November 18th, 2014

Emerging Risk: Periodic Payment Orders

Posted at 1:00 AM ET

For a number of reasons the United Kingdom represents an extreme example of the impact of annuity compensation structures. For severe bodily injury cases it is now highly likely that the claimant will opt for an annuity structure (known as a periodic payment order, or PPO) rather than a lump-sum. These are often indexed accordingly to the Annual Survey of Hours and Earnings (ASHE) (1). As a consequence, the uncertainties that had previously been transferred to the claimant are now retained by the insurer (and to a certain extent, its reinsurers). Unlike an individual claimant, the insurer needs to articulate these risks in its capital modeling. These risks can be categorized as follows:

  • Longevity
  • Retail Price Index (RPI) (Real discount rate (RDR) relative to RPI, given the insurer’s investment strategy)
  • ASHE (”basis” risk between RPI and ASHE, which is currently unhedgeable)

Keeping in mind that these risks are being generally funded by non-life motor insurers, it becomes readily apparent that PPOs present these insurers with significant challenges. Shareholders who have invested in non-life companies face the prospect of finding themselves owning what are essentially life insurance businesses.

The mismatch between life exposures and a non-life balance sheet is accentuated by regulatory treatment. Accounting practice, such as US Generally Accepted Accounting Principles, which permits discounting of reserves for life business, does not permit this for ostensibly non-life loss reserves. Regulators of non-life companies discourage investment strategies that might mitigate these risks, as would be normal practice for a life insurer, instead, pushing non-life insurers towards low-yield bonds.

Ultimately, regulatory treatment has the effect of apparently creating “new” losses, as in the case of the risk margin, which is prescribed by forthcoming International Financial Reporting Standards (IFRS) guidelines and incorporated within the Solvency II regime. The risk margin is in effect the discounted future cost of capital of funding PPO claims, in addition to the actual compensation paid to the claimant. Holding risk margin results in a market-consistent valuation - the amount a third party would charge the insurer in return for taking over the liability. In some cases, this may have the effect of doubling the economic impact of a PPO on an insurer.

It may be argued that the risk margin is not so much a “new” loss as the articulation of an existing loss that simply has not previously been recognized. Certainly, this would be the implication of the IFRS guidelines on risk margin. For this reason we would characterize PPOs as a “crystalizing” emerging risk, whose dimensions are still uncertain. For insurers the cost of uncertainty is very high. However, the crucial question arises as to the extent to which insurers have correctly recognized this in their financial statements. There is still a “tension” between the life and non-life sectors that underlines the potential shortfall in valuation of PPOs. This “tension” is exhibited by current market pricing of the non-life capitalization RDR of 1.5 percent and the life annuity RDR of -1.5 percent to -2.0 percent. This “tension” would at least be partially resolved by application of the IFRS Risk Margin.

This is a good example of where the risk is defined by the methodology, which is a recurring theme in the realm of “emerging risks.” Some feel that this is the fundamental task of regulators: to enforce a prudent risk management methodology that preserves a sustainable and level playing-field for responsible competition.

The PPO example also reveals other recurring themes in “emerging risks.” The most notable of these is that “emerging risks” do not respect the boundaries of how the insurance industry has traditionally been organized. The traditional demarcation between life and non-life has in this case proven to be an obstacle to a solution. Rather than exploiting the relative capabilities of their respective balance sheets in order to create value from the PPO problem, the life and non-life sectors have tended to accentuate their own shortcomings. Faced with a problem that crosses traditional boundaries, it is necessary to find a solution that transcends those boundaries and mobilizes risk capital accordingly.

Thinking more broadly, it is worth considering whether a more collaborative approach would actually benefit the claimants themselves - after all, this is the whole point of the endeavor. A more coordinated approach to long-term care might result in tangible benefits to the claimants, as well as having economic benefits for insurers. Going even further, governments might consider issuing debt with instruments that match the duration and indexation of annuity payments.

As the Executive Chairman of the World Economic Forum writes in the preface to Global Risks 2014, “Moving from urgency-driven risk management to more collaborative efforts to strengthen risk resilience would benefit global society.”(2) These words could not apply more than to the risk of emerging compensation structures.

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Note:

1. United Kingdom, Office for National Statistics, Annual Survey of Hours and Earnings.

2. World Economic Forum, Global Risks 2014, Page 7.

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