October 14th, 2010

Periodic Payment Orders – Issues and Implications for Reinsurance

Posted at 1:00 AM ET

Issues

Following the passage of the Courts Act 2003, which gave courts in England and Wales the power toimpose rest-of-life structured settlements, known as periodical payment orders (PPOs) to provide for the long-term care and loss of earnings of severely injured third parties, the actual incidence of such awards in the market has been relatively low. It is clear however that the trend towards PPOs has accelerated over the past year, partly driven by low interest rates. This trend presents real challenges to both insurers and reinsurers of casualty classes, particularly for motor.

A PPO imposes several risks on the insurer that for a traditional lump sum payment would rest with the claimant :

■ Longevity risk - if a claimant lives longer than the medical experts predict at the date of settlement,then a lump sum award may prove to be insufficient to fund his care for his entire life. With a PPO,this longevity risk rests with the insurer.

■ Investment risk - a lump sum award incorporates assumptions about future investment returns, which may not, in practice, be achievable. A PPO transfers this risk from the claimant to the insurer.

■ Future inflation risk - under a lump sum award, the claimant assumes the risk that the future cost of care may run ahead of expectations. An indexed PPO again transfers this risk to the insurer.

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A PPO in itself causes an insurer new problems, such as how to reserve for what is essentially an unknown ultimate cost.The additional problem associated with inflation risk is that the courts have determined, in two much reported cases, that the indexation of the PPOs will be effected by reference to two indices (average earnings for loss of earnings and ASHE 6115 for the cost of care). Both of these indices have historically risen faster than retail prices index (RPI), which the drafters of the Courts Act had originally intended to be used. If this pattern continues in the future, the ultimate cost of a PPO linked to average earnings would be higher than one linked to the RPI.

Of course, small differences in annual rates of inflation between the indices over the life of a lengthy PPO could potentially make a huge difference to the final payout. It is not difficult to come up with examples, based upon assumptions on loss of earnings, cost of care, and life expectancy, where the compound effect of the switch of indices can have a very significant impact on the total payout under a PPO.

Hedging the Risks Using Annuities and Capital Markets

Of course, the risks of longevity, inflation, and investment are traditionally handled by the life assurance market and ideally insurers would be able to transfer these risks to the life market by the purchase of annuities. Unfortunately, the impaired annuity market in the UK currently concentrates on moderate impairments from medical conditions, not severe impairments such as those suffered by accident victims, that would be subject to PPOs. While certain life insurers are beginning to show an interest in this issue, which should, after all, be an opportunity for them, it could be a considerable time before a proper market develops for this and it may never develop for certain types of injuries.

At present it is clear that life companies will be more interested in offering capacity where:

■ A ‘block’ of PPOs can be offered, either historic or prospective

■ Individual risks can be medically underwritten

■ The longevity risk only is covered

Some annuity writers prefer to take the investment risk as well as the longevity risk, but at present these companies are reluctant to look at reinsuring PPOs as the inflation risk (ASHE 6115) is not hedgable.

A hedge against ASHE 6115 is, at present, not available, although GC Securities*, a division of MMC Securities (Europe) Ltd., which is authorized and regulated by the Financial Services Authority, was very close to negotiating one in 2007 before the credit crisis took such projects off the agenda for all financial institutions. With a critical mass of PPOs in the market and a return to more normal risk appetites in the financial markets, such products could become available in the future.

In certain continental European countries, many insurers with exposure to the equivalent of PPOs are composite writers with a life as well as a property/casualty business. In these cases, the life company usually writes the impaired annuity for its sister company. Of  course, this is advantageous because it keeps any profits ‘in the family’.

The lack of market for impaired life annuities in the UK may well mean that other solutions will emerge, such as the formation of an industry captive or a pooling arrangement, whereby the exposures under PPOs are assumed by a separate company, funded by means of contributions from motor insurers.

Periodic Payment Orders - The Implications for Reinsurance

PPOs present particular challenges to reinsurers and the cover they provide under XOL reinsurance structures. It is an obvious point to make that a PPO will push a reinsurance recovery well into the future, a problem exacerbated by the effect of an indexation clause that is common on most UK motor programs. The standard UK Index Clause, for example, indexes the reinsurance retention, initially to average earnings, but once a PPO is awarded or agreed, the index to be applied to the retention changes to that on which the PPO is indexed. Assuming the past relationship between the various indices continues, the effect of the switch of index will be to push a reinsurance recovery even further into the future (the index is applied to each installment).

This problem is worse for larger buyers of reinsurance who typically run significant retentions. To illustrate this, consider a PPO settled with a lump sum award of GBP2 million and periodic payments of GBP200,000 per annum, indexed to ASHE 6115. In comparison to most PPOs seen to date, these are reasonably big numbers. Assume a GBP5 million indexed retention and a three-year-delay from the date of the accident and the PPO.

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Even for a ‘large’ PPO such as this, and on reasonably realistic assumptions about earnings inflation, pre-PPO, and ASHE inflation post-PPO, this claim would take approximately 20 years to impact the reinsurance program (1).

This is a situation that the reinsurance market needs to address. As it stands in the absence of an annuity purchase, buyers of excess of loss reinsurance are faced with the prospect of self-funding a PPO loss, possibly for many years, with only the distant prospect of a contribution from reinsurers. In the meantime, buyers will be running a potentially significant credit risk, an area of some sensitivity in the current climate. An additional problem confronting both cedent and reinsurer is how to account for the future liabilities from a PPO. As yet, no universal approach has been adopted.

Periodic Payment Orders - Possible Reinsurance Approaches

Capitalization of Reinsurers’ Share of a PPO

A number of Guy Carpenter’s long-tail clients in the UK have expressed a general preference for capitalization of claims mainly because of the credit risk mentioned above. Equally, we believe that most reinsurers will be well disposed towards capitalizing PPOs as they will wish to get the liability (and the attendant uncertainty) off of their balance sheet(s). If both sides of the transaction favor capitalization, then it should be relatively easy to accomplish.

Several UK insurers have already received indicative quotations from reinsurers for the capitalization of individual PPOs, and it is already clear that such capitalization negotiations will revolve around reinsurers’ and reinsureds’ views of the three risks identified above, namely longevity, future inflation of the PPO and future investment returns. In reality, reinsurers’ views of these factors may well be very different from the cedents’ and could easily cause a difference in valuation of several million pounds on an individual claim. To reduce the potential for this, it might be possible to agree to a formulaic approach, at least to the risks of inflation and investment returns.

While the capitalization of a PPO will remove the reinsurer credit risk, it will leave the primary insurer with the risks of longevity and inflation. These risks may, in time, cause insurers to reject capitalization as a universal solution. A reinsurer’s ‘promise to pay’ may simply be the best asset available to set against the PPO liability. As the Solvency II treatment of PPOs becomes clearer, the balance of costs and benefits of capitalization will also become clearer.

Capitalization Clause, with Arbitration

As discussed above, the problem with capitalizing a claim is that, when it is necessary (i.e., after the PPO award), reinsurers may well come up with a capitalization offer that is significantly less than the buyer’s own evaluation. In the past year or so, the market has seen at least two attempts to introduce clauses into reinsurance contracts (i.e., pre-loss) that  would set out the process to be followed to ensure an ‘agreed’ capitalization of future PPOs. In both cases this involved a form of binding arbitration on those parts of capitalization negotiation not dealt with by a formula. Not surprisingly, given the market’s lack of experience in dealing with PPOs and the fact that the primary carrier would retain the longevity risk, buyers’ reaction to these initiatives has been, and remains, less than enthusiastic.

The PPO landscape is fast changing, but our current view is that any compulsory element is not likely to gain wide acceptance among buyers until there are sufficient numbers of PPOs in the market to give all parties comfort with the process, and to be able to take a ‘some you win, some you lose’ view of unexpected longevity and inflation outturns. However, we believe that a form of non-binding arbitration is worth pursuing.

Amendment to the Indexation Clause to Produce Fairer Treatment of PPOs

As we showed above, the problem PPOs present to traditional excess of loss contracts is exacerbated by the effect of the index clause in moving the date of reinsurance recovery even further into the future. Another possible approach is to amend the index clause, effectively to freeze the index (and the retention) at the date the PPO is awarded. It seems somewhat arbitrary that with a lump sum award the index is fixed at the date of payment, but if a PPO is awarded then the retention is indexed for decades into the future, with a subsequent delay and reduction in the reinsurance recovery. We believe that the logic for this approach needs to be questioned in the market.  Indexation exists to preserve the “real” value of the retention. A PPO is awarded in lieu of a lump sum but because the PPO is itself indexed then indexing the reinsurance retention means that the burden of claims inflation falls too heavily onto the buyer.

Collateralization of Reinsurers’ Liability Under a PPO

The most commonly used structure in annuity reinsurance is for assets equivalent to the expected value of reinsurers’ obligations to be deposited with a mutually satisfactory custodian in a segregated securities account in the name of the reinsurer, but subject to a charge in favor of the cedent. In these arrangements it is important to establish an effective security interest in favor of the cedent, but the key is to ensure that the reinsurer’s rights to access the assets are appropriately restricted and that the cedent will have timely access to the those assets on the occurrence of a trigger event (such as insolvency or an obvious precursor to such). The charge would ideally be structured to fall within the Financial Collateral Arrangements (No 2) Regulations. In cases where this form of collateral has been established cedents have not had to make a provision for reinsurance credit risk within the requirements of INSPUU 2.1.

There are a number of other methods of obtaining security but none are as efficient as the charged account described above. These include irrecoverable letters of cre dit with “evergreen clauses”, trusts, and parent company guarantees.

The Future

Looking ahead the PPO landscape is not clear. Much will depend on how many PPOs are awarded or negotiated in the next few years. However, assuming that recent trends continue, more choices will open up for cedents: we expect markets to become more willing to take on liabilities and that reinsurance contracts will evolve to redress the balance of power towards buyers of excess of loss reinsurance. The following diagram represents what we believe will be possible within the next two years.

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Note:

1 Of course, for a buyer with a lower retention, recoveries occur much quicker and, for the loss example given, a retention of GBP2 million or less means that the buyer recovers the periodic element of the PPO as it is paid.

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Guy Carpenter & Company, LLC provides this report for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only.

Guy Carpenter & Company, LLC makes no representations or warranties, expressor implied. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such.  Readers are cautioned not to place undue reliance on any historical, current, or forward-looking statements. Guy Carpenter & Company, LLC undertakes no obligation to update or revise publicly any historical, current, or forward-looking statements, whether as a result of new information, research, future events, or otherwise.

Statements concerning, tax, accounting, legal, or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal, or regulatory advice which we are not authorized to provide. To the extent that you discuss such statements with your clients, be sure to advise your clients that all such matters should be reviewed with their own qualified advisors in these areas.

© 2010 Guy Carpenter & Company, LLC

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