Annuities in Third Party Bodily Injury Claims Settlements in Europe: Do They Have a Future Role to Play in Casualty Reinsurance?
Annuities have long been used to indemnify third party bodily injury victims by providing them with a guaranteed source of regular income. The indexed annuity has been a commonly accepted method of settling third parties’ loss of earnings and long-term care costs arising from the accidental injuries in jurisdictions where a) the cost of care has not been absorbed by a national scheme but has been passed to the private insurance industry (either directly or by way of recourse) and b) the courts (or out-of-court settlements) have awarded structured or rest-of-life settlements as opposed to lump sum payments.
The combination of a) the transfer, in cases where negligence can be proved, of the injury-related cost of care from the state to the private third party liability insurer and b) long pay-out patterns, has historically been a characteristic of bodily injury claims in France and Germany. It is therefore logical that annuities have been used the most in these two jurisdictions.
In other Western European territories, lump sum settlements have been favored for most large bodily injury settlements. Annuities have only been used in cases where the judge considers that assets need to be protected to ensure that funds for long-term care remain available.
Over the last decade, however, annuities have increasingly been demanded by plaintiffs in jurisdictions across Central and Eastern Europe, most notably in the Czech Republic and in Poland. Annuities have also now come into focus in the UK as a result of the introduction of period payment orders under the Courts Act 2003.
In the current low interest rate environment, fixed annuities, especially indexed annuities, have become prohibitively expensive to purchase. The market for impaired life fixed annuities is currently almost non-existent, so there are few annuity products priced to reflect a lower-than-expected life expectancy. With very little net present value discount available, the market for fixed annuities has become unattractive, and has left insurers and their reinsurers unwilling to purchase annuities from life insurers as part of a structured settlement, preferring instead to reserve the annuity liability on their own balance sheets and bear the long-term investment risk themselves.
Let us assume a hypothetical case of a third party bodily injury award where the judge provides for the victim to receive regular monthly indexed payments for the rest of his/her life. The remaining life expectancy is calculated, using a standard mortality table, at 25 years, even though there is a strong probability that the victim may only live for a shorter period. The cumulative value of the monthly payments, indexed at an annual rate of 5 percent for the 25 year period, is calculated at EUR5 million. In the graph below, we can see a comparison of the approximate purchase price of an annuity, given a range of discount rates between 0 percent and 5 percent:
The net present value of the monthly payments discounted at 5 percent amounts to EUR2.56 million but if the discount factor is reduced to 2 percent, the up-front payment to finance the annuity increases by 46.5 percent to EUR3.75 million. The larger the difference between the annuity discount rate and the rate of indexation to be applied to the payments, the larger will be the capitalization required to finance the future payments.
In Germany, insurers and reinsurers enjoy an advantage related to the fact that existing legislation has not been updated to reflect the current economic environment. The long-term discount rate specified in the relevant German insurance law (BGH [Federal High Court] decisions affecting insurance law in practice as well tax law) is still at 5 percent, whether for direct claims from the injured party or for recourse. The current legal guidelines still regard a 5 percent investment return as being achievable over the long term and at the same time project that the long-term cost of care will not increase at a rate of inflation above 5 percent.
Under the HGB (Handelsgesetzbuch) German commercial legal accounting rules, the German insurer would hold the reserve in any case on an undiscounted basis, but the 5 percent growth rate would be assumed to match the expected costs inflation. If the same insurer were, however, to purchase an annuity in today’s life insurance market to cover the expected liabilities over 25 years, the discount rate would fall far short of the projected 5 percent growth rate.
The purchase of an annuity would, furthermore, only allow the insurer to close the claim if the injured third party were to accept such annuity or equivalent lump sum as a full and final settlement. In Germany, the injured third party rarely agrees to such annuity or lump sum as full and final settlement of their claim because this would remove their right to return to the court for a re-appraisal of their award in the case of deterioration as a result of their injuries. Hence large bodily injury claims are seldom capitalized in the German market.
From a reinsurance perspective, in accordance with the German contract wordings, it is only when the aggregate of monthly payments reaches the (indexed) attachment point of the liability excess of loss (XOL) reinsurance contract that the reinsurer begins to pay the claim. In the case of the early death of the injured party, the insurer will only have paid a portion of the expected total claim and the reinsurer will be able to close his reserve without payment. On the other hand, there is the risk of the German claimant returning to the court to demand an increased monthly payment on the basis of a worsened condition.
Thus, even if the reinsurer were to use an annuity to purchase-out his future liabilities, he would still be left holding the deterioration risk on his balance sheet, so the annuity purchase would not allow him to close the file. The alternative option for the reinsurer of commuting the outstanding liabilities with their cedent through capitalization of outstanding losses is also rarely used in Germany, because the cedent will require a substantial IBNER (incurred but not enough reported) provision for the deterioration risk. Without the ability to achieve a full and final settlement of liabilities, there is little incentive for the reinsurer to capitalize losses. It is, therefore, not surprising that German insurers and their reinsurers choose to hold these long-term recurring payment liabilities on their own respective balance sheets, and it is unlikely that the purchase of annuity products or any other form of capitalization will play a role in the settlement of German third-party bodily injury claims in the near future.
In France, by contrast, annuities continue to play a major role. Most severe bodily injury cases in France are settled by means of an indexed annuity. For motor accidents, the indexation part is reimbursed to insurers by the “Fonds de Garantie des Assurances Obligatoires” (FGAO). Strict rules have been established by the French state: present value is calculated using the 1988/90 mortality table and a discount rate which is not allowed to exceed 60 percent of the average return on government bonds (TME-Taux Moyen d’emprunt), capped at a maximum of 3.5 percent per year.
Increasingly, French cedents have a clause in their motor third-party liability XOL treaties that provides for reinsurers to pay the capitalization in full and then have the benefit of a commutation of their liabilities under these compulsory annuities. It is of course in the cedent’s interest to negotiate the lowest possible discount rate to maximize the capital sum payable by the reinsurer, but this in turn will have an effect on the reinsurance cost. In fact, most reinsurers are already offering treaty conditions which encourage cedents to retain a contractually fixed discount rate. Equally important is the preservation of the right to re-open the loss in the case of a worsening of the injured party’s condition. There is pressure from reinsurers to limit the period during which the case can be re-opened down to 10 or even 5 years. The preservation of an unlimited period for re-opening annuity reserves can add 15 percent to 30 percent to the reinsurance rate. In general, the treaty conditions will provide for an automatic reimbursement to reinsurers of the excess amount paid when a cedent stops paying the annuity within a period of 5 years from the date the annuity is established.
The high cost of annuities clearly has a critical effect on liability XOL reinsurance pricing. If a reinsurer is obliged at the present time to fund the purchase of an indexed annuity or capitalize the loss through straight transfer of funds to the cedent, he will have to face an extremely costly gap between the present value discount calculated using a depressed rate of investment return and the potentially much higher index rate being set for future payments to cover the cost of care.
The experience of the French and German markets now provides an interesting source of reference for UK cedents to consider. In the UK, the provisions of the Courts Act 2003 have left insurers and their reinsurers exposed to long-term structured payments for the first time, and this has led to a major discussion regarding the capitalization of losses, including the possibility of purchase of an annuity to finance such future recurring payments. Faced with the prospect of a variation order, the UK cedent is taking back a significant potential exposure if he allows the reinsurer to commute at an early stage, but the reinsurer is equally reluctant to capitalize the loss if he is obliged to re-open the case at a later date.
UK cedents and their reinsurers are confronted therefore by a choice: should they, like the Germans, simply hold onto their long-term obligations and manage them? Or should they, like the French, adopt the annuity system and seek wherever possible to buy-out their liabilities? The low discount rate and lack of fixed annuity products available on the UK life market, combined with the potential exposure to a variation order, does not suggest that the future lies with traditional fixed annuities.
A better rate of return should be available through the use of variable annuities, and these products are now actively being considered by liability insurers across Europe as a means to commute guaranteed long-term regular payment liabilities. The problem is to convince third party victims to accept variable annuities as an alternative to fixed annuities for final settlements. Since they are unit-linked, they are associated with a higher risk of downturn and are sensitive to changing capital market parameters,such as interest rates (Rho), volatility (Vega), and equity prices (Delta). The insurer will, therefore, usually be left with a residual liability in the case of failure of the variable annuity to provide the required level of monthly indemnity. An active hedge strategy can, however, be implemented to manage the downside risk and reduce the heavy solvency capital requirement under Solvency II of unhedged asset risk. The diagram on the following page illustrates the beneficial impact of hedging on the Solvency Capital Requirement for a variable annuity product.
Fixed annuities are an expensive option for settlement of severe bodily injury claims in the current economic environment. They may appear to state legislators as a sensible provision to ensure the long-term financing of the victims’ cost of care, but the victims themselves may think they can get a higher return by managing their own investment of a lump sum. Fixed annuities also hold little attraction for insurers and reinsurers, especially where a residual risk of variation remains.
Perhaps the variable annuity will provide the answer. It is a product that can guarantee long-term payments but can be purchased at a higher discount rate thanks to a higher expected rate of return. If hedging can reduce the inherent riskiness, it is a product that could be attractive to both claimants and (re)insurers.
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