head of large and specialist loss Karl Parr says. “There is clearly going to be challenges around reserving issues and the impact with regard to making recoveries from reinsurers.”
Some are trying to look on the positive side. AXA’s claims director David Williams says: “I think their increased use is a good thing; they genuinely protect damages for later life – and whilst difficult at times to set up – should be supported.”
Indeed, some commentators suggest that the news that the Lord Chancellor is set to review a potential reduction in the discount rate (see box, ‘Insurers’ discount rate burden’) for personal injury claims could mean PPOs become less popular. Any such reduction will increase the value of the lump settlements.
But for insurers, such a move would be a no-win solution. A large reduction in the rate could lead to payouts similar to the record £13.7m compensation paid to Guernsey cyclist Manny Helmot earlier this year.
However, the general consensus is that the government is unlikely to cut the discount rate significantly because such a move is not in its own interest. A large number of claims are settled through the NHS Litigation Authority, meaning the government is unlikely to increase its own cost burden in the current economic conditions.
“For policy reasons, the government is going to be reluctant to reduce the discount rate and make PPOs unattractive again,” Brown explains.
Consequently, industry experts believe that PPOs are here to stay and the sector will have to find a way to grapple with the challenges they represent. It looks like this particular monster is set to grow and grow. IT
The Court Act 2003 allowed for payments to
inflate annually in line with the retail prices index, allowing insurers to match the liability by buying
Since the Thompstone case, when this provision was successfully challenged, wage-based indices can be used instead.
There are a number of indices available, but the most popular index used so far, and the one selected to be used by the judge in the Thompstone case, is the annual survey of hourly earnings (ASHE) carried out every year by the Office of National Statistics.
ASHE reports in a number of formats, including hourly earnings and annual earnings.