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Spotlight on periodical payment orders: How do insurers manage PPO risks?

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Are periodical payment orders turning general insurers into composites holding both general and life insurance risks? Would it be better for general insurers to ‘transfer’ these risks to life insurers?

Aviva director of technical claims Andrew Wilkinson: PPOs present risks that general insurers would not traditionally have been exposed to. Risk profiles of general insurers are therefore evolving and we would expect companies to be carefully considering both the specific new risks to which they are now exposed and their broader overall risk profile. One way to manage these new risks is to seek to transfer them to life insurers who have much greater experience of them.

Axa UK chief investment officer Guillaume Tissot: PPOs do include a longevity risk component and, as such, they are related to life business. However, they are not changing the business model of GI, at least not at Axa – they are just introducing an additional risk factor. Axa has the knowledge and tools to model longevity risk (even in the UK through the management of the staff pension scheme), so the additional risk requirement is not an issue to manage.

Institute and Faculty of Actuaries general insurance experts: It is certainly true that the rise of PPOs brings significant additional risks for general insurers to manage. However, PPOs are unlike typical annuities held by life insurers in a number of respects, and so would also be difficult to manage from a life insurance perspective.

PPOs are normally of much greater duration than annuities, with a mean term of 43 years, and some future durations of up to 80 years or more. A further difficulty is the link of regular PPO payments to the Annual Survey of Hours and Earnings Index, rather than Retail Price Index (or in some cases no indexation). Therefore, whether life or general insurers are exposed to PPO liabilities, both have to address the issue of finding suitable assets that can match the nature of PPO liabilities – i.e. of long enough duration, and providing some hedge against ASHE indexation.

Although general insurers’ exposure to PPOs is growing, where an individual insurer’s PPO exposure remains limited, the impact of this exposure can be relatively modest. An insurer with limited PPO exposure could potentially diversify this away fairly well from their ‘mainstream’ GI portfolio. However, over time where the PPO exposure grows, it can became more of a headache for the firm to manage once the PPOs begin to dominate the balance sheet.

“Although general insurers’ exposure to PPOs is growing, where an individual insurer’s PPO exposure remains limited, the impact of this exposure can be relatively modest.”
IFoA GI experts

General insurers with a particularly high PPO exposure may be an exception, but for now it would probably be an over-statement to suggest that GI firms with PPOs were already becoming composite in nature.

Motor Insurers’ Bureau CEO Dominic Clayden: It is a materiality test in that it depends on the overall size of the [insurer’s] balance sheet. What I see and hear anecdotally is that insurers are aware of this and it is one of the reasons why they don’t want to do PPOs. So they are managing their balance sheets and carrying those PPOs, but as a percentage of their overall exposure it is relatively small.

In my mind it is a question for the regulator, particular in terms of things like close match provisions that life companies have got to have. Does it create a requirement – once you get over a threshold of materiality – in terms of conversations that need to be had [for the general insurer to have them too]?

But at the moments the volumes are still small out there. So I don’t see it being an issue, as the materiality is not there. And the other factor that I am hearing is that the pricing of the annuity-based product is not competitive even to the lump sum; and so that is another issue.

NFU Mutual GI reserving actuary Jon Read: As a composite insurer we already have the advantage of being experienced in handling life liabilities. We have a relatively small number of PPOs and the majority of the risk is passed to reinsurers via excess of loss cover. Transfer of PPO risk has been considered in the past and would certainly offer practical benefits if it could be done in an efficient and cost-effective way.

Zurich spokesperson: To an extent it is true that general insurers are now exposed to both inflation and longevity risk. However, claims that settle with a PPO will still be a small proportion of the total claims that are paid out, therefore the risk relative to premium is much lower than for a life insurer. With that in mind de-risking the balance sheet might only make sense if it is economical to do so.

Due to the liabilities being linked to ASHE, it is difficult to find a partner to transfer these liabilities to as they are equally exposed to the uncertainty in this index, which would need to be priced in. Other valuation assumptions can vary materially between parties also, and even internally when considering IFRS versus Solvency II valuation bases for example. It is therefore difficult to move these liabilities economically. Perhaps, when the industry moves to an IFRS17 basis, the valuation assumptions will more closely align making such a transfer more viable.

How do you see insurers managing their PPO risk?

Tissot: Axa continues to cover PPO risks and we share a proportion of the risks with our reinsurers through our normal motor and liability reinsurance arrangements. Market-related risk factors linked to PPOs are hedged wherever possible. We are reserving fully for the longevity risk from PPOs within our technical provisions, and when measuring our capital requirements under Solvency II we make full allowance for the future uncertainties of PPO risks over the expected lifetimes of PPO claimants.

IFoA GI experts: The IFoA PPO Working Party’s qualitative survey indicates that PPOs have become a less prominent concern to insurers themselves. This may reflect insurers’ build-up of experience in managing PPOs as a liability class, and could indicate that they are managing their PPO exposure appropriately. The PPO Working Party has, over the last few years, informed and educated the GI/ PPO community, so hopefully this has contributed to greater industry confidence in PPO risk management.

Although insurers can use reinsurance to reduce their PPO exposure, contracts reinsuring PPO liabilities often come with capitalisation clauses. These clauses specify that at a certain period of time (e.g. the date of PPO settlement or inception of the reinsurance treaty), the reinsurer will pay the insurer a lump sum in order to crystallise the reinsurer’s liabilities to the insurer in respect of that PPO. At this point, any risks previously mitigated by the treaty revert to the insurer. However, such clauses do at least reduce the insurer’s dependence on the reinsurer over the duration of the PPO.

Clayden: It comes back to the issue of materiality – and why it is still low is down to a number of aspects. For instance, I suspect other than the bottom end of PPOs, a significant majority are in reality reinsured.

Which is another dynamic in terms of balance sheet management. I think there are different approaches contractually. Some of the reinsurance contracts I suspect have commutation clauses in them. Others, particularly the early ones, don’t so there is a debate whether the PPO is really sitting on the primary insurer’s balance sheet or is it sitting as a credit issue in terms of the rating of the reinsurer that sits behind it?

And that is the other complexity that is a variable. But I still see a real reticence by reinsurers wanting to summon up those PPOs and instead really urging their insurers to go for lump sums.

Read: Robust actuarial modelling to ensure we have sufficient reserves and capital to cover the risk, together with excess of loss reinsurance cover keeps us on top of managing PPOs. The Solvency II risk margin requirements are currently onerous for PPO settlements and Brexit may offer an opportunity for the Government to review the regulatory position.

What would you say to those who suggest some firms are not reserving appropriately for their PPOs (particularly on future ASHE-inflation assumptions or in other words the net discount rate on any reserving basis)?

Wilkinson: The ultimate cost of PPOs is extremely sensitive to a small number of key assumptions, many of which are subjective assessments looking many years into the future. The range of possible reserving estimates is therefore very wide. Against this context, we would expect general insurers to be setting assumptions carefully, within a clear framework of assurance, and with good reference to market benchmarks.

Clayden: I have not seen any real evidence of it. It is a question that should be asked to the audit community as the vast majority of insurers are audited by a limited number of firms, and that is one of the critical factors. Certainly from my days as a claims director one of the questions I was always asked was: ‘What is your reserving approach?’ And I sat there with the chief actuary and they’d slice and dice us in terms of what was going on.

And that independent review gives some comfort that it might be over blown. It is something that it is worth looking at and assessing in terms of what is going on. But that independent view probably gives me more comfort than some of the anecdotal soundbites.

There are a range of factors that will impact ASHE from Covid-19 and Brexit in the short term, to macro-economic factors and government policy in the long term.”
Zurich spokesperson

Zurich spokesperson: It is very difficult to arrive at a robust ASHE assumption, due to a lack of assets linked to this index. Therefore, as external factors impact the markets view of general inflation, it is left to the actuary to judge what the rate of AHSE will be. Over the very long term, AHSE seems to have followed RPI reasonably closely (or at least RPI plus x%), it is hard to say if this will continue into the future. There are a range of factors that will impact ASHE from Covid-19 and Brexit in the short term, to macro-economic factors and government policy in the long term. We can say with confidence though that modelling future AHSE rates will remain a difficult problem for the foreseeable future.

Do you think GI firms in future will buy-out PPOs in the same way that buying out DB pension schemes has become standard practice? If yes, when do you think they would do it?

Wilkinson: Companies should be seeking to manage their PPOs carefully and this will lead to various innovative approaches over time. “Buying-out” PPOs is one possibility which may be investigated by general insurers in the future. Aviva would note though that many PPO recipients are vulnerable or protected parties and any such approach would have to be demonstrative of being in the best interests of that party. We are interested to see what other approaches might also evolve.

Tissot: There is currently no discussion about a full buyout of the PPOs book to take this risk fully off the balance sheet. A market for such a transaction does not seem to exist at the moment. It could be done if there is reasonable pricing for such a book at some point in the future. Axa UK has previously entered in transactions to reduce the volatility of its balance sheet, such as the one with River Stone in 2017 on industrial disease.

IFoA GI experts: As the PPO Working Party qualitative survey work has shown over many years, there is an appetite amongst insurers to pool their PPO risk. To date, to our knowledge a private solution has not got off the ground despite the interest in one.

Over time, a viable transfer solution may become available, although for any acquirer of PPO liabilities, the asset-liability management challenges covered above would still apply, and the capital requirements to back such liabilities would be significant. This is particularly so if transferred PPO liabilities were the sole line of business the acquiring firm offered, as there would be no/limited diversification benefits from other lines of business. This means that pricing could be unattractive relative to the general insurer retaining the liability.

The economics of PPO transfer solutions and their capital requirements may evolve however, particularly if post-Brexit the UK solvency regime diverges from Solvency II in a way that reduces the capital that needs to be held against long-term PPO/ annuity-type liabilities.

Interest in a Government-backed pooling schemes has emerged recently in the context of pandemic risk; such an approach could also potentially be applied in a PPO context.

Clayden: There is going to be a trend in that space, especially if there is sufficient volume. It is less about the appetite from the insurers than the appetite of the people wanting to take [these risks] onto the balance sheet. And for them to create a market.

And defined benefit pension schemes are a good example of one where there was a lot of talk about it, it never went anywhere and we all got sick of hearing about it. And then suddenly some large players entered and this was a proper grown up massive business sector.

It is less about the appetite from the insurers than the appetite of the people wanting to take [these risks] onto the balance sheet.”
Dominic Clayden

It is a bit like long tail disease claims; I would put it in the same grouping. Where lots of people were talking about it, and there was the odd deal, but now with regards big firms it is probably easier to name those who have not done a transfer in some form, as opposed to those who have. So I think it is more about [creating a] market where people come in and want to acquire these risks, than the people who want to cede it.

Zurich spokesperson: The reason that claims settle as PPOs is that it is in the best interest of claimants. It would need to be clearly demonstrated to the insurer, the claimant, and a judge that crystallising the PPO was in the claimant’s best interest. We have seen this happen in the past, but it is not common, as for many claimants the best option is the security that a PPO offers. Therefore, I don’t foresee that GI firms would do this at scale. Furthermore, if it was common to settle as a PPO, then crystallise shortly after for more than on an Ogden basis, then it is likely that legal firms representing claimants would quickly become savvy to this and change their behaviour when settling claims.

How has the most recent 2021 ASHE inflation figures [with the gap between care earnings and inflation widening] impacted your view on the reserves you are holding in terms of PPOs?

Tissot: Historically, ASHE care earnings do not closely track inflation and divergence between the two is common. We therefore continually monitor this trend and adjust our reserves as necessary to allow for this. We are currently analysing the 2021 ASHE experience in comparison with the allowances made in our reserves as part of work done to ensure our year-end reserves are sufficient. The varying historic trends contribute to uncertainty about the future course of care earnings, and we recognise both the level and the uncertainty from these trends when setting our year-end reserves and capital requirements.

Clayden: When setting the reserves for PPOs, it’s necessary to make an (ASHE) inflation assumption for the next 40 plus years. Therefore, the actual ASHE inflation in any one year would not typically lead to a change in long-term assumptions, especially when that year has been impacted by several transitory features including Brexit, Covid-19, minimum wage changes, etc.

The long-term ASHE inflation assumption used in our reserves will be revisited as part of our annual independent actuarial review exercise which will take place early [this] year. We don’t expect that the experience of 2021 alone will result in a change in this assumption, but instead our actuaries will consider longer-term trends and inflation forecasts in selecting their assumptions.

Read: With care cost inflation a hot topic at present as a result of the pandemic, short-term fluctuations in ASHE inflation are to be expected. We take a long-term view and set our inflation assumptions over the lifetime of the PPO claimant. We will continue to review our projections for the longer term as we emerge from the pandemic.

Zurich spokesperson: The majority of PPO payments are indexed based on the 80th percentile of care worker hourly earnings and the provisional release of this index implies an increase of 2.3% for the year to April 2021. This increase was lower than what was implied by the RPI and as a result this latest ASHE release drives a favourable movement in reserves as a result of lower than expected upcoming payments. This new release has also increased the uncertainty of whether the ASHE index will continue to follow the RPI (or RPI plus x%) over the long term, as the gap widening between care earnings and inflation could be the start of longer-term misalignment or a short-term deviation driven, perhaps, by the immediate impacts of Covid-19 and/or Brexit, for example, which would be less material over the lifetime of a PPO

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