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The Actuary The magazine of the Institute & Faculty of Actuaries
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GI: PPOs - A little goes a long way

Structured settlements, or periodical payment orders (PPOs), are not a new phenomenon. While over the years there have been episodes of consternation in the insurance industry over their emergence, they never seemed to materialise in any great number and the industry only ever saw a handful settling each year. Over the past 18 months or so, however, we have witnessed a significant increase in the number of PPOs being settled in the courts. This article looks at what a PPO is and discusses what may have caused the increase in their numbers.

What is a PPO?
If someone is seriously injured in a car accident, for example, then they will make a claim on the insurance of the responsible party in order to be financially compensated. This compensation can either be in the form of a single lump sum or, alternatively, as a series of regular payments over the remainder of the claimant’s lifetime. This latter form of compensation of regular payments is known as a structured settlement, or PPO.

These payments are typically made either once or twice a year and are linked to an inflation index that is agreed at the time of settlement. They can apply to any future pecuniary loss elements but, to date, they have been seen to primarily apply to the future cost of care element. A lump sum can be made alongside the regular payments; for example, the future care costs may be covered by a PPO, whereas the loss of earnings element could be in the form of a lump sum.

There can be a provision for step changes in the regular payment amount to be written into a PPO. These are known as stepped PPOs and will apply at fixed points in time to situations where a specific change in circumstance has already been foreseen at the time of settlement. For example, there could be a provision for a one-off increase in payments to be made in the case of a claimant whose parents are the primary carers. This would allow for the time when the parents cannot deliver the same standard of care and additional care costs will need to be incurred.

Similarly there can be a provision for variability orders, whereby the case can return to court in specific circumstances, such as a deterioration in the claimant’s medical condition, say. For both the stepped and variability orders, the terms under which the increase in payments will be triggered have to be defined clearly at the time of the settlement. A deterioration in the claimant’s medical condition that had not been foreseen and specifically allowed for as a variability order at the time of settlement would not result in an increase in the regular payment amount.

Where some of the cost of care is borne by the local authority, insurers may need to offer a guarantee in the PPO to cover costs in the event that the local authority payments are reduced or withdrawn in the future.

Lump sums versus PPOs — the claimant’s perspective
Even though claimants have historically tended to prefer a settlement in the form of a lump sum, it is widely argued that it is in the claimant’s best interest to receive compensation in the form of regular payments instead. The primary reason for this (other than the possibility that a claimant may choose to spend most of the money up front) is that a PPO takes away most of the risks that are inherent in a lump sum, such as mortality, inflation, investment and credit risk.

For example, should the claimant live longer than was anticipated at the time of the settlement, there is the potential for the funds from a lump sum to run out, whereas, by definition, a PPO will continue to pay out for the remainder of the claimant’s lifetime.

Changes in the economic environment can also affect the value of a lump sum; for example, if inflation proves to be higher than was expected at the time of settlement then the value of the lump sum will be eroded. Similarly, if investment returns are lower than anticipated at the time of the award then there is a risk that the lump sum will not be sufficient to cover the claimant’s costs. Though, conversely, they would not be able to benefit from good returns if investment markets perform better than expected or if they had opted to invest in potentially higher-yielding (though more risky) investments such as equities.

So how many are there?
The Profession’s working party on PPOs has undertaken an industry survey of the UK motor market, which estimates that there are currently around 60 PPOs a year settling (excluding PPOs settled in respect of the NHS and the Motor Insurers’ Bureau (MIB). Figure 1 shows the number of PPOs settled in each quarter between 2005 and 2009.

So far, the majority of PPOs have come from the motor insurance market. PPOs do also emerge from employers’ liability and general liability covers but, to date, these have been much less frequent.

Why has the number of PPOs increased?
The Courts Act 2003, which was implemented in 2005, allowed the courts to impose a PPO award for the first time, irrespective of the wishes of the insurer or the claimant. Historically, claimants have tended to opt for a lump sum settlement even though it is argued that this is not in their best interest. Initially, this legislation did not seem to have a material impact on the number of PPOs being awarded.

The index used to inflate annual payments was originally automatically linked to RPI. However, in 2006 a court case was brought in the form of Thompstone v Tameside and Glossop Acute Services NHS Trust, which questioned this assumption and suggested that the payments for future cost of care would be better linked to wage inflation. The court agreed and the annual inflation increase was linked to the Annual Survey of Hours and Earnings (ASHE). The case was appealed and a number of other cases were put on hold pending the outcome. In 2008 the Court of Appeal upheld the ruling and since then the majority of PPOs have had inflation linked to ASHE (as shown in Figure 1 by the colour coding of the bars).

On top of that, it is likely that the investment market crash of 2008 will have also contributed to the relative attractiveness of PPOs for claimants. Lump sums are calculated by the courts with reference to Ogden tables. The Ogden tables implicitly allow for a real discount rate, which is set by the Lord Chancellor. It was last changed in 2001 and currently stands at 2.5% per annum. This contrasts with current real yields on index-linked gilts of less than 1% per annum.

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See also:
GI: PPOs - A step into the unknown
Antony Claughton explores the impact of PPOs on the insurance sector
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