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The Actuary The magazine of the Institute & Faculty of Actuaries
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GI: PPOs - A step into the unknown

Periodical payment orders (PPOs) are funny things. In a sense they are a very simple change. Future payments that traditionally are converted into a single lump sum and paid by the insurer will instead be paid out over time. With deterministic assumptions, the annuity formula learned in actuarial and finance exams will calculate the gross cost. Yet that small change has significant ramifications for both the insurance industry and the general public.

The issue for the insurance industry is one of uncertainty. Unfortunately, uncertainty has a cost. Although we do not know exactly how PPOs will play out, we do know some things. They will increase the time that claims take to settle and the cost to manage the claims, and consequently the reserves will increase. Variation orders and guarantees will mean costs can increase in the future unexpectedly with little warning. Insurers’ future payments will be sensitive to economic factors and will be highly correlated — so we can be certain that things will be less certain.

As a result insurers will need to hold greater capital, a cost that will feed into prices. The size and materiality of any increase will be difficult to quantify with the dearth of experience to date. The price implications will depend on the assumptions made by insurance companies on many other issues as well, not just capital costs — assumptions such as the real discount rate, how an impaired life population will behave, PPO desirability and reinsurer behaviour.

These are key decisions where actuaries and businesses will need to make a call, ones that may have a significant impact on the prices charged today and the profitability that eventually results from written business. That we won’t know which insurers are under/overpricing on PPOs for many years is something that will surely give the regulators a few uncomfortable moments.

There is also a great deal of uncertainty about the impact on the purchase of reinsurance. For direct insurers the value of reinsurance will reduce. First, the standard market reinsurance clauses allow the retention to increase with wage inflation over time. PPOs, with their slower payments than lump sums, result in a higher net cost to insurers. Second, Solvency II will force credit risk to be considered, which PPOs increase. From the reinsurer’s point of view, the beneficial impact of the indexation clause may be offset by the uncertainty impacts discussed above, which have a geared-up impact for reinsurers as the bulk of their exposure is to large claims.

How this will affect the insurers’ and reinsurers’ dance at renewal is unknown, but it is sure to add some new steps. For the general public this may all feed into higher motor insurance prices. But that is not the only way they are affected. The NHS is settling many claims as PPOs, with reputedly little reserves in place for them. Earlier this year the NHS had 800 active PPOs on its books. The exact nature of these claims has not been reported, but if they have a profile similar to those settled in the motor market then the reserves could exceed £1.5bn. With different assumptions it is possible this could be even more.

At a time when the UK is grappling with how to reduce its future obligations, it is uncertain how aware the government and the public is that it is building up new obligations via the NHS. Pushing payments into the future can be beneficial for government organisations, but planning needs to be done to make sure there are no unpleasant surprises.

I should make it clear that PPOs can be very good for claimants. There are many scenarios where it makes a great deal of sense to pass risks that are significant for the claimant onto insurers where they are less material and can be pooled. At a time of depressed investment markets, many may view a fixed-income stream as higher value.

At the recent GIRO conference, a presentation was given summarising key findings from the 150-page paper produced on PPOs by a working party. It was titled ’PPOs — be afraid. Very afraid’. Although the title was slightly tongue-in-cheek, hopefully this article will help actuaries realise, they do need to know what they are, how they could be affected and have a plan to deal with PPOs’ pricing, reserving and capital implications.

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See also:
GI: PPOs - A little goes a long way
Sarah MacDonnell explains why the use of PPOs for GI claims is on the rise
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