IUA and IUA02-017: Per Claimant Capitalisation Clauses Commentary September 2012

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1 IUA and IUA02-017: Per Claimant Capitalisation Clauses Commentary September In 2011 the IUA s Casualty Treaty Group (CTG) established a Sub-Group to consider whether a model per claimant capitalisation clause, which outlined a practical methodology for the calculation of a capitalised value of a bodily injury claim which had been the subject of a periodical payment order (PPO), could be drafted. The Sub-Group invited reinsurance brokers and reinsureds to provide input on the proposed clauses. During these discussions it became clear that two clauses would be necessary to reflect the differing opinions in the market in respect of the discount rate to be used for the purposes of the capitalisation calculation (discussed further below). However, in all other respects the two clauses are identical. 2. This commentary contains an outline of the rationale behind the decisions to include certain sections in the clause. It is hoped that this will help contracting parties understand the application of the clause. 3. Section The opening section makes clear that, while the clause sets out a methodology for the capitalisation of a claim involving Periodical Payments (as defined), in the event an annuity has been purchased by the reinsured to cover all, or any part, of their liabilities in respect of the relevant claim there will be no capitalisation of that claim It is expected that, in circumstances where a reinsured purchases an annuity, there will have been some discussion with reinsurer(s) regarding how this approach would be managed, as imposed by the provisions of many claims co-operation and reporting clauses (e.g. IUA02-015). 4. Section This section makes clear that indexation of the claim (in line with the index clause (or similar) in the underlying contract) ceases at the Capitalisation Date (as defined). This highlights one of the advantages of capitalisation from the perspective of a reinsured which is that indexation of the deductible ceases significantly earlier than if the claim continued to be paid on a traditional basis (i.e. the reinsured paid each PPO payment and only received reinsurance recovery once the total amount paid to the claimant exceeded the deductible, which had been increasing each year in line with the index clause) As is the case with other IUA clauses the words [Response, e.g. index clause / stability clause] are used to acknowledge that different terms may be used in specific contracts. The contracting parties should therefore use the most appropriate term to replace the words in square brackets. 5. Section This section details the components that will be used to calculate the Capitalised Lump Sum (as defined). The intent of the Sub-Group, reflected in the drafting of this section, was to remove, as far as possible, the variables to be negotiated as part of the calculation of the Capitalised Lump Sum The Sub-Group also sought, as far as possible, to reflect the process followed by a Court when calculating a traditional lump sum award. 6. Section The first component of the calculation is the Annualised Amount(s) [as defined] of the Periodical Payment(s) The Sub-Group noted that there are PPOs awarded on a monthly or quarterly basis but it was considered that, for the purposes of calculation of the Capitalised Lump Sum, an annual figure would be more straightforward. Therefore, in the event that (for example) a periodical payment is paid monthly,

2 the monthly figure would need to be multiplied by twelve to reach the annualised figure. Similarly, the above words clarify the periodical payment amount to be used for calculation of the Capitalised Lump Sum in the event a pro-rata or interim periodical payment is made This section states that the annualised value of the Periodical Payment to be used to calculate the Capitalised Lump Sum is the value of such payments at the Capitalisation Date. This is to clarify that, in cases where (for example) a claimant has been awarded a PPO the payment of which does not commence for some years in the future, it is the value of the periodical payment at the date it begins being paid and not at the date it was awarded. This formulation takes into account any inflation in the value of the periodical payment between the date it was awarded and the date that it is first paid. 7. Section As noted above, the Sub-Group have tried, where possible, to remove the scope for disagreement over the components to be included in the capitalisation calculation in order to ensure that consensus can easily be reached in all cases on the Capitalised Lump Sum. Therefore, this section clearly sets out how the life expectancy component will be calculated Given the impact that the life expectancy estimate will have on the Capitalised Lump Sum the basis of that estimate is clearly important. The Sub-Group considered that it was equally important for contracting parties to agree, at inception, on how the life expectancy estimate would be reached. Given that the capitalisation was an agreement between the reinsured and reinsurer, the approach adopted in the clause is based on the life expectancy estimate stated by the reinsured s expert during settlement of the claim. It should be noted that, before reaching agreement on the approach adopted by the clause, the Sub-Group noted that there were alternative approaches to the life expectancy element of the calculation which might be considered appropriate by contracting parties, including: 1. Unimpaired life expectancy; 2. An average of the claimant s life expectancy estimate and the defendant s life expectancy estimate (which reflects the reserving approach adopted by some insureds whereby, at least initially, the defendant s estimate is used by the insurer to calculate a reserve). 3. An estimate based on statistical tables It is intended that the words...expressed in number of years of life remaining at the Capitalisation Date, based on the estimate of the reinsured s medical expert or the agreed joint expert using all available medical evidence disclosed during settlement of the claim... will mean that any time that elapses between the settlement of the claim and the Capitalisation Date is subtracted from the life expectancy which was disclosed during settlement. 8. Section The words...intended date of the final Periodical Payment, or the life expectancy as calculated in 3.2., whichever is the shorter... were included to clarify that any element of a PPO which was to be paid after the claimant s death (e.g. future earnings for the benefit of dependants) would not be taken into account by the capitalisation calculation). It may be possible for reinsureds to ensure that any future earnings for the benefit of dependents is included as a lump sum award rather than as part of the periodical payments. 9. Section This section differs in the two published clauses to reflect the fact that there was no consensus among those involved in the drafting process (including reinsurance brokers and reinsureds) on the best approach to setting the discount rate (which represents an allowance for future investment income and future inflation) to be used when calculating the Capitalised Lump Sum. Clearly this is a crucial element

3 of the clause and contracting parties are advised to carefully consider the most appropriate method to be adopted IUA utilises a fixed discount rate. Contracting parties agree at inception the figure to used for all capitalisation calculations under the contract. This has the advantage of ensuring clarity at inception of the contract but does mean that the Capitalised Lump Sum may have been calculated using a discount rate which does not reflect the economic conditions at the time that the Capitalised Lump Sum is calculated IUA utilises a floating discount rate. This means that the discount rate used to calculate the Capitalised Lump Sum for any given claim will differ to reflect the prevailing bodily injury discount rate at the time that the Capitalised Lump Sum is calculated. This has the advantage that the methodology used will more closely reflect the economic conditions at the time the calculation is undertaken however it does introduce a level of uncertainty on the potential future value of a Capitalised Lump Sum Both of the above approaches have positives and negatives associated with them and it is for contracting parties to decide on the most appropriate in light of the many variables and the implications arising therefrom. 10. Section The Sub-Group included this section to ensure that the contracting parties are using the same model to calculate the Capitalised Lump Sum, so that there is a reduced possibility that the same inputs will lead to calculation of a different Capitalised Lump Sum by each party. This section suggests the use of the IUA Per Claimant Capitalisation Calculator, but also allows contracting parties to adopt any other tool for the purposes of calculating the Capitalised Lump Sum. 11. Section This section imposes a time limit within which the Capitalised Lump Sum must be agreed. This was considered sensible in order to avoid circumstances where a reinsured had to wait a significant length of time before they received the Capitalised Lump Sum. 12. Section 6 and Section 7 (Mediation / Arbitration) Despite the intention to remove the scope for disagreement, the Sub-Group acknowledged that contracting parties might be unable to find a consensus in respect of the Capitalised Lump Sum within the six month negotiation period (stipulated in Section 5). Therefore it was agreed that specific mediation provisions should be included in the clause Contracting parties should ensure that this mediation provision does not conflict with any mediation / arbitration provisions in the underlying treaty. For example, some reinsurance treaties may utilise ARIAS provisions as opposed to CEDR Contracting parties might decide that the mediation / arbitration provisions in the underlying treaty are sufficient in which case these sections can be removed. 13. Section The issue of statutory funding (whereby a portion of the claimant s costs are paid by a local authority, PCT or the NHS) is a relatively complex one, particularly given the fact that PPOs have been in existence for a relatively short period of time. The Sub-Group noted that, although the number of PPOs which include an element of statutory funding is relatively small (only 12% according to the 2011 IUA PPO Study), the value of such statutory funding can be significant. This could mean that a reinsured was not required to pay the full value of a PPO as a portion would be provided by the State. However, it

4 Section 9 was acknowledged that there was no guarantee that statutory funding which was available at the date the PPO was awarded would continue (either at the level originally set or at all) for the full term of the PPO. As a result it was agreed that the capitalisation clauses should include a section which allowed contracting parties to agree on what portion of statutory funding, if any, should be deducted from the Capitalised Lump Sum. The calculation of the total amount of statutory funding to be deducted is relatively straightforward and is based on multiplying the amount of statutory funding to be paid in the first year by a number of years (agreed by the contracting parties). This section acknowledges that, in some circumstances, the life expectancy of the claimant may be less than the number of years agreed by contracting parties at inception of the contract. In such circumstances the lesser figure is used for the purposes of the calculation. In the event that contracting parties agree that no statutory funding should be taken into account for the purposes of capitalisation, the [x] years in this section can be set to This section addresses the issue of any Variation Provision (as defined), whereby a PPO might include an agreement that, in the event a specific deterioration / improvement (the former being more common) in the claimant s condition occurs in the future, the level of periodical payments will be increased / decreased to reflect this change. Given that the probability of deterioration / improvement is an unknown factor the Sub-Group considered that the Capitalised Lump Sum should be calculated without reference to any Order for Variation 14. Section The intention behind the inclusion of this section is, as with Section 5, to impose a timeframe within which the Capitalised Lump Sum will be paid to a reinsured This section also includes a provision to ensure that, in the even the claimant dies before the Capitalised Lump Sum is paid to the reinsured, that Capitalised Lump Sum will not include future expected periodical payments but will only constitute the amount of periodical payments already paid to the claimant (i.e. any interim or pro-rata periodical payments). This is to ensure that it is clear to all parties that, where it is known (during the negotiation period) that the reinsured will have no further periodical payment liabilities, the reinsured only receive the value of payments already paid In the event that the claimant s death occurs during the negotiation period but is only confirmed to the reinsured after that date (most likely on receipt of proof of life at the first anniversary of the commencement of payment of the periodical payment), it is expected that the Capitalised Lump Sum paid to a reinsured (except for the element made up of periodical payments already paid) will be returned to reinsurer(s). Section The definition of Annualised Amount has been drafted to clarify that any pre-agreed increase or decrease in a periodical payment order (e.g. future step changes) should be included in the Capitalised Lump Sum calculation. Further, the definition is intended to incorporate any pre-agreed future provision for capital purchases. 15. Section The definition of the Capitalisation Date makes clear that this is the date on which the first full (i.e. not an interim or pro-rata) periodical payment is paid to the claimant. This is to ensure that, in circumstances where periodical payments are awarded or agreed sometime before they are to begin being paid (for example, where the claimant is a minor who will begin receipt of the periodical payments on their 18 th birthday), the Capitalised Lump Sum will be based on the value of the periodical payments

5 when they begin being paid and not the value on the date of award or agreement. Therefore any inflation in the periodical payments will be taken into account. 16. Section The definition of Capitalised Lump Sum includes the word all to further (in addition to Section 14) clarify that any provision for stepped increases agreed as part of the PPO will be included in the capitalisation calculation. Section This section clarifies that, in respect of the calculation provision in Section 8, only Statutory Funding for which the Reinsured is entitled to receive credit should be taken into account. This section also makes clear that, in circumstances where a third party (e.g. a claimant s carer) receives any Statutory Funding on behalf of the claimant, this should also be included in the Section 8 calculation. DISCLAIMER 17. The views expressed in this document and the accompanying model clause(s) / wording(s) are not to be regarded as either definitive or mandatory. All contract terms and conditions must be negotiated between the parties to a contract and IUA is not in any way either endorsing this commentary as the typical interpretation or suggesting that the model clause(s) / wording(s), or any part thereof, is typical in the London Market. Each party to a contract should reach its own view on the appropriateness of model clause(s) / wording(s) according to their own circumstances and may accept, disregard or modify the model clause(s) / wording(s). 18. This commentary represents the consensus views of the individuals (not their employer organisations) involved at the time of drafting the model clause(s) / wording(s). It does not form part of any model clause(s) / wording(s) and has been prepared in order to provide guidance on the understanding of the accompanying model clause(s) / wording(s) and a possible starting point for negotiating contract clause(s) / wording(s). 19. This commentary is not intended to be exhaustive or definitive and is subject to any views or interpretation by a Court, regulator or similar body. By including this commentary, IUA is not providing legal advice and IUA does not accept any responsibility for subsequent interpretation of the commentary or the accompanying model clause(s) / wording(s), or any part thereof. Any party considering adopting any of the model clause(s) / wording(s), or any part thereof, should seek their own legal advice for clarification of the use and intention of the model clause(s) / wording(s).