Compensation for provision of long-term care for bodily injury is becoming an increasingly challenging problem for society in general and insurers in particular.
Due to the confluence of a number of global systemic factors that characterize “emerging risks,” traditional responses need to be replaced by a more collaborative and imaginative approach. Uncertainties that had previously been transferred to the claimant are now retained by the insurer in many regions.
“Lump Sum” Compensation
In many countries bodily injury typically involves providing a “lump sum” compensation package to the claimant. The calculation of this “lump sum” is determined by estimations of the following factors:
- Annual cost of care
- Life expectancy, given the nature of the injury
- Inflation on the annual cost of care
- Investment yield
The annual cost of care is relatively straightforward to estimate. Advances in medical technology have had two major effects: First, a greater rate of survival from injuries that previously would have proved fatal, simply causing more people to need long-term care, and second, a significant increase in the cost of such care, in some cases as much as USD500,000 per year for a single claimant.
Life expectancy for impaired lives is a complex subject, not helped by the relatively limited data base. Generally the reductions from normal life expectancy have been weighted in favor of the claimant. However, one point is certain: for any particular claimant, the chosen life expectancy will most likely turn out to be incorrect.
The relationship between inflation on annual cost of care and investment yield is critical. In many cases the working assumption has been that they effectively cancel-out. Recent experience in the United Kingdom, however, suggests that inflation for medical care costs (as shown by the Annual Survey of Hours and Earnings (ASHE),(1) which measures earnings of healthcare workers), differs from general wage inflation, as well as the Retail Price Index (RPI).
The “cancelling-out” assumption implies a real discount rate (RDR) of 0 percent, however some observers suggest an RDR of -1 percent to -1.5 percent relative to RPI, and as much as -3 percent relative to the current yield curve. There are therefore substantial uncertainties involved in the estimation of “lump sum” packages, given the prospect of an 80 year “tail” and annual costs of up to USD500,000.
Given these uncertainties the benefits to an insurer paying a “lump-sum” compensation far outweigh the potential downside, namely that the claimant might not reach the assumed life-expectancy. The main point is that the insurer achieves certainty.
However, this certainty is only achieved by passing on the uncertainties to the claimant. For a number of reasons public sentiment views this as an unacceptable burden to the claimant, as well as his or her family and the broader social network that supports the claimant, not to mention the state welfare system - the provider of last resort. This changing perception should be seen in the context of the erosion of traditional social networks while governments are increasingly trying to reduce welfare obligations. Long-term care is effectively being privatized and someone needs to pay for it.
Demographic changes only add to the problem. The systemic risk of improving longevity arguably applies equally to impaired lives as it does to normal lives. Generally the growing preponderance of an aging population, as well as the need to provide care for the associated chronic illness, will also have an effect on healthcare costs. Moreover, there is a systemic risk of a medical breakthrough that extends the life expectancy of a previously impaired category of lives.
Finally, the recent global economic crisis has highlighted the financial risks of taking lump-sum compensation, especially given the low-yield environment for “risk-free” investments that seems likely for at least the medium-term.
1. United Kingdom, Office for National Statistics, Annual Survey of Hours and Earnings.