The award of periodical payment orders (PPOs) to settle large insurance claims has steadily become more prevalent in recent years.
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- Antony Lee
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1 Insights February, Beware the PPO iceberg The award of periodical orders (PPOs) to settle large insurance claims has steadily become more prevalent in recent years. The cost of managing the uncertainties that accompany them and their increasing materiality on insurers balance sheets mean that the majority of insurers will have to make adjustments, not only in how they determine claims reserves but also in areas such as reinsurance policy, capital modelling, pricing and investment strategy. Introduction Since their introduction through the Courts Act, and subsequent implementation in 5, periodical orders (PPOs) have begun to change the landscape of how large injury claims are paid in the UK. The Act granted the courts the power to award a portion of a settlement to a claimant as a continuing index-linked annual through their lifetime, rather than awarding just a single lump sum to cover all future needs as had been the traditional practice. After an initially slow take-up, awards have risen more quickly since 8. Two main factors have contributed to the increase. The first was the change in the earnings link from the Retail Price Index (RPI) to the Annual Survey of Hours and Earnings (ASHE). Secondly, investment conditions in the wake of the financial crisis have made one-off s less attractive due to the discount rate (.5%) applied to the Ogden heads of damage lump sum tables. Nonetheless, the growth seen in the number of PPO awards may only represent the tip of the iceberg. That is because the ultimate position, including the wider operational implications for insurers, may still not be apparent to companies with relatively few cases. It has been estimated, based on data from surveys undertaken by the Third Party and PPO working parties of the Institute and Faculty of Actuaries, that for every PPO currently settled there could be in the range of two to four times as many PPOs in total for which insurers are currently on risk. In fact, some calculations imply that up to 5% of insurers motor liabilities could be accounted for by PPOs in the relatively near future. Increased uncertainty Because of the timeframes involved (the future lifetime of a PPO claimant is on average 4 years), PPOs by their very nature breed uncertainty. How many general (re)insurers are accustomed to managing liabilities that might remain in place for several decades or taking into account factors such as movements in overall life expectancy (and impaired mortality rates in particular)? Below, we look at the impact on uncertainty of: Inflation Longevity Propensity Consistency across the market Inflation As a result of the 8 Court of Appeal ruling that confirmed the use of ASHE to calculate inflationary increases for annual s, there are several complications associated with ASHE that insurers need to find ways to overcome: It is a survey rather than an index, for which the methodology has not always been consistent and from which no long-term projections of costs are available. The percentile of earning increases within a given profession can vary from one PPO to another. Overall care costs can be influenced by outside factors, including new legislation. The link of PPO s to earnings inflation, and specifically to the increase in wages of care workers, has also complicated insurers ability to hedge these liabilities. While there is a limited number of asset classes that could provide an inflation-linked return to manage the exposure to changes in RPI, there are absolutely none that are specifically linked to ASHE.
2 Insights February Longevity On average, the age of PPO claimants is relatively young (at around 4 years) which leads to significant difficulty in trying to predict the future lifetime of the individual. In addition, a high proportion of PPOs are settled in respect of claimants in their early twenties, and so predictions require projecting mortality rates for many decades ahead. In addition, the nature of the injury leading to the PPO claim leads to extra uncertainty in trying to predict longevity. Examined in more detail, currently a large majority of PPOs are awarded for serious brain injuries (see Figure ), stemming from claims on motor and employer and general liability policies. The significance of this fact is that these types of injuries typically have the most uncertainty associated with how long those who have suffered them will survive. Within individual PPO awards, the possibility for variation orders according to the needs of the recipient over time and factors such as the age of primary carers may also need to be considered. Propensity Another area of uncertainty for insurers is the future propensity of PPO settlements and how their mix of business might affect their risk exposure. Between 8 and the proportion of large motor claims over million that settled as PPOs rose from 8% to over 5%. With a typical delay to settlement for an average motor PPO of six years, this rapidly increasing trend may have to be a short-term consideration for a number of insurers. Furthermore, over 5% of large claims paid for from the Motor Insurance Bureau fund are made as PPOs, which eventually feed into the annual levy that insurers are required to pay. These overall numbers do, however, hide some variation in propensity between insurers. The results in Figure are based on responses to the most recent PPO Working Party survey. The responses not only potentially reflect individual mixes of business but may also hint at degrees of resistance towards or acceptance of PPOs. Consistency Even this relatively quick overview of the uncertainties arising from PPOs will have given an indication of the broad range of assumptions that companies could apply to assessing their impact. Therein lies a further potential issue. Because of the proportion of insurers liabilities that PPOs are on course to represent, the fact that there is currently no consistency between insurers in those assumptions could have a significant effect on comparative financial results within the market. If one just takes future life expectancy as an example, the lack of data in particular on brain injuries means that there are varying expert opinions, some of which may err on the side of caution. Clearly, depending on whether companies take a mid/low/high forecast, it could paint their results in a completely different light to competitors. Therefore, there is a balance to be struck between prudent reserve levels and meeting the market s financial expectations. Figure. Number of PPOs by type of injury Source: Institute and Faculty of Actuaries PPO Working Party Brain 7 Spinal Figure. Distribution of PPO propensity by insurer Source: Institute and Faculty of Actuaries PPO Working Party 4 5 Other % % % 4% 4 5% towerswatson.com
3 Insights February Reserving challenge Turning to operational issues, setting appropriate claims reserve levels to take account of liabilities that could remain on their books for, in some cases 6 years or more, is one of the biggest challenges facing (re)insurers. If that was not daunting enough, Solvency II means that general insurance actuaries have to potentially (re)learn a whole new set of life-based reserving techniques to do so, including understanding the issues surrounding impaired lives and future mortality improvements. This is because the Directive requires PPOs to be valued as life annuities and reserves classifi ed under the so-called seventeenth class ( Annuities stemming from non-life insurance contracts ). But the potential need for re-education is not just confined to the actuarial department. More widely, business managers and directors who monitor reserve levels and take decisions partly based on them will have to adjust to differences in what they are seeing. In particular, individual PPO settlement reserves could appear to increase from year to year. This is attributable to two factors. Firstly, under life insurance reserving methods, it is assumed that if a PPO recipient has already survived a year, then the chances of future survival will have increased. Secondly, the discounting of reserves under Solvency II means that, for balance sheet purposes, allowance for interest earned on reserves over the year is transferred from the reserves allocation to the amount earned from investments over the year, creating an apparent increase in reserves. Figure. Profile of a motor PPO Typically brain or spinal injuries Average age at settlement 4 Delay to settlement 6 years Future life expectancy at settlement 4 years Future life expectancy reduction years Indexation is linked to ASHE 65 Annual PPO 8, Lump sum million There are a broad range of assumptions that companies could apply to assessing the impact of PPOs. Therein lies a further potential issue. towerswatson.com
4 Insights February Beyond reserving The scale of the unknowns that lie under the surface of the PPO iceberg means that the impacts raise far wider operational questions for insurers. This section briefly highlights some of the issues and looks at: Capital Investment strategy Pricing Administration In moving from lump sum s for large claims to a smaller lump sum with indexed annual s, reinsurance recoveries are substantially delayed making the benefits of reinsurance more difficult to estimate. Figures 4a, 4b and 4c demonstrate this by showing the development of the gross and net of reinsurance s over time. The examples apply an excess of loss layer with a million retention limit, indexed using the European Market Indexation Clause. The equivalent Ogden values, also shown on the graphs, are based on a male with a future life expectancy of 4 years as at the time of the Court Award. The net and reinsurance s are shown on the graph at the point of the future life expectancy. Three scenarios are shown: Figure 4a: 8, annual, million lump sum Figure 4b: 8, annual, million lump sum Figure 4c:, annual, million lump sum Not only will the amount of reinsurance recovered vary depending upon the lifetime of the claimant, but the net value paid by the insurer is not possible to determine at the outset. Accurate record keeping is required merely to calculate the indexation. Figure 4a. 8, annual, million lump sum millions Equivalent Ogden Value Years since occurence date Gross s limit Figure 4b. 8, annual, million lump sum millions Equivalent Ogden Value Gross s limit Years since occurence date Figure 4c., annual, million lump sum Net Net Under Figure 4b, if an Ogden lump sum settlement were to be used then there would be no reinsurance recoveries. However if the claimant were to survive for more than 4 years from the date of accident, then reinsurance would become payable. It can also be seen that reinsurance s may not start until many years after the court award is made. Wider questions raised include: With PPO liabilities potentially lasting for 6+ years, will reinsurers last the course? Insurers need to be aware of the increase in reinsurance credit risk. To commute or not to commute? But, how do you value commutation? millions Equivalent Ogden Value Gross s limit Years since occurence date Net 4 towerswatson.com
5 Insights February Capital The major concern from a capital perspective is that uncertainty about future liabilities affects the cost of capital. The inherent uncertainties that PPOs force into reserves such as longer-term economic assumptions, mortality, the threat of legislative and legal reforms, and greater reinsurance default risk mean that capital holdings are likely to require sufficient flexibility to enable companies to respond to their evolving financial obligations. We would urge anyone reading this paper in an insurance company to ask themselves the question: How much have we done to understand the nature of this cost of capital risk to our business? Investment strategy PPOs push general (re)insurers into unfamiliar investment territory. How many (re)insurers have experience of investing for liabilities with a potential time horizon of 6 years? The inflationary nature of the PPOs and the uncertain period over which they are paid adds to the difficulties in looking to manage this exposure using conventional asset classes. The answers may lie in taking lessons from the pensions market. The Towers Watson Investment division advises on strategy for many of the largest worldwide pension funds, and sees a number of similarities between the needs of insurers in planning to meet PPO liabilities and the investment techniques employed by these pension funds. Pricing The potential for additional capital costs, more intangible reinsurance recoveries, the cost of PPOs compared to lump sums, future PPO propensity, and investing for very long-term liabilities all of these are elements which, if factored into pricing models, will make pricing more accurate and sensitive to the prevailing market conditions. Administration For some PPOs, the insurance company may have to remain in contact with and make regular s to the injured party for many decades. Current administration and customer relationship management systems are unlikely to be able to cope with the responsibilities placed on insurers to service a PPO award effectively. Navigating the iceberg We believe it is safe to assume that PPOs are here to stay, even if the discount rate on Ogden heads of damage lump sum tables were to come down. There is always likely to be a proportion of claimants who are more comfortable with the idea of deferring some s rather than taking the risk of outliving a lump sum settlement. Part of the art of navigating the challenges that PPOs present for insurers will involve re-education. We suspect that the life insurance techniques stipulated for valuing liabilities under Solvency II, for example, will be new to a lot of non-life actuarial departments. Equally general management teams will have to become adept at interpreting claims reserves that take account of a growing proportion of long-term liabilities. But, it is common knowledge that the most dangerous part of an iceberg is what lies beneath the surface. In the same way, for many insurers the wider impacts of PPOs may remain largely hidden by what are still a relatively small number of PPO settlements within individual insurance companies. Much as it is likely to be impossible to completely manage the uncertain nature of PPO risks across the business, it is certainly worth taking a closer look within your organisation to ensure that financial performance is not holed from within....it is common knowledge that the most dangerous part of an iceberg is what lies beneath the surface. towerswatson.com 5
6 Insights February More information Karl Murphy karl.murphy@towerswatson.com Karl is the UK Leader of Towers Watson s property and casualty insurance consulting business. His main expertise is in personal lines insurance and he is considered to be one of the UK s leading personal lines pricing and reserving experts. Sarah MacDonnell sarah.macdonnell@towerswatson.com Sarah has written and presented widely on the issues surrounding PPOs and is a member of the Institute and Faculty of Actuaries PPO Working Party. Investment Alasdair MacDonald alasdair.macdonald@towerswatson.com Alasdair joined Towers Watson in 999 and heads the UK investment strategy team. He advises a number of the largest UK DB pension funds, insurance companies and sovereign wealth funds on all aspects of their investment strategy. He is a member of the TW Global Investment Committee, which is responsible for all our global capital markets views. A particular area of interest is ESGs and Alasdair was instrumental in the development of the TW ESG. Andrew Epsom andrew.epsom@towerswatson.com Andrew is a Senior Investment Consultant within our Investment strategy team. He has expertise in assisting insurers and pension funds develop appropriate investment strategies and frameworks for managing investment risk. Notes: For a copy of the Towers Watson Insights article: Periodical Payment Orders, which provides a background to the subject of PPOs, please contact Ruqaiyah Jaffery on or ruqaiyah.jaffery@towerswatson.com The PPO Working Party survey received data from insurers, comprising 66 motor PPOs and liability PPOs. These insurers include nine out of the top insurance groups, as ranked by Motor gross written premiums in the FSA returns, and represent 87% of the FSA regulated market (based on gross premium volumes). Towers Watson carried out the analysis on behalf of the working party. For a copy of the Towers Watson Motor Industry Report: Light at the end of the tunnel? please contact Ruqaiyah Jaffery on or ruqaiyah.jaffery@towerswatson.com 6 towerswatson.com
7 Insights February towerswatson.com 7
8 Insights February About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 4, associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Towers Watson is represented in the UK by Towers Watson Limited, Towers Watson UK Limited and Towers Watson Capital Markets Limited. Towers Watson Limited is authorised and regulated by the Financial Services Authority. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, eu.unsubscribe@towerswatson.com with the publication name as the subject and include your name, title and company address. Copyright Towers Watson. All rights reserved. TW-EU--46. February. towerswatson.com
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