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The Actuary The magazine of the Institute & Faculty of Actuaries
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The Ogden discount rate's road to balance

The UK government is to increase the Ogden discount rate to counteract the 2017 reduction, which caused motor insurance and reinsurance premiums to rise significantly. Mohammad Khan, Sundip Mistry and Andrew Corner explore how uncertainty around this change affects insurers


08 FEBRUARY 2018 | MOHAMMAD KHAN, SUNDIP MISTRY & ANDREW CORNER 


iStock
iStock


It was certainly an interesting year for the UK motor insurance industry in 2017.

The Ogden discount rate – the rate used to value lump sum awards for claimants who have suffered serious injuries in either motor or workplace accidents – had not moved since 2001, when it was set to 2.5% based on a three-year average of the returns on index-linked bonds at the time.

On 27 February 2017, the former lord chancellor announced a change in the Ogden discount rate from 2.5% to -0.75%, which essentially led to an increase in value of lump sum awards – typically of the order of three to fivefold. After the announcement, insurance companies had to significantly increase their premiums and reserves within the motor and liability lines of business to ensure the premiums covered the new increased costs of claims and that they held sufficient reserves to cover these liabilities. Reinsurers had been slow to react to the original December 2016 announcement, with many not reflecting the possibility of an Ogden change in the January renewals in 2017. 

After the February announcement, they did increase rates for the July renewals and are currently trying to increase rates consistent with a -0.75% rate for January 2018 renewals.  

The timing of the original decision – just when many insurers were announcing their 2016 results – caused great surprise across the insurance industry and had a significant downward impact on many insurers’ 2016 results.

The government introduced a six-week consultation process shortly after the announcement of the original Ogden discount rate change, owing to the impact on the insurance industry. The results of the consultation were due in August 2017 but were not released then. However, on 7 September 2017, the new lord chancellor announced that the government would legislate to change the basis on which the discount rate is set. 

Based on current investment conditions, the government expected the Ogden discount rate would be set at between 0% and 1%. The Justice Select Committee provided their recommendations on the Ogden rate at the end of November, which indicated further delays in determining the new rate. However, these recommendations are not binding on the government.  

The draft legislation comments that the Ogden discount rate should mirror what claimants earn on investment of the lump sums they are awarded. In particular, it notes that they should be treated more as “cautious” rather than “ordinary prudent” investors. The legislation defines this as investing in a low-risk diversified portfolio rather than just in low-risk investments (eg, index-linked government bonds).  

Although the make-up of the low-risk portfolio is still to be ultimately defined by the government, the Government Actuary’s Department did show two example portfolios as detailed (below). 

Then on 30 November 2017, a Justice Select Committee report on the UK bodily injury discount rate announced that “clear and unambiguous evidence” should be gathered about the way claimants invest their lump-sum damages before legislation is changed, potentially postponing future changes even further.

As things stand, the next steps regarding the review of the Ogden discount rate are as follows:

The lord chancellor is awaiting comments on the draft legislation introduced on 7 September. 

The government needs to decide which bill to attach the legislation to, which will then be debated in parliament and subsequently voted on.

Assuming the bill passes through parliament, there may be another consultation period of 90-180 days if further changes are proposed and also to consider the revised investment conditions. The current draft of the legislation does not have this third step within it, and it may be that this will only occur when the Ogden discount rate is revised again.

The Lord Chancellor will then announce the Ogden discount rate, which will then be amended again within a three-year period.

Even without the third point above, we may not know what the new Ogden discount rate is until well into 2018 – causing significant uncertainty as to what Ogden discount rate insurers should assume when setting their reserves for their 2017 accounts and in pricing their new business.

As a result of the announcement in September, a number of important considerations present themselves to insurers.


Should insurers reflect the September announcement in their year-end or 2018 Q1 reserves?

There are a variety of different approaches insurers are taking with regards to the September announcement. As there is still a large amount of uncertainty surrounding whether the bill will pass, when it will pass and the eventual discount rate that is eventually settled upon, a number of insurers are not moving from the -0.75% rate. These insurers are additionally wary about the fact that if they increase their Ogden discount rate assumption, release reserves and therefore increase the contribution to profit, they may then need to increase reserves (and reduce profits) at a later date if the legislation does not pass. 

Other insurers are considering increasing their assumption, but trying to take into account the possibility that the bill may not pass, and therefore may pick a number between -0.75% and the low end of the 0% to 1% new expected range.

Given the materiality of the rate change on many insurers’ results, one of the key issues for insurers to consider is the disclosure they need to produce if they make a change. Not moving from -0.75% may mean the least disclosure needs to be published, which may be attractive for some insurers.

To make matters more complicated, many insurers have been settling large injury claims since 27 February (when the original discount rate change to -0.75% was announced) at between 0% and 1%, as everyone expected the consultation to increase the rate. Should insurers reflect this recent experience in their reserves? 

If the bill doesn’t pass – and therefore the discount rate will remain at -0.75% for at least the next two years as the government cannot introduce new legislation before then owing to the Brexit timetable –the rate at which large claims settle would probably reduce from this 0%-1% range towards -0.75%.

Companies will also need to consider the impact on periodic payment orders (PPOs) within their analysis. When insurers moved to -0.75%, many insurers reduced their PPO propensities to a minimum percentage, as they perceived that claimants would prefer to settle on a lump-sum basis rather than a PPO basis (which typically assumes a discount rate of around 0%).  Moving the Ogden discount rate to 0% or above may mean that PPOs become more attractive to claimants and insurers may need to increase their PPO reserves to reflect this.  


Are there any potential problems from a reserving analysis perspective? 

Many insurers have adjusted their case estimates to be based on a discount rate of -0.75%, potentially changing the historical data that actuaries typically look at to analyse and estimate future claims and reserves. This means traditional actuarial techniques can be distorted, because they do not properly allow for an increase in incurred claims. If the outstanding claims have all been restated at -0.75%, continuing to use the same development factors in the chain ladder method can potentially distort the level of incurred but not reported (IBNR) actually required. As mentioned above, some claims since February have been settling at between 0%-1%, so there is a distortion, in that historical claims have been settling at about 2.5% (the old rate) and in more recent periods at between 0% and 1% but the case reserves are being set at -0.75%.

Here is an example to demonstrate the above. Let’s say that an insurer had a claim with £500k paid and £500k outstanding, using a discount rate of 2.5%, and the selected factor to ultimate is 1.2. This results in a £200k IBNR and ultimate of £1.2m.  

Now let’s assume that using a discount rate of -0.75%, case estimates have been updated and are now £1m. This means case estimates have been uplifted by 100%. Using the same factor to ultimate would result in an ultimate of £1.8m, which is £1.5m multiplied by 1.2. This would leave us with an IBNR of £300k, which is a 50% increase on the previous IBNR. This is not consistent with the uplift to the case estimates. The above is summarised below:

Summarised table

This example demonstrates the potential need to use updated reserving methodology, as the previous factor to ultimate is inconsistent. This is because the paid claims are based on a 2.5% discount rate, whereas the outstanding claims are based on a discount rate of -0.75%. 

A further area to consider will be the events not in data (ENID) provision as part of the Solvency II calculation. Depending on the discount rate insurers adopt, they may wish to consider an ENID in light of the rate moving to a more adverse or favourable position.


What does the future hold? 

Apart from a reserving perspective, the proposed change in the discount rate will have implications in the following areas: 

  • Pricing, where, in motor insurance, premiums are already showing signs of reducing slightly. Our view is that this is likely to continue into 2018.
  • Reinsurance renewals, where the recent announcement is likely to reduce the increases that insurers were likely to experience in their reinsurance costs for 2018 renewals. For insurers buying “excess of loss” reinsurance from £1m – that is, the reinsurer pays any loss above £1m that the insurance company receives – prices are likely to rise between 20% and 30% rather than the increases of between 30% and 40% that insurers who renewed at 30 June 2017 incurred. 
  • Capital coverage ratios – for those insurers who are slightly less well capitalised, the news will be welcomed.  

 

However, while lump-sum payments may reduce, insurers should be aware that the number of those claims settled on an annuity basis may increase, as these will appear more attractive to claimants.

The Ministry of Justice has indicated that the discount rate will be reviewed at least every three years. This has implications for insurers in that there is a need to develop flexible reserving methodology that allows for a changing discount rate. A potential solution could be using reporting year triangles as part of the reserving analysis.  

In conclusion, there is continued uncertainty around the way in which the future Ogden discount rate will be set and what it might move to if the draft legislation passes through parliament. The consultation will need to balance its choice of Ogden discount rate with insurance pricing and also to ensure that the new rate treats and pays claimants fairly for their severe injuries. Given this uncertainty, insurers will need to consider the wider implications on business planning, capital and pricing. 


Mohammad Khan is partner and head of general insurance at PwC


Sundip Mistry is a principal consultant at PwC


Andrew Corner is a consultant at PwC