The Discount Rate reduction, what next?

The Discount Rate reduction, what next?

The Discount Rate reduction, what next? 520 265 Alex Lyne

In February, the Lord Chancellor, Elizabeth Truss, announced a reduction in the discount rate from 2.5% to -0.75%, effective 20th March 2017. The new rate is based upon the three-year rate of return of Index Linked Gilts and, when inflation is taken into account, real returns on such bonds have become negative. Many within the insurance industry have complained that claimants do not solely invest in Index Linked Gilts and the government admitted in an abandoned consultation on the discount rate in 2013 that evidence demonstrates claimants invested in “mixed portfolios”. The Chancellor acknowledged this argument within her statement but was not persuaded by it.

Since the announcement there has been a furore within the motor insurance market, with the ABI labelling the decision as ‘crazy’ and many insurers and reinsurers announcing significant hits to their balance sheets as they re-reserve their share of large bodily injury claims. Willis Towers Watson has estimated that the decision will lead to “a material one-off reserve charge of approximately £5.8 billion”

The impact on current reserves is much easier to discern than the effect the reduction will have on insurance and reinsurance pricing in the future. Catastrophic bodily injury claims can take, on average, eight years to settle (or longer in cases with younger claimants) and it is possible that new or recent claims will not settle based on the current discount rate. With this in mind, it would seem overly punitive for insurers’ upcoming renewals to be priced on the current rate. However, reinsurers may be reluctant to price on a higher discount rate as this would require somewhat blindly speculating on future changes.

Insurers will inevitably be applying their own price increases to policyholders in the coming months; many have already done so. The Office of Budget Responsibility predicts that insurance premiums are likely to rise by an average of 10% this year and this is already on top of a series of increases to insurance premium tax (IPT) and rate increases that insurers pushed through to counter the recent claims inflation. It will be important for insurers to demonstrate that these original rate increases have been applied without any major changes to their risk mix. This will present a more favourable picture to reinsurers as these original increases will offset the increased exposure that the change in discount rate creates. For stable books with a risk mix that reinsurers can trust to remain constant, it may be beneficial for insurers to look for reinsurers to price their programmes on a price per vehicle basis. This would allow for original rate increases to be directly incorporated into the rating calculation for their reinsurance.

It will be an interesting and turbulent year. A further consultation will be conducted before Easter which will consider whether the methodology for setting the discount rate is correct and whether more frequent reviews should be implemented. The ABI is aiming for a new rate before the end of the year but in the absence of another rate change, the market must respond to the decision as it’s been made. Uncertainty is clouding the market and it may not be until the 2018 renewal season begins in earnest that the impact of the change, for insurers and reinsurers alike, is fully understood.

By Alex Lyne