With the implementation of the Courts Act 2003 on 1 April, reinsurers may well be forced to consider employing alternative methods of capitalising reinsurance settlements, explains Christopher Rowland
Changes to the system of UK personal injury awards are leading reinsurers to consider new ways of capitalising reinsurance settlements for injury-exposed business.
Such a re-think of potential claims settlement strategies became necessary after the 1 April 2005 implementation of sections of the Courts Act 2003, which is legislation designed to reform the court system in England and Wales and includes rules on damage awards. Judges in these jurisdictions are now permitted to order insurers to make periodical payments to personal injury claimants, rather than lump sums - as has been the case historically. But the time to develop creative reinsurance capitalisation is now.
The use of periodical payments increases the potential tail for reinsurers from five to 10 years to possibly 50 or 60 years, depending on the life expectancy of the injured person. Given that most UK liability reinsurance is written on an excess-of-loss basis with sizeable deductibles, reinsurers may not begin to pay their portion of a large loss for many years, under current reinsurance structures.
Under UK law, judges still have the option to award lump-sum payments. However, the government would prefer that periodical payments be used because they assure claimants receive payments for life, while lump-sum awards could be exhausted and therefore the costs of looking after a claimant fall back on the state.
A gap in the market
The problem for the UK insurance industry is that the market for impaired life annuities, which provides periodical payments to claimants, has all but disappeared. Over the past several years, the UK life and pensions market has generally pulled out of the impaired-life annuities business, as a result of the state of the equities market, low interest rates, reserving difficulties and uncertainty over capital provisions.
The Courts Act also requires index-linked periodical payments, which adds a further disincentive. Gone are the days when reinsurers could remove such personal injury liabilities from their balance sheets by writing a cheque to an annuity provider.
As a result, until there is a return of the annuities market in the UK, its liability insurers must find ways to self-fund periodical payments.
Without access to a vibrant annuity market, insurance companies and their reinsurance brokers will face the administrative nightmare of having to collect small but regular payments from a group of reinsurers that participated in a particular treaty year, perhaps originating from contracts that could be decades old.
Further, the reinsurer's security becomes an important issue with such a long tail, with claims being paid out for many years. Just examine the reinsurers on a treaty that is only five years old - along with those financially sound reinsurers with household names, there may be many others that have failed. Now consider a 25-year-old contract - many of the names on the treaty are unrecognisable because they have been out of business for such a long time.
In for the long-haul
Although the bulk of today's reinsurers are financially sound, committed, long-term industry participants with proven track records, naive capital will always be a factor in the industry and weak players will continue to fall by the wayside. Given the requirements of periodical payments, if a ceding company has to wait 25 years before reinsurers open their cheque books, security adequacy may one day become the primary concern.
In the past, the principal reserving risk for self-funded personal injury claims was the potential for extended life expectancy due to medical advances. However, the security of reinsurance recoverables must become the number one concern if the tail extends to 50 years.
Until the UK annuities market returns, most insurers will have to self-fund periodical payments. This will be easier for a property/casualty insurer that also operates a life company, which could theoretically provide the required annuity. Self-funding also is possible for non-life companies with no in-house life insurer, although the process is more fraught because reserving rules for life products are different than those for non-life products. The insurance industry is currently awaiting firm guidance from the Financial Services Authority with regard to self-funding.
The UK insurance industry has also looked to attract North American annuity providers with little success, despite their greater expertise and significant premium base.
A best-practice approach
Until annuities are once again available, it is wise for the industry to consider a best-practice approach to manage self-funded claims settlements within the structure of the act. It is possible to solve the problems surrounding self-funded periodical payments, which will benefit both ceding companies and their reinsurers.
One such initiative under active consideration is a type of reinsurance capitalisation, whereby a reinsurer and its ceding company client would enter negotiations to calculate the amount of the reinsurance recovery for the projected lifetime of the claimant. The reinsurer would pay that amount in a lump sum to the insurer, which in turn would have the benefit of the cash upfront, years of accumulated investment income and an ultimate reduction in the administrative burdens and security issues involving future reinsurance collections.
In response to the enactment of the damages section of the Courts Act on 1 April many 2005 UK casualty treaties written during the 2005 January renewals, included a letter of intent from clients, which stated that reinsurance capitalisation should ideally be considered.
There is a danger of losing momentum to develop a best-practice approach - until the industry starts to see some large periodical payment awards for personal injury claims, there is no pressing urgency to develop a standard capitalisation procedure. If the industry fails to take the necessary action, it is highly likely that reinsurers and their ceding companies will be forced to respond overly quickly, rather than in a measured manner.
Until the UK annuity market returns, it may be preferable to establish a reinsurance capitalisation initiative, so that the industry will not have to handle a temporary period of business with a 50-year tail brought on by the lack of a UK impaired-life annuity market.
- Christopher Rowland is an underwriter, casualty treaty, for GE Insurance Solutions.
It's all in the Act: other provisions
- The legislation is retrospective and applies to all claims that have not yet reached court.
- Periodical payments are applicable to all court-awarded injury claims. However, more than 85% of personal injury awards involve out-of-court settlements, which are not covered by the Act, and hence could be paid with traditional lump sum.
- Any claim involving a minor or patient (or ward of the court) will be subject to periodical payments.
- The Financial Services Compensation Scheme (FSCS) to self-fund for a short period until there is a change in market conditions or until life and pension companies once again begin offering annuity products.
- Periodical payments may continue to run after a claimant's death, for the benefit of dependants.
- Courts Act guidance notes recently issued by the Department of Constitutional Affairs said if Lloyd's or the Motor Insurance Bureau are insurers for a personal injury claimant, the award either would have to be made as a lump sum, or the judge could order a periodical payment, requiring an annuity to be purchased from an FSCS-protected company, even if it is bought at uneconomic terms.
- Claims can be re-opened if circumstances change and if permitted by the original court order.