A2J. An Investigation into Cost Savings Arising from Proposed Government Reforms to Personal Injury Claims

Transcription

1 A2J An Investigation into Cost Savings Arising from Proposed Government Reforms to Personal Injury Claims 6 January

2 Contents Introduction and Executive Summary Executive Summary... 5 Background and Scope Scope... 7 Claims Costs Bodily Injury Cost... 8 Number of insured vehicles/drivers Future Increases in Numbers Accident Frequency Cost Savings Average Savings per Policy IPT rises Projected overall savings from loss in IPT revenue Savings per Car Investment returns PPOs and Ogden discount rate Impact of Solvency II Impact on Reinsurance Economy post Brexit Reserve releases by insurers Background Results Net effect to the consumer Motor Legal Expenses Insurance Other motor add-ons Profits generated by Insurers Legal Firms Motor market capacity Potential impact of pricing optimisation on the distribution of potential savings Impact on Whiplash Savings New Business and Renewal Savings Wide Range of Market Premiums Quoted for the Same Risk Appendix Glossary of definitions

3 10.2 Bodily Injury Claims Guidelines MOJ Impact Assessment Soft Tissue PSLA Damages - Option 1.1: Removal of PSLA compensation for all minor RTA related soft tissue injury claims with a duration of b) 9 months or less Legal Fees - Option 3: Raise the small claims limit to 5k (from 1k) for b) RTA claims only Comparison to Mazars estimates

4 Introduction and Executive Summary Mazars LLP has been appointed by Access to Justice ( A2J ) to provide an investigation of the true impact of the cost of personal injury claims and other factors on motor insurance premium pricing bearing in mind the proposed government reforms to personal injury mooted in Her Majesty s Government ( HMG ) said the following in their Spending Review and Autumn Statement 2015: Lower motor insurance costs The government is determined to crack down on the fraud and claims culture in motor insurance. Whiplash claims cost the country 2 billion a year, an average of 90 per motor insurance policy, which is out of all proportion to any genuine injury suffered. The government intends to introduce measures to end the right to cash compensation for minor whiplash injuries, and will consult on the details in the New Year. This will end the cycle in which responsible motorists pay higher premiums to cover false claims by others. It will remove over 1 billion from the cost of providing motor insurance and the government expects the insurance industry to pass an average saving of 40 to 50 per motor insurance policy on to consumers. The Ministry of Justice ( MoJ ) on the 17 th November 2016 (post instruction and scoping of this report) issued a consultation paper on Reforming the Soft Tissue Injury ( Whiplash ) Claims Process, which also maintains a saving now limited to 40 per insurance policy. Our intention is to provide a forensic calculation of the possible savings, compared to the range proposed by HMG, and our commentary is based on our interpretation of current rules, regulations and practice and a set of assumptions about the future. The assumptions, which are documented in subsequent sections of this report, must be understood in order to place our conclusions in their proper context. The future is very uncertain due to numerous factors that affect motor insurance pricing and it must be understood that the eventual outcome could differ materially from the figures presented here. In addition, our work is subject to inherent limitations. For example, we are relying on market statistics provided by the Association of British Insurers ( ABI ) amongst other market sources. These statistics are necessarily generic and high level, and their accuracy cannot be validated by us. This report is written in consideration of the principles of the relevant TASs including Technical Actuarial Standard R: Reporting Actuarial Information ( TAS R ), and the Insurance TAS issued by the Financial Reporting Council ( FRC ). As this is an investigation based on benchmarks and public data, we do not believe our work need to follow the TAS, however, we have followed the same principles wherever possible. It is important that the report is read in its entirety before any judgements are made on the comments contained herein. 4

5 This report, the opinions and conclusions, are for the sole use of the Senior Management of A2J but may be released to Third Parties subject to the written agreement of Mazars LLP. Third parties reading this report may not have access to the background information needed to understand it properly. 1.1 Executive Summary In Section 5 of this report, Mazars has estimated that the maximum amount of the potential savings of the proposed whiplash reform to an individual policyholder (for one vehicle year), excluding the behavioural impact, is a headline figure of 31 (mid). We have subsequently back tested this figure against the Impact Assessment released by the government in November 2016, we found that this figure is in line with the figure quoted in the Impact Assessment. The comparison is detailed in Appendix 10.3 of this report. Once the Figure of 31 is established, there are however some other elements of market costs which are reducing the cost savings: 1. Mazars has in addition estimated that, owing to the negative outlook for future investment return, the above savings may be offset by 3 (for one vehicle year). This is calculated from reductions in the net discount rate of PPO claims and Ogden discount for lump sum claims for the valuation of motor large losses. The calculation is detailed in section 7 of this report. This results in saving being reduced to 28 (mid). 2. In addition, for those insurers who have been generating profits from Alternative Business Structure ( ABS ), Mazars has estimated that the above savings may be offset by a further 1 to 3 (for one vehicle year). The calculation is detailed in section 9.2 of this report. For these insurers, this results in a further reduction in saving to 26 (mid). 3. Furthermore, for those insurers who have also underwritten the motor legal expenses insurance ( MLEI ), Mazars has estimated that the claims cost is likely to increase by 5.6 (for one vehicle year), excluding the behavioural impact. Hence, potentially for those insurers the above savings may be offset by a further 5.60, the calculation is detailed in section 9 of this report. For these insurers, this results in a saving of 20 (mid), assuming they also have ABS. 4. A2J has commissioned Capital Economics ( CE ) to review the Ministry of Justice s assumption that 85% of savings from the proposed reforms will be passed onto consumers. This work is ongoing and the final report will be published later this year, but CE have shared with us their analysis to date and interim findings. CE s analysis shows that the assumption of 85% cost pass-through is likely to overstate the benefit to consumers. They argue that the appropriate rate of pass-through for any cost increases is likely to be in the region of 50% to 70%. Meanwhile, they report that it is unlikely that any cost reductions, such as those that might result from the proposed reforms, would be passed on to the same degree. As a result, we have assumed 50% of savings from the proposed reforms will be passed onto consumers. This results in a saving of 10 (mid) to be passed on to customers. 5

6 The various impacts on the savings (mid) is illustrated in chart 1.1 below. Chart 1.1 When we analyse and extrapolate the figures calculated by the Office for Budget Responsibility to show the estimated reduction in IPT revenue to the Government, it appears they are expecting no more than 12 saving in year , which is again inconsistent with HMG s estimate of in the Autumn Statement Insurance premium pricing is driven to a large extent by claims costs, however also by other elements such as investment returns, reinsurance cost and market conditions including the influence of price aggregator websites. The impact of Periodic Payment Orders on investment strategies, reinsurance costs and reserving strategies under Solvency II may also affect insurers considerations in the pricing process, as will the increased cost of regulation implied by the new Solvency II regime, which was finally implemented from 1 January All these factors mitigate against and reduce insurers capacity to apply any savings in claims costs to their consumer pricing. The extent to which savings are passed on to the customers from the insurer (brokers) will also depend on the behaviour of insurers and customers as well as the capacity and level of competition in the market. Generally speaking, those customers who shop around are more likely to get a better deal than those who do not. Insurers always use some form of price optimisation to maximise revenue and profit from different market sectors, so applying or identifying an across the board reduction is in practice difficult. So, there can be no certainty whatsoever that all UK motor insurers will be able to achieve savings of 40 per policyholder and then pass this on to their policyholders. The impact of other motor add-on covers and reduced profits from insurer-owned legal firms are also relevant and discussed in Section 9 of this report. The PRA has suggested that insurers assumptions on claims inflation rate are low and claims reserves may need to be increased by up to 25%. This would also impact on insurers ability to pass on any savings on claims costs, as they would need to add to reserves for existing claims, however this element is impossible to quantify. In addition, analysis of four large UK insurers claims inflation, from publicly available records calls the PRA assumption into question. 6

7 Background and Scope In his autumn statement in 2015, the then Chancellor of the Exchequer, George Osborne announced that individuals making personal injury claims worth up to 5,000 would have to use the small claims court and cannot recoup the cost of any legal advice. In addition they would no longer be able to get any cash settlement for minor soft tissue injuries for pain and suffering caused, although they would be able to claim for physiotherapy and loss of earnings. HM Government asserted that the reduction in claims cost to insurers would be per policy, which insurers hopefully would pass on to the consumer as a premium saving. A2J wish to challenge and investigate the basis of the reforms and in particular the basis of calculation of the This figure of 40 to 50 was then downgraded to 40 in the Consultation document dated 17 th November The proposal was as follows 1 : The government will bring forward measures to reduce the excessive costs arising from unnecessary whiplash claims, and expects average savings of 40 to 50 per motor insurance policy to be passed onto customers, including by: removing the right to general damages for minor soft tissue injuries 2 removing legal costs by transferring personal injury claims of up to 5,000 to the small claims court (increased from 1,000) This legislation would come into effect in the tax year Scope The areas of research covered under the agreement between A2J and Mazars are detailed in the signed engagement dated 26 August Please note that the work was performed by Mazars during October 2016, prior to the release of the document entitled: Reforming the Soft Tissue Injury ( Whiplash ) Claims Process - A consultation on arrangements concerning personal injury claims in England and Wales November HM Treasury and The Rt Hon George Osborne MP (2015). Spending Review and Autumn Statement 2015, Section Claimants will still be entitled to claim for special damages, including treatment for any injury if required and any loss of earnings. 7

8 Millions Claims Costs 3.1 Bodily Injury Cost The chart below shows the movement in total bodily injury cost by calendar quarter of payment for the past three years. 3 Chart 3.1 Total BI Cost 1,400 1,200 1, Q Q Q Q Q Q Q Q Q Q Q Q4 Q1 Total BI Cost We can see that on average the bodily injury cost is approximately 900 million a quarter or between 3-4 billion a year. The costs display seasonality: the costs are higher in the Q1 than other quarters. The costs have decreased since the peak in 2013 Q4, however only marginally. The market consensus was that this reduction was owing to the impact of LASPO reform, the legislative changes throughout 2013: The implementation of a number of recommendations from Lord Justice Jackson s review of civil litigation costs, implemented via LASPO. The increase in general damages awards as a result of case law (Simmons vs. Castle). A number of changes in Civil Procedure Rules (CPR). The key components of these changes, which significantly affect recent accident years are as follows: Implemented on 1 April 2013 A ban on referral fees The removal of recoverability of success fees and after the event ( ATE ) premium A 10% uplift in general damages, implemented as a result of case law A new regime of qualified one-way-costs shifting ( QOCS ), implemented by CPR Implemented on 30 April 2013: A reduction in fixed legal costs in the portal, implemented by CPR. 3 Association of British Insurers (2016). Q Motor Insurance Claims. 8

9 Average Motor Premium Implemented on 31 July 2013: Vertical extension of the portal from 10k per claimant to 25k per claimant, implemented by CPR. The following graph shows the progression of Average Motor Premiums, as recorded by the ABI. It can be seen that, following a brief reduction after LASPO in 2013, premiums have continued to rise. The limited reduction in claims cost stemming from LASPO may have been responsible for a brief downturn in prices (equally it could have been driven by market forces). Chart Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr

10 Number of insured vehicles/drivers We considered the data for private motor from the ABI, for which the exposure measure is vehicle years, and data from the DVLA, for which the exposure is the number of cars in Great Britain. We have focussed on private cars as we have used market benchmark on private car throughout this report. The graph below displays the exposure (vehicle years) and number of cars (in thousands). Table 4.1 Year Vehicle Years (ABI) Cars 000 (DVLA) ,370 29, ,121 29, ,720 30,250 Both measures of exposure show the exposure increasing over the period. The ABI data may not reflect the whole of the UK motor insurance market as not all insurers may contribute. The DVLA data is more objective as it is independent of contribution of industry participants. Owing to this we have decided to use the DVLA data to estimate the future number of insured vehicles/drivers in Great Britain. 4.1 Future Increases in Numbers Data from the Department for Transport 4 suggests that there are 36.7m vehicles in Great Britain as at 2016 Q1, of which 30.5m are cars. Using a weighted-average of the increase in the number of cars in Q1 for 2014, 2015 and 2016 the annual increase was calculated to be 1.8% each year. The data was used as of Q1 as this is the last available data for each tax year. This annual change was used in order to calculate the number of cars in Q1 for subsequent years. This is shown in the table below. Table 4.2 Year Cars , , , , ,730 These assumptions have not considered any future disruptions to the number of cars, e.g. petrol price fluctuations, changes in insurance costs or disruptive motor technology such as driverless cars. 4 Department for Transport (2016). Vehicle Licensing Statistics: Quarter 2 (Apr Jun)

11 Accident Frequency The proportion of motor claims, which involve whiplash has been estimated using the TPWP slides, 5 which contain the claims per million policy years by bands of claims costs. The graph below displays the frequency of claims by cost bands for bodily injury claims. These figures are for 2013 as banded statistics and are not available on a market basis for subsequent years. Table k 1k - 10k 10k - 20k 20k - 50k 50k to 100 k 100 k - 250k 250 k - 500k 500 k - 1m 1m - 2m 2m to 5m > 5m Frequency exc zero claims (finishing in layer) per million policy years 788 7,899 1, Based on this, the estimated frequency of whiplash claims (claims between 1k-10k) was estimated to be 0.79% (i.e. 7,899/1,000,000). We acknowledge that the actual whiplash frequency may be lower than this figure, however, market data suggests the vast majority of the claims falling into this band are whiplash claims. 5.1 Cost Savings We have estimated the savings in general damages based on the Judicial College s Guidelines for the Assessment of General Damages in Personal Injury Cases 6. The low value for minor soft tissue injuries is estimated to be 2,050 (where a full recovery takes place between three months and a year), which we took to be the lowest possible saving. The high value for minor soft tissue injuries is estimated to be 3,630 (where a full recovery takes place within a period of about one to two years), which we took to be the highest possible saving. The average of the two values was selected as a midpoint estimate - 2,840 which is supported by CLR statistics which show an average whiplash claim to be valued in the region of 2,500. The estimates for legal cost savings were based on the update from the IFoA TPWP from January This suggests that the legal cost is 25% of the claims cost post LASPO 7. We use this proportion in deriving the range from 513 to 908 for legal costs. In addition, we have calculated the savings in claims handling costs to be 10% of the savings in general damage and legal costs. The estimates for the general damage, the legal savings and the claims handling costs per claim are displayed below. 5 Institute and Faculty of Actuaries (2015). Update from the Third Party Working Party, Slide Judicial College (2015). Guidelines for the Assessment of General Damages in Personal Injury Cases, 13 th Edition, Oxford University Press. 7 Institute and Faculty of Actuaries (2015). Update from the Third Party Working Party, Slide

12 Table 5.2 Low Mid High General Damage saving 2,050 2,840 3,630 Legal cost saving Claims handling saving Total 2,819 3,905 4, Average Savings per Policy Using the frequency of whiplash claims derived from table 5.1 (0.79%) and the assumed savings in legal and general damages costs shown in table 5.2 above we were able to estimate the savings by multiplying the two. This tells us the reduction in overall costs should none of the 7,899 claims per million policies shown in table 5.1 occur. We considered a low, middle and high scenario. The results are displayed in the graphics below. Table 5.3 Low Savings Mid Savings High Savings Market

13 Chart 5.4 Only under the highest savings scenario does the market level of savings approach the expected level of savings of 40-50, and the caveats in the following paragraphs apply. Due to limitations in available data, note that these figures are all calculated on a number of assumptions: a) that the proposed reforms would eliminate all whiplash claims b) that all claims in the band 1k-10k are whiplash c) that all general damages for soft tissue injuries are whiplash Accentuating this effect is the fact that, whilst it is assumed that all of the claims in the 1k-10k band are whiplash, it is possible some are for different injuries. 13

14 IPT rises 6.1 Projected overall savings from loss in IPT revenue George Osborne predicted that the legislative changes associated with the autumn 2015 budget would generate savings, which the government hoped would be passed on to the consumer by insurers in the form of lower premiums for motor insurance policies. Spending Review and Autumn Statement 2015: Policy Costings 8 describes that as a consequence of the lower premiums there will be a reduction in the Insurance Premium Tax (IPT) revenues. This will be effective from April 2017 if the proposal goes ahead. Using a tax base consisting of all motor insurance premiums that are currently covered by the standard rate of IPT, the Office for Budget Responsibility 9 ( OBR ) forecasted tax base growth annually until The forecast for IPT receipts until , as of November 2015, is shown in the table below. Table 6.1 billion IPT Receipts Forecast Insurance premium tax receipts are expected to rise by around 20% in and around 30% in , reflecting the July Budget measure to increase the standard rate of IPT to 9.5%. Note: Since the OBR forecast, the 2016 Summer Budget increased the rate to 10% from 1 October 2016 and the 2016 Autumn Statement announced a further increase to 12% effective 1 June These increases will not have been taken into account in the OBR forecast figures above. The loss in IPT revenues is then calculated by the OBR 10 by assessing the reduction in pre-tax prices for motor insurance policies, which is shown in the table below. Table 6.2 million Loss in IPT revenue HM Treasury and The Rt Hon George Osborne MP (2015). Spending Review and Autumn Statement 2015: policy costings, page Office for Budget Responsibility (2015). Economic and Fiscal Outlook. 10 Office for Budget Responsibility (2015). Economic and Fiscal Outlook. 14

15 Table 6.2 shows that IPT receipts have been reduced by around 50 million a year on average to account for the reform designed to reduce the cost of certain forms of road traffic personal injury claims. The rationale is that individual premiums will reduce as insurers pass on savings, thus the total revenue base (of which IPT is a percentage) will reduce relative to what was originally projected. Furthermore the reduction in IPT receipts has been adjusted to account for a behavioural response where customers increase the quality of motor insurance they purchase in light of lower post-tax prices. 11 Without this assumption the loss in IPT revenue would be larger; the OBR does caveat that there is uncertainty around the behavioural assumptions 12. We will discuss the points raised i.e. the increase the quality of motor insurance customers purchase and the customer behavioural assumptions in the subsequent sections of this report. By grossing the loss of IPT revenue by the IPT rate of 10% (given the IPT will rise from 9.5% on 1 October ), the expected savings in premium per year are as follows: Table 6.3 Year Loss in IPT revenue ( millions) Premium Saving ( millions) However it is important to note that if the behavioural assumptions didn t hold to the extent that the OBR has assumed, the loss in IPT revenue would be larger and the savings therefore would increase. 6.2 Savings per Car With the projected values of the number of cars from section 5.1, the saving per car could be determined by dividing the saving per year (Table 6.3) by the number of cars in that year (Table 4.2): Table 6.4 Year Premium Saving ( m) Number of Cars (000s) Saving per car , , , The total saving in insurer premium per car expected by the OBR for each year is substantially lower than the saving per car suggested in the budget statement. The total saving per car might 11 HM Treasury and The Rt Hon George Osborne MP (2015). Spending Review and Autumn Statement 2015: policy costings, page HM Treasury and The Rt Hon George Osborne MP (2015). Spending Review and Autumn Statement 2015: policy costings, page HM Revenue & Customs (2016) Changes to Insurance Premium Tax: increase to the standard rate. 15

16 increase if the assumption about behavioural response was removed, however the effect of this assumption is not quantified in the calculations for loss of IPT revenue. In order to reach a total saving of at least 40 per year per car, the loss in IPT revenue (millions) would have to be the following for each of the years above: Table 6.5 Loss in IPT revenue Year (millions)

17 Investment returns 7.1 PPOs and Ogden discount rate Periodic payment orders ( PPOs ) are a form of compensation awarded by the courts to settle injury claims in the UK. The compensation is payable to the claimant as a payment stream (plus lump sum element of the total claim) as opposed to a single lump sum payment. PPOs are an increasing concern for general insurance companies, in particular motor insurers, as it has a significant impact on reserving, pricing and the amount and cost of capital that an insurer or reinsurer needs to manage the long term nature of the exposure. The long-tailed nature of PPOs increases the uncertainty in the ultimate cost of claims and supporting capital. The risks transferred to the insurer (or reinsurer) include mortality, changes in medical condition, inflation and investment under a PPO arrangement. The term of the payment schedule will depend on the longevity of the claimant resulting in mortality risk being transferred. The increase in investment and inflation risk is driven by the earnings index which the PPO cashflows are indexed against, which is predominately ASHE inflation rather than RPI. Earnings inflation is usually above RPI and it is difficult to match with investments. Therefore the discount rate will be a key variable when reserving. The final consideration in the risks associated with PPOs will be the availability of reinsurance to mitigate the risks associated with PPO settlements. From research carried out by the IFoA PPO working party update in April , there is increasing concern in the market regarding the increasing number of PPOs, fall in investment returns, impact of Solvency II on the valuation of PPOs and the long tailed nature of PPOs Impact of Solvency II The challenges faced by general insurers due to the long term nature of PPOs is increased further by Solvency II. 15 Solvency II regulations require the use of cashflow modelling and the calculation of capital requirement. Insurers who were previously reserving PPO liabilities in line with the Ogden tables need to refine their modelling of cashflows to comply with the requirements and ensure they hold adequate regulatory capital. The capital requirement ensures the company is able to meet their liabilities as they fall due with a level of confidence of 99.5%. The total capital requirement will be impacted by the increased exposure to market risk and underwriting risk. Market risk arises due to the uncertainty in long term investments to match the long term nature of PPOs. The underwriting risk component is based on policies that are yet to be written and is increased as there is uncertainty surrounding the longevity of claimants as this impacts the length of time PPO payments are made. A further consideration is the inflation risk, as this will need to reflect the inflation in care costs to reflect the ASHE index. Further consideration is required in respect of a Solvency II concept known as the risk margin. The risk margin is an additional capital requirement to reflect the cost of capital to back the very long term liabilities. The risk margin is derived from the solvency capital requirement. Therefore PPO 14 Institute and Faculty of Actuaries (2016). PPOs What s the market doing? 15 Baxter Bruce (2016). PPOs Post Solvency II: From Bad to Worse 17

18 liabilities increase the size and volatility of the risk margin due to their long term nature, increased underwriting risk and the current low interest rates Impact on Reinsurance The increased uncertainty from PPOs on general insurance companies, also causes concern and challenges for reinsurance companies. The cost of motor reinsurance coverage has increased since the emergence of PPOs. 16 This cost is then passed on to motor policyholders. Further problems result from the indexation clause on excess of loss reinsurance, whereby the reinsurance retention is indexed to the index of the PPO arrangement. This delays the reinsurance recovery further into the future. Therefore a significant degree of inflation risk can remain with the insurance company. In some cases, reinsurers have implemented new capitalisation clauses, which allow them to pay the insurer a lump sum to cover the costs of a PPO. This removes the reinsurance credit risk, but the longevity, inflation and investment risks associated with PPOs are transferred back to the insurance company. These additional risks and possible lack of adequate reinsurance may be reflected in the pricing of the motor policies and the additional costs will be passed onto the policyholder. This will reduce the amount of savings possible arising from other areas such as claims reforms, although it is difficult to quantify the impact at this stage due to the uncertainty surrounding PPOs in general Economy post Brexit The United Kingdom voted to leave the European Union on 23 June ( Brexit ) led to high volatility in financial markets and a marked rise in news-based measures of uncertainty. While markets have since stabilised, sterling has depreciated by around 10% in trade-weighted terms since the referendum. For 2016, GDP growth has been supported by a strong performance prior to the referendum, even though business investment contracted. Developments to date are broadly consistent with the more moderate scenarios set out prior to the referendum and reflect prompt action by the Bank of England in August. However, GDP growth is projected to slow to 1% in 2017, well below the pace in recent years and forecasts prior to the referendum. Uncertainty about the future path of policy and the reaction of the economy remains very high and risks remain to the downside. In the longer term, the UK s future trading arrangement with the EU and other partners will be critical to its economic prospects 17. Therefore, Brexit has a negative impact on the future investment return that may be used to discount the PPO liabilities. Furthermore, the Ogden discount may be reduced downward from the 2.5%. Focusing on the investment return and inflation rates used for discounting, we calculated how the value of an average PPO payment varies by changing the discount rate. From the IFoA PPO working party update in April 2016, the real discount rates (i.e. the real investment return above the ASHE index) used by insurers and reinsurers varied from -1.5% to 1% over 2014 and The real discount 16 Miller Insurance Services LLP Reinsurance Insights: The rise in Periodical Payment Orders 17 Kierzenkowski et al (2016), "The Economic Consequences of Brexit: A Taxing Decision" OECD Economic Policy Paper No. 16, April, OECD Publishing, Paris. 18

19 rates are used for valuation of PPO liabilities for (re)insurers accounts under the IFRS or local GAAP basis. The graph 18 below shows the real discount rates used by various insurance companies in the market. Graph 7.1 The table below shows the average PPO arrangement from the GIRO Working Party PPO 19 report Table 7.2 Age at settlement 36 Life expectancy 41 Annual PPO payment 83,046 Lump sum payment 1,808,397 The following table shows how the total gross liability value for the average PPO arrangement varies with different real discount rates. These values are calculated based on the ASHE and Average Weekly Earnings (AWE) indices, both fixed at 2.5% from 2016 onwards. The valuation is based on the assumptions that the year the PPO award commences in 2016 and the lump sum of 1.8m is paid in Institute and Faculty of Actuaries (2016). PPOs What s the market doing? 19 Institute and Faculty of Actuaries (2010). Update from the Third Party Working Party. 19

20 Table 7.3 The Real Discount Rate Total Gross PPO valuation -1.50% 5.2m -1.00% 4.9m -0.50% 4.6m 0.00% 4.3m 0.50% 4.1m 1.00% 3.9m 1.50% 3.7m 2.00% 3.6m 2.50% 3.4m The table above shows by reducing the real discount rate from 2.5% to 0%, the total gross valuation increases by approximately 27%. The uplift is equivalent to reserving large losses from the lump sum Ogden basis with real discount rate of 2.5% to the PPO basis with real discount rate of 0% (graph 7.1 shows that the majority of the (re)insurers use 0% real discount rate). Also, the table above shows by reducing the real discount rate from 0% to -1.5%, the total gross valuation increases by approximately 21%. Therefore, a low future investment return post Brexit is likely to increase the total reserves motor insurers have to hold for the known and future PPO claims. Similarly, by reducing the Ogden rate from 2.5% to 1.5%, the total gross valuation increases by approximately 9%. Table 7.4 shows that the burning cost for PPO may increase by 0.7 if the market uses a -1.5% real discount rate, instead of 0% real discount rate. Furthermore, the burning cost of large losses (lump sum basis) may increase by 2.4, if the Ogden discount rate is reduced from 2.5% to 1.5% (based on our wider market knowledge, the reduction in Ogden discount rate is likely to be 1%). The combined effect on burning cost is 3.1. We have estimated this cost using the market statistics from the TPWP report and the PPO working party report. 20

21 Table 7.4 Basis Component 1m-2m 2m-5m >5m Total Burning Cost for Large Losses Ogden Lump Sum Basis (2.5%) Propensity of Large Losses to become PPOs 10% 41% 74% Large Loss Burning Cost Relating to PPOs % Real Discount Rate -1.5% Real Discount Rate Increase in PPO Burning Cost (%) Increase in PPO Burning Cost (Absolute) Increase in PPO Burning Cost (%) Increase in PPO Burning Cost (Absolute) 27% 27% 27% % 21% 21% Basis Component 1m-2m 2m-5m >5m Total Ogden Lump Sum Basis (2.5%) Burning Cost for Large Losses Increase in Large Loss (non-ppo) Burning Cost (%) 9% 9% 9% Ogden Lump Sum Basis (1.5%) Increase in Large Loss (non-ppo) Burning Cost (Absolute) Total Increase in Burning Cost

22 Reserve releases by insurers 8.1 Background The Prudential Regulation Authority (PRA) issued a letter to insurance CEOs on 18 July 2016 outlining their recent analysis and observations regarding industry reserving and pricing trends 20. The regulator highlighted their current concerns on both of these topics and the fact that this type of analysis will be used as part of their individual firm supervision going forward. In the past the profits announced by insurers have been supported by reserve releases from previous underwriting years; if this trend continues then it will impact the ability of insurers to pass on potential savings. The letter details a number of key observations of which the accurate measuring, monitoring and projecting of calendar year trends (e.g. inflation) is a consistent theme: Calendar year inflation is poorly understood and insurers may not be giving the risk of future inflation enough consideration. Calendar year inflation, and changes in inflation, is different for each company. Calendar year inflation in historical data was estimated and compared to implied future inflation assumptions in an insurer s booked reserves. One of the most striking examples in the PRA letter demonstrates a way of assessing an insurer s reserve adequacy by comparing the historic rate of claims inflation with the implicit future rate, where the latter is found by working backwards from the posted reserves. An extract from page 6 of the letter: In several cases, our estimate of implied future claims inflation was lower than that implied by the claims inflation inherent in the historic data. In an extreme case, as illustrated graph 8.1, we estimate the historic claims inflation to be 5% per annum, whereas to obtain the insurer s booked reserves would imply a claims inflation assumption of -2%. For this particular class, this would suggest that if the future trend is in fact in line with past inflation, booked reserves would need to be 25% higher than currently assumed. Graph 8.1 below illustrates this. Graph Prudential Regulation Authority (2016). Analysis and observations from regulatory returns and monitoringthe-market questionnaire. 22

23 Logarithmic Scale Logarithmic Scale If the PRA s assertion were accurate, the need for insurers to divert profits to bolster reserves on existing claims would further challenge their ability to reduce premiums and achieve savings in the cost of insurance for consumers. 8.2 Results Publically available data from the PRA returns of four large UK motor insurers were investigated to calculate their historic implied inflation and assumed future inflation suggested by their posted (i.e. booked) reserves. The results are shown on the below graphs. Graph 8.2 Inflation Analysis - Insurer A Required to get Firm's Reserves Observed in Data Graph 8.2 shows that historic past burning cost inflation stays constant at approximately 0% between 2005 and 2008, increasing slightly until 2013 where inflation then follows a decreasing trend for future years. Burning cost inflation is affected by change in claims frequency, severity and business mix of the insurer. This insurer was known to have de-risked the portfolio following the economic recession, leading to the negative calendar year inflation. However, the assumed future inflation for Insurer A is largely positive. Graph 8.3 Inflation Analysis - Insurer B Required to get Firm's Reserves Observed in Data 23

24 Logarithmic Scale Logarithmic Scale Graph 8.3 shows that implied past burning cost inflation stays constant at approximately 0% until 2010 where it then increases linearly for future years. The assumed future inflation for Insurer B is in excess of the estimated future inflation. As other insurers de-risked, due to the recession, Insurer B increased their exposure to the market, this may have led to an increase in calendar year inflation, owing to the change in the business mix of the growing book. Graph 8.4 Inflation Analysis - Insurer C Required to get Firm's Reserves Observed in Data Graph 8.4 shows that implied past burning cost inflation stays constant at 0% until 2008, where it decreases until 2009 and then remains constant at 0% again for future years. The drop in calendar year inflation is related to the insurer s de-risking. The assumed future inflation for Insurer C is positive. Graph 8.5 Inflation Analysis - Insurer D Required to get Firm's Reserves Observed in Data 24

25 Graph 8.5 shows that implied past burning cost inflation stays constant at 0% until 2008 then increases until 2013 with periods of positive inflation and 0% inflation. Insurer s calendar year inflation has increased due to increased exposure to the market, as other insurers have de-risked. Inflation then remains constant at 0% for future years. The assumed future inflation for Insurer D is positive. The results of the graphs differ in comparison to Graph 8.1 since the data used represents motor insurance claims. The assumed future inflation trends by the insurers are high, which is likely to be due to, amongst other things, allowance for an increase in the number of future PPOs being settled. We have discussed the uncertainty and challenges surrounding the ultimate cost of PPOs claims in the previous section. The results show that the assumed future inflation is positive for all of the investigated insurers. This suggests that each of the insurers investigated seem to have made a reasonable assumption for future calendar year inflation, albeit, there is a wide range amongst the 4 insurers. As a result, it seems that there should be no immediate reserving issue preventing the four insurers to pass on any savings generated from the proposed whiplash claims legislation. 25

26 Net effect to the consumer The purpose of the proposed reform is to tackle the alleged compensation culture within motor insurance claims. However, others might argue that the claimants are just exercising their legal rights and reducing the level of legal assistance they can receive will impact severely on their ability to exercise their legal rights. As a result of the proposed government reforms stated in the autumn statement in 2015, and the November 2016 Consultation, vehicle occupants who make a personal injury claim may no longer receive any compensation for general damages valued at less than 5000, as this is now only one option; the government may designate a fixed amount or a fixed amount then a tariff based system - both of the latter options will have a negative impact on the suggested savings of per policy. As only circa 1% to 2% of motor policies have bodily injury claims 21, this impacts these claimants only. However, HMG suggests that on average the effect of the proposed reforms is that all consumers will save on their motor insurance premiums; this saving affects all motor policies, which is a much larger population. We believe the impact of the proposed whiplash claims legislation across the whole economy (as opposed to the UK motor insurance industry) is not significant, however, its impact across different sectors and geographical regions of the economy is likely to be different. 9.1 Motor Legal Expenses Insurance Motor Legal Expenses Insurance (MLEI), also known as legal cover, is an additional option offered to consumers when purchasing motor insurance. MLEI operates to allow the policyholder to pursue their legal rights to recover uninsured losses when they are not at fault for a motor accident. In a report by the Financial Conduct Authority (FCA) 22 it was concluded that consumers have little understanding of what MLEI does, i.e. what cover they receive under their standard motor policy and what additional cover MLEI provides. Consequently the FCA recommended that firms should provide customers with better explanations of MLEI. The typical price for MLEI ranges from for different insurers 23. MLEI is commonly sold on an opt-out basis (58%) or an opt-in basis (18%) as opposed to being included in the core policy (24%), which discourages consumers from purchasing it 24. Given the lack of understanding and current marketing of MLEI, it is unclear whether consumers will use their savings in motor insurance costs from the proposed reforms to purchase MLEI. However, insurers may aim to recoup some of the losses in premium revenue by reviewing/increasing premium levels and pushing the marketing of MLEI and other motor add-ons more in future. If more MLEI is sold, this will mitigate against the net effect to the consumer of any savings in premium arising from the proposed reforms. Whilst defendant insurers will save the cost of whiplash claims, including the legal cost element, some insurers who have also underwritten MLEI and will therefore face paying for legal costs for their insured as a claimant in the event of the same bodily injury claim. To try and calculate the impact on overall claims cost saving Mazars has estimated that the cost of such claims is on average 5.6. The table below shows the breakdown of the estimate. The estimate is calculated as the legal cost savings 21 Institute and Faculty of Actuaries (2015). Update from the Third Party Working Party, Slide Financial Conduct Authority (2013) Motor Legal Expenses Insurance (MLEI) Report on the thematic project. 23 Competition and Markets Authority (2013). Private Motor Insurance Market Investigation. 24 FCA Thematic Review on MLEI June 2013, Page 15 26

27 of 710 (from our mid scenario detailed in section 5) multiply by the whiplash claims frequency of 0.79%. The total cost is estimated as the burning cost of 5.6 multiplied by the total vehicle (car) for 2015 of 30.25m. Table 9.1 Legal Cost saving Claims Freq / Number relevant for whiplash claims Implied burning cost Total Cost ( m) Third Party Working Party 2013 (from the 2015 report) % Other motor add-ons In addition to MLEI there are additional motor add-ons, including protection for the no-claims bonus, personal injury cover (raises the level of cover from the basic level), breakdown cover, courtesy car and hire car, lost/stolen keys, uninsured driver protection and wrong fuel cover. The table below contains some typical prices for different motor insurance add-ons. The prices for the following addons were not estimable as they are not shown on price comparison websites: key loss cover, extended foreign use cover and enhanced courtesy car cover (provides the consumer with a like-forlike replacement car or a replacement car of a superior quality than the standard). Table 9.2 Motor Insurance Add-ons 25 Typical Price ( ) MLEI Breakdown cover Courtesy car cover Personal accident cover No claims bonus protection Driver Specific Buying one or more of the motor insurance add-ons could lead to the potential saving of the proposed whiplash legislation being absorbed in the motor insurance premium as discussed in the behavioural response. 25 Competition and Markets Authority (2013). Private Motor Insurance Market Investigation. 27

28 9.2 Profits generated by Insurers Legal Firms While the LASPO Act banned personal injury referral fees, the insurers have created an alternative way to achieve the same business goal. Alternative Business Structures (ABS) are regulated organisations providing legal services that have some form of non-lawyer involvements (referred to in the press as Tesco Law ). The first ABS was licensed in March The aim of ABSs was to give consumers more choice and hopefully allow them to benefit from reduced prices, better access to justice and improved levels of service and greater convenience. From March ABS were registered. This includes a number of participants in the insurance industry such as Admiral, DLG, Ageas, Allianz, Saga, the AA and BGL. ABSs allow insurance companies, brokers and accident management companies to, in effect, refer claimants to their own law firms and generate revenue from providing legal services rather than receiving a referral fee from a third party solicitor as they did before LASPO 26. If the proposed changes to legislation went through this would result in a loss of earnings for these firms. We considered the profits of two insurers which were generated by these firms to consider the impact. The legal operating income and vehicle years are displayed in the table below. Table 9.3 Insurer Legal Operating Income ( m) Vehicle year ( 000s) Burning cost ( ) , , The burning cost is calculated as the legal operating income divided by the exposure (vehicle years). This is a crude measure as it is difficult to estimate the proportion of the legal costs relating to minor injuries. However this does indicate that if the legal operating income was reduced by the changes in legislation, that this would reduce the profit levels (and therefore funds available to return to the consumer as a saving) of those insurers who have ABS. 9.3 Motor market capacity On 28 July 2016 the Financial Services Compensation Schemes ( FSCS ) has declared Enterprise Insurance Company PLC in default, and is working closely with the liquidator, Grant Thornton, and the Financial Services Commission in Gibraltar, where Enterprise is based, to establish the best way to help its policyholders. Enterprise is permitted to conduct business in the UK. This above is an example that from time to time motor insurers do fail and as they withdraw from the market, the supply of motor insurance in the market is reduced, which is likely to result in higher market premium for customers. Capacity can be an important driver in movements in the cost of motor insurance. The larger the number of insurers then generally the lower the cost of the product that they are offering. As investors look to obtain investment returns in a low interest rate environment, insurance or 26 Institute and Faculty of Actuaries (2015). Update from the Third Party Working Party, Slide

29 reinsurance can be seen as an opportunity to obtain higher returns than for example corporate bonds or gilts. In theory the more capital that is available to insurers then the cheaper that capital should be. On the other hand in times when capital is in short supply and is expensive then there can be an upward impact on insurance premiums. Insurance events external to the motor industry can also potentially impact premiums. Catastrophic losses can reduce the health of reinsurer balance sheets. Asbestos is an example of a major insurance loss to the insurance and reinsurance industry. Such events can force insurance and reinsurance premiums to rise across not only the originating class of business, but also other classes that form part of the portfolio. 9.4 Potential impact of pricing optimisation on the distribution of potential savings Price optimisation is the use of mathematical analysis by a company to determine how customers will respond to different prices for its products and services through different channels or by different segments. It is also used to determine the prices that the company determines will best meet its objectives such as maximising operating profit or sales volume. Price optimisation practice has been implemented in industries including retail, banking, airlines, casinos, hotels, car rental, cruise lines and insurance industries. A survey done in 2010 made the following observations: Price optimisation techniques are extremely widespread and are embedded in BAU ( business as usual ) pricing for the vast majority of major directs and panel intermediaries; Pricing management are generally fully conversant with optimisation concepts and the role of optimisation in Key Performance Indicator targeting; Any material systems and data issues constraining initial implementations have generally been overcome; Cultural and TCF (treating the customer fairly) inhibitions have typically been overcome and resolved 27 Pricing optimisation for motor insurance requires the estimation of price elasticity: The price offered may vary away from standard rates on a random basis, for example, 40% of the quotes may be on the standard rates, 30% of the quotes may be on the standard rates +5%, and the remaining 30% of the quotes may be on the standard rates -5%. The price test samples above enable the motor insurers to estimate price elasticity for different segment of customers. Use of competitiveness measures, such as the average top 5 quotes from PCWs, alongside price tests enhances elasticity predictions Impact on Whiplash Savings Motor insurers are able to carry out pricing optimisation by taking into account the fact that different customers have different losses and react differently to price variations. 27 The Actuarial Profession (2010). GIRO conference and exhibition 2010 Price Optimisation