Mohammad Khan, Francisco Sebastian and Andrew Corner share the Ogden Discount Rate Working Party’s findings on a potential new rate, and whether the insurance sector is prepared for one
The Ogden discount rate is set by the British government and prescribes the discount rate to be applied in the calculation of bodily injury claims. It was last reviewed in 2019 for England and Wales, being increased from -0.75% to -0.25%. This decreased the lump sum payments paid by insurance companies to bodily injury claimants. The Government Actuary’s Department (GAD) suggested that a +0.25% rate for England and Wales would give equal chances of a claimant being under or over-compensated. The government then decreased the rate by 0.5% to give an approximately two-thirds chance of a claimant being fully compensated. Scotland and Northern Ireland have a separate process for setting their own discount rates.
The government has said it will revisit the Ogden rate every five years, at most; this means the next rate must be revised by 2024 at the latest. This seems like a long time, but given the average six-year life span of a large injury claim, roughly half of the large claims open at year-end 2021 might be expected to settle on a future discount rate. However, given the uncertainty in UK investment markets and the fact that a number of insurance companies have material exposure to Ogden-exposed liabilities, many companies are considering whether they should allow for a change in the methodology and estimation of the rate within their reserves.
The IFoA’s General Insurance Practice Area established the Ogden Discount Rate Working Party to consider issues and uncertainties relating to the implementation of any new Ogden rate. Here we set out some of our initial findings – including what would happen if you replicated the original GAD analysis, research into the dual rate-based methodology, and the outcomes of a survey on practice across the market. The survey was sent to chief actuaries and heads of reserving in order to understand their reserving approach to Ogden-impacted business. We have also covered our findings in a recorded IFoA webinar.
“A dual-rate framework could reduce the number of claimants who would be undercompensated at any given rate”
What did we find?
The working party wanted to not only replicate what had been done before, but also consider the problem that the Ogden rate tries to solve: what is the appropriate discount rate, implied from a suitable basket of investments, for an injured party to invest in to meet their losses and costs during their remaining lifetime? We therefore tried to replicate GAD’s analysis, and also adjusted certain areas to see the discount rate’s sensitivity to changes. We did this by:
- Seeking input from specialist financial advice firms (some of whom responded to the Lord Chancellor’s Call for Evidence when the Ogden discount rate was last reviewed) to see what changes could be made to the rate while fulfilling the Lord Chancellor’s mandate
- Modelling the investment returns and risk of the claimants’ positions using efficient frontiers.
- We did not review the assumptions for inflation, tax and investment expenses, but did get feedback from financial advisers on these points.
Our initial findings are that:
- If we re-estimated the Ogden discount rate as at August 2021 as a scenario, using comparable investments and assumptions to those used by GAD, and applying the additional Lord Chancellor’s -0.5% haircut, the discount rate would be about -0.75%. This is purely due to the current economic conditions, and we highlight that this estimated scenario rate would change on a day-to-day basis.
- In GAD’s original advice to the government, it mentioned that it had considered dual rates. We took this into account by:
- Shifting towards an efficient frontier approach in order to capture claimants’ differing attitudes towards risk
- Refining the model used to estimate the relevant rates so that it assumed claimants made rational investment decisions – in other words, that the asset allocation was optimised for a notional liability stream.
Enhancing fairness through dual rate-based methodology
The alternative methodology we have explored is based on three sets of notional liabilities extending over 10, 20 and 30 years. For each set, we estimated an efficient frontier via an optimisation process with an objective function that minimised the standard deviation arising from the joint asset and liability position for different levels of expected return.
The differences between the efficient frontiers estimated for the 20 and 30-year timeframes were minimal. Based on our modelling experience, the results from any optimisation based on a timeframe horizon above 30 years are very similar to those based on 30-year horizons. We therefore used the 30-year horizon to represent the rational behaviour of a claimant with investment horizons exceeding 30 years. Bearing in mind the similarities between the points at 20-years and above, we built the discount rates based on the 10 and 20-year notional liability streams. The intermediate points were linearly interpolated to derive the discount curve in Figure 1.
Figure 1 shows the minimum, maximum and neutral risk points
from each efficient frontier, alongside GAD’s advised 2019 rate and our estimate of what that rate would be in 2021. In our opinion, ‘neutral’ is the most relevant construction because it assumes that the claimant prefers using the investment portfolio to neither reduce nor increase risk – in other words, the joint asset and liability position arising from the efficient frontier is equal to that of the liability stream, individually considered.
The neutral curve is below the estimated rate for investment horizons of shorter than 15 years, and above it for longer ones. The Ogden rate therefore appears too high for claimants with shorter investment horizons (thus undercompensating claimants), and too low for those with longer horizons (thus overcompensating). This is where a dual rate may be helpful, and GAD has indicated that it will give further thought to a dual-rate model by the time of the next review. A dual-rate framework could also reduce the number of claimants who would be undercompensated at any given rate, reducing the need for the government’s prudence margin.
How are insurers thinking about the impact on their reserves?
We surveyed chief actuaries and heads of reserving about their approach to reserving for classes of business impacted by the Ogden rate. Our key findings include:
- Data – Most insurers had access to granular head of damage data for each claim, but few used it when reserving. All insurers used size bandings to revalue claims on different discount rates, but there was no consensus on how this was done.
- Methodology and assumptions – More than half of respondents reserved an Ogden-impacted book by re-basing claims to be on a consistent basis. However, others simply excluded impacted diagonals, assuming that development patterns pre and post-change were similar. All respondents were aware that their chosen methods had limitations, and almost all said they would benefit from benchmark data. We aim to help produce benchmarks as a next step.
- Future-proofing – Despite almost all insurers thinking that the rate will change in the next few years, almost all respondents said their current processes were only ‘somewhat’ robust enough to automatically cope with a change. In addition, no insurer said it would automatically be able to cope with a dual discount rate or something similar, although it seemed to be on most agendas.
- Settlement analysis – Few respondents had quantified the implied discount rate on settlement. Those that had noted that claims were settled using an effective rate of 0% following the rate’s change to -0.75% (presumably expecting a subsequent review to increase the rate to this level), but that claims are now consistently settled at -0.25% following the rate change. Respondents believed that the next rate review would occur in 2024 and that it may decrease, based on current investment conditions. However, given that investment conditions are uncertain, it was difficult to assess what the future rate may be.
Although the Ogden rate change may not occur until 2024, insurers are looking at its potential impact. The work we have carried out shows there is a lot of thinking that can be done to refine the next rate.
Mohammad Khan is chair of the Ogden Discount Rate Working Party and general insurance leader at PwC
Francisco Sebastian is an investment actuary at Wellington Management
Andrew Corner is a senior manager at PwC