Joe Monk and Sally Horrocks consider the implications of the UK's newly introduced Courts Act
The Courts Act 2003 came in to force on 1 April 2005, giving judges the power to impose periodical payments as a settlement in personal injury claims rather than the traditional lump sum award, even if neither claimant nor defendant requests them.
For reinsurers, lump sum awards are straightforward with a one-off payment for the value of the claim above the excess point. Periodical payments are rather more complex to handle, particularly with indexed deductibles.
This change in legislation arises from the government's aim of social responsibility. Under a lump sum award it is the claimant who takes on both the investment and mortality risk. These risks are far better handled by the insurer giving the claimant a regular income to match their outgoing costs.
This is the fundamental reason behind the introduction of periodical payments and this will be uppermost in judges' minds when they impose this type of award. The difficulties for re/insurers are significant in these cases but this is unlikely to influence the judges in their decision-making process.
The act is fully retrospective, which means that all claims currently outstanding with an element for future cost of care could settle with a periodical payment. Claims attaching to reinsurance policies from many years ago may also be affected. The wording on these policies may not have been written with periodical awards in mind. Therefore, it is important that re/insurers agree how to handle these claims as soon as possible.
This article outlines the implications of periodical payments with indexed deductibles, the decisions that must be made by all reinsurers and the mortality and investment risks that the insurance industry will soon be taking on.
Periodical payments will increase on an annual basis linked to Retail Price Index (RPI) in "the great majority of cases" according the explanatory notes for the Courts Act. Claimant lawyers have argued in the past that payments should be linked to the cost of care and no doubt will do so in the future. However, in the case Cooke v United Bristol Healthcare in October 2003 the court rejected such arguments as undermining the discount rate as set by the UK Lord Chancellor's department.
It would be a major change to have personal injury awards increasing at cost of care inflation. Given the major impact this would have for both the insurance industry and the National Health Service this would need approval by the Lord Chancellor and the Department of Constitutional Affairs. While this may happen, it does not seem likely in the near future.
The International Underwriting Association (IUA) is performing a great deal of work to ensure that policy wordings are suitable for periodical payments, in particular for the indexation clauses.
Indexation clauses are complex and require technical calculations to be performed. The rate of increase in the deductible is a weighted average of the bodily injury and non-bodily injury elements of the award and needs to be re-calculated every time a payment is made.
The key element to note is that after the point of settlement the deductible does not increase with RPI, but at a lower rate. This means that for each periodical payment the reinsurer pays a greater percentage as time goes on. This is shown in the graph on the following page.
Reinsurers have three options following the award of a periodical payment:
- Reinsurers pay their proportion of each payment until the claimant dies
- Commute with the insurer by valuing the expected future reinsurance payments
- Take on the insurer's liabilities in return for a commutation payment.
The first of these options is simply to pay the portion of each payment and hold the future liabilities on the balance sheet. This would lead to reinsurers having a liability in respect of these claims for many years to come.
This approach would mean that the reinsurer would take on most of the mortality risk. As soon as the cumulative claim payments reach the deductible they would make the majority of each future payment. There are advantages and disadvantages to taking on the mortality risk which are discussed later in this article.
For reinsurers there is an issue with regards to the increase in the administration of handling these claims. For each payment that is made to the claimant, the deductible needs to be recalculated to allow for the latest RPI and a payment made to the insurer. Where there would have been one payment to the insurer for a lump sum award, periodical payments will be made quarterly for as long as the claimant lives.
This is likely to be the option favoured by most reinsurers. It removes the liabilities from the balance sheet and in the absence of reviewability (variation orders) is a full and final settlement.
However, the basis on which a commutation is calculated is not as straightforward as it may seem.
Current market thinking is that commutations will be performed using the Ogden tables, with the discount rate as stated by the Department of Constitutional Affairs. This is currently set at a real rate of 2.5% pa.
It may be the case that neither of these assumptions is appropriate. Ogden table mortality may not be suitable for individuals with catastrophic injuries. Discount rates should be linked to the actual investment returns on assets and it would be an unusual insurer who achieves a real investment return of 2.5% pa on suitably safe assets in the current market.
Negotiations on both the assumed mortality table and the discount rate to be used in a commutation may be time consuming. For claims on historic reinsurance bordereaux it is unlikely that such an explicit commutation clause exists to cover these cases.
The mortality risk and investment risk are key issues here and are both discussed further on in this article.
Reinsurer takes on the insurer's liabilities for a suitable commutation
This is the third potential option for reinsurers and one which most would probably dismiss out of hand. However, there may be circumstances where this is the logical option to take.
First, for these claims it is the reinsurer that has the bulk of the mortality risk and therefore the commutation valuation for the insurer's portion of the liability is far less sensitive to the assumptions applied.
Secondly, reinsurers are likely to have more periodical payment settlements than the smaller insurers. Predicting the life expectancy of an individual is far more difficult than predicting the average life expectancy of 10 lives. The variability of the mortality risk is much reduced when more lives are covered.
Thirdly, reinsurers operating in European markets and those with life business may be more able to take on these risks than, say, a UK-based direct motor insurer.
There are benefits of taking on the mortality risk and the above factors may mean that some reinsurers are in a better position than the cedant to take on the liability.
Along with this, a reinsurer with several lives on its books is in a better position to set up the administration systems to pay claimants compared with a small insurer with only one life. There is an issue with regards to settlement in court where the reinsurer takes the place of the insurer, but given how active reinsurers are intending to be in these claims this may be resolvable.
Lump sum settlements in court are theoretically calculated using the Ogden tables with a real discount rate of 2.5% pa. However, this does not bind the insurer and reinsurer to commute on the same basis, even if early indications are that these would be the chosen assumptions.
There are two aspects to consider; the mortality risk and the investment risk.
Mortality risk - The mortality rates applied in court are taken from the Ogden tables. These are produced by the government actuary's department (GAD) and are based on national census data. Crucially, these allow for future improvements in mortality. Over the past 100 years mortality has improved from generation to generation. There have been particularly large improvements from the generation born in the inter-war period. This generation had a healthy diet and gave up smoking, both of which have very positive effects on longevity.
There are two issues arising from this. First, is it appropriate to project these historic mortality improvements into the future? Secondly, are the mortality tables based on the whole population appropriate for bodily injury claimants?
On the first point there are many arguments and counter-arguments, but one only has to watch Jamie Oliver's School Dinners to realise that the diet of the current generation of children is not as healthy as the generation before it. The so-called "obesity epidemic" is well documented and diet is one of the main factors affecting longevity.
Secondly, the Ogden mortality tables are based on the population as a whole. We would suggest that those with catastrophic injuries have reduced life expectancy. For example, an individual with significantly impaired mobility is unlikely to get as much exercise as one with no impairment, which would have a knock-on effect on life expectancy.
Whilst there is understandably a lack of data to demonstrate this potential effect, it is one which should be considered.
These two issues mean that future mortality rates should not be taken blindly from the Ogden tables and that there may be potential gains from taking on the mortality risk if commutations were made on the Ogden table basis.
Investment risk and the discount rate - The discount rate applied by the courts is set by the Lord Chancellor. This is based on the real rate of return achieved on index linked gilts after tax. The prevalent rate of 2.5% pa is far greater than the return which would currently be achieved on index-linked gilts which is about 1.75% pa before tax.
By reducing the discount rate, the present value of the periodical payments increases. This in turn increases the commutation valuation.
There are a number of considerations to be made in selecting the discount rate to apply in a commutation. The most important of these is which assets should back the liabilities. Index-linked gilts are expensive and, currently, do not have long enough terms to match these liabilities, which may last for many decades. Ultimately, the assets held must be approved by the Financial Services Authority. It is interesting to note that the range of acceptable assets is much narrower for a life office than for a general insurer.
From the investment point of view, the standard court assumption of a discount rate of 2.5% pa would result in a lower commutation value than if actual current investment returns were applied.
Periodical payments present a challenge to the insurance industry and the co-operation between insurers and reinsurers is at the heart of this. This article covers only some of the issues, for example variation orders, reserving strain and the impact on capital requirements must also be considered.
If periodical payments are badly handled it could lead to a bout of claims inflation. This could arise from insurers offering claimants higher lump sum values in order to avoid periodical payments or by purchasing expensive annuities to remove the liability from their balance sheet.
However, if they are well handled with perhaps a mutual being set up to pool the mortality and investment risks then it is possible that gains may be made in comparison with the current system.
The views expressed in this article are those of the authors and not necessarily those of Lane Clark & Peacock LLP.
Joe Monk is a partner at Lane Clark & Peacock LLP (LCP) and a recognised expert in clinical negligence, and Sally Horrocks is an actuary with responsibility for Lloyd's syndicates and clinical negligence clients at LCP.
The blue line with pink markers shows the movement in the retention with indexation based on wage inflation up to the point of settlement (the red point) and with blue markers based on weighted RPI beyond that point.
The green line shows the increase in RPI beyond the settlement date. As can be seen the deductible does increase with RPI but at a lower rate.
The implication of this is that both the insurer and reinsurer pay part of each periodical payment once the deductible has been breached and the reinsurer pays an increasing proportion of each payment over time.