Valuation issues persist for PPOs

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1 Insights December 2015 Valuation issues persist for PPOs Periodical payment orders (PPOs) are now an established part of the UK motor insurance claims landscape; some insurers methods for reserving for them accurately, less so. Low interest rates, interpreting future earnings trends and the arrival of Solvency II are only complicating matters. Introduction In the six years after a pivotal appeal case (Thompstone v Tameside) in 2008, over 350 PPOs, whereby large claims are settled through inflation-linked annual payments rather than a single lump sum, were awarded in the UK for motor claims in excess of 1 million. Reserves held against PPOs awarded in the UK motor market stood between 1.5 billion and 2 billion in Even with a fall in PPO propensity, these figures will only grow as more awards are made. These are big numbers in their own right, but the major challenge for property and casualty (P&C) insurers is the duration of the liabilities and the implications for valuing them. Based on information from the Institute and Faculty of Actuaries (IFoA) PPO Working Party, for example, the average life expectancy from settlement of recipients of motorrelated PPO awards is nearly 44 years. Figure 01. PPO motor claims PPO propensity 45% 40% 35% 30% 25% 20% 15% 10% 5% Number of large claims (including PPOs) 0% Settlement year Exposure PPO propensity Source: Institute and Faculty of Actuaries PPO Working Party (2013 year-end survey)

2 Uncharted territory However, the extended duration of these liabilities, of the type normally associated with life insurance, is far from the only testing characteristic of PPOs. A key aspect of valuing PPOs is the discount rate applied to allow for investment returns above or below wage inflation over the lifetime of the liability. Interest rates that are at or near all-time lows are therefore an important factor. By their nature, PPOs are expensive and expose P&C insurers to new risks, such as the UK s generally increasing life expectancy, reinsurance bad debt, market risk and operational risk. Furthermore, valuing them for the purpose of reserve requirements is bedevilled by uncertain or imperfect assumptions. A key aspect of valuing PPOs is the discount rate applied to allow for investment returns above or below wage inflation over the lifetime of the liability. Interest rates that are at or near all-time lows are therefore an important factor. Most P&C insurers currently value PPOs using a real discount rate of between -1.5% and 1%, with recent research from the IFoA indicating a most commonly used rate of 0%. This rate is significantly lower than the currently prescribed Ogden discount rate of 2.5% that is used to value future costs for traditional lump sum settlements. Although Ogden has been under review since 2010, there does not appear to be a great deal of political will to drop it. The effect of this discrepancy is that an average PPO claim discounted at 0% costs around 5.5 million, whereas the comparable lump sum claim costs 4.1 million on an Ogden basis an increase of 35%. Calculating a company s PPO reserve Annual PPO payments + discount rate, including wage infl ation adjustment (based on ASHE Annual Survey of Hours and Earnings) + life expectancy of claimants + outstanding claims that may be settled as PPOs. 2 towerswatson.com

3 Figure 03. Measures of wage and earnings inflation 10% 8% 6% 4% 2% 0% -2% AWE Whole population Diesel Health and Social Care ASHE th percentile Source: IFoA PPO Working Party However, given that PPO liabilities are similar to those of life insurers, a scan of current life insurance market practice suggests that even a 0% discount rate may be somewhat optimistic. As of the second quarter of 2015, discount rates used by the four leading UK life insurers writing RPI linked annuities varied between -0.1% and -0.49%, and wages have grown 1.9% per year more than prices on average from 1960 to Wage infl ation Since the severity of injuries suffered by most PPO claimants generally requires long-term medical care, valuations include an allowance for wage infl ation based on the Annual Survey of Hours and Earnings (ASHE), which records wages paid to care assistants and home carers (historically under occupation code 6115, which has recently split into 6145 and 6146). The use of ASHE has always presented problems for motor insurers, due to the fact that it is a survey rather than an index, meaning that results can vary quite considerably from year to year, and due to the lack of investment products that are available to match asset holdings to it. Following the approach increasingly adopted by life insurers, recent experience has added fuel to the argument that a broader assessment of economic conditions, used in conjunction with the ASHE findings, might result in better earnings-adjusted valuations. The main limitations of ASHE are that it has a limited history and the data that has been available has been typically quite volatile in nature (see Figure 03). The logic, therefore, is that the lumpy average trends seen in ASHE 6115 make it advisable to base PPO projections on median trends for all workers, which are currently at a similar level to ASHE Even then, there are judgement calls to make. Notably, while there have been increases in real median wages in the UK in the past 25 or so years, they have remained virtually flat in the United States. So, insurers would still need to determine if they thought the future benefits of economic growth would be relatively evenly spread or be largely absorbed by high earners, as has occurred across the Atlantic. Following the approach increasingly adopted by life insurers, recent experience has added fuel to the argument that a broader assessment of economic conditions, used in conjunction with the ASHE findings, might result in better earnings-adjusted valuations. towerswatson.com 3

4 Valuation under Solvency II Regardless of how firms choose to interpret the relevant economic data in discounting future payments, however, Solvency II may soon take some of the elements of discretion out of their hands. That is principally because the yield curve for investment returns is prescribed by the European Union Directive. Based on this fixed yield curve and the most common assumption for inflation currently used in the market of 4%, this results in a negative real discount rate in excess of 2%. Referring back to our average PPO cost of 5.5 million based on a 0% discount rate, this negative rate would push the cost of the same PPO up to 8.2 million. While there are other remedies that can help reduce the liability, the reality is that it is likely to be difficult to justify a neutral real discount rate under Solvency II, thereby putting upward pressure on costs. The potential remedies principally consist of the matching adjustment (MA) and the volatility adjustment (VA). The MA allows an increase in the discount rate based on documented returns from a company s investment portfolio. In practice, however, while PPOs would be likely to meet the stringent liability eligibility requirements, the diffi culty of demonstrating a matching investment link to ASHE makes compliance onerous. As a result, few, if any, UK motor insurers currently plan to apply for the MA for their PPO liabilities to our knowledge. Regardless of how firms choose to interpret the relevant economic data in discounting future payments, however, Solvency II may soon take some of the elements of discretion out of their hands. 4 towerswatson.com

5 Some UK motor insurers are known, however, to be looking into using the more accessible VA. As with the MA, approval is required from the Prudential Regulation Authority (PRA), which has set out various criteria that it would expect insurers to fulfil: A written risk management policy accompanying the submission. A consideration of the liquidity of the liabilities relative to the assets under both normal and stressed circumstances. Avoidance of pro-cyclical investment behaviour. Comparison of the yield on the assets with the yield assumed in the discount rate (although this is not explicitly stated, we infer that this means the PRA would expect the asset yield to exceed the discount rate used). While some uncertainty remains about the eligibility of future PPO settlements for the VA, as opposed to PPOs in payment, it should be possible for most UK P&C insurers to meet these requirements. However, due to the current low level of credit spreads on bonds, and the current UK maximum VA of 20 basis points, the benefi t is likely to be quite small. We estimate the impact on technical provisions for PPOs to be around 3% to 5% over their full lifetime. Unfi nished business Despite the recent drop in awards as a proportion of large claims which may or may not continue PPOs are here to stay in the UK and will make up a signifi cant part of motor insurers liabilities in years to come. Many UK insurers are still finding their feet when it comes to refining approaches to valuing them for the benefit of all stakeholders. The current economic and regulatory environment is not making matters any easier. Certainly, the current level of interest rates and the implications for the discount rate used in valuing PPOs cannot afford to be ignored, particularly given current discounting practice among life insurers and the enforced strictures of the Solvency II yield curve. Many UK motor insurers could find themselves materially understating their PPO liabilities, both for reporting and regulatory purposes. Some respite from the requirements coming in with Solvency II in January 2016 may be available through permitted adjustments, primarily the VA. However, fi rms need to be conscious of the criteria for eligibility set down by the PRA. towerswatson.com 5

6 Finding ways to deal with the imperfections of the ASHE survey data may also need to be examined. Life insurers could again point the way to solutions with their growing tendency to look at valuing liabilities with reference to broader economic indicators. PPOs have provided a steep learning curve for most UK motor insurers, with no signs of any fl attening in the near future. Contacts For further information, contact your regular Towers Watson consultant or: Andy Staudt andy.staudt@towerswatson.com How can Towers Watson help? Towers Watson s actuarial and investment consultants have in-depth experience of the challenges of managing PPO liabilities and asset matching, and also contribute to research on PPOs through involvement in industry bodies, including the Institute and Faculty of Actuaries PPO Working Party. Estimating claims reserves, variability and the capital adequacy implications and getting them right is one of the keys to the success of an insurance company. Towers Watson is an established thought leader in reserving, providing advice and tools, such as our industry leading P&C reserving software, ResQ. Patrick Tingay patrick.tingay@towerswatson.com Rob Treen robert.treen@towerswatson.com PPOs have provided a steep learning curve for most UK motor insurers, with no signs of any flattening in the near future. 6 towerswatson.com

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8 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With 16,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at towerswatson.com Towers Watson 71 High Holborn London WC1V 6TP Towers Watson is represented in the UK by Towers Watson Limited. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, eu.unsubscribe@towerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2015 Towers Watson. All rights reserved. TW-EU December towerswatson.com /towerswatson