The cost of motor insurance

Supplementary evidence from the Association of British Insurers (CMI 13a)

1 The UK insurance industry is the third largest in the world and the largest in Europe. It is a vital part of the UK economy, managing investments amounting to 24% of the UK’s total net worth and contributing the fourth highest corporation tax of any sector. Employing over 275,000 people in the UK alone, the insurance industry is also one of this country’s major exporters, with a fifth of its net premium income coming from overseas business.

2 Executive Summary

2.1 The ABI has already submitted a response to the Transport Select Committee regarding the rising costs of motor insurance. This supplementary submission should be read in conjunction with our earlier evidence. This submission outlines the ABI’s position with regard to the Lord Chancellor’s recent confirmation of his intention to conduct a review of the discount rate. For the reasons outlined below, the ABI strongly opposes any reduction in the discount rate as this will lead to substantially increased costs to insurers, which will ultimately have to be passed onto consumers through higher insurance premiums.

3 The Discount Rate

3.1 The discount rate is used to calculate the size of the lump sum payment awarded to a claimant to meet their ongoing needs. The discount rate is applied to all lump-sum payments (but not to periodic payments which are paid, as the name suggests, in regular instalments) and is set by the Lord Chancellor pursuant to section 1(1) of the Damages Act 1996.

3.2 All insurers are bound to apply the discount rate set by the Government to lump-sum payments of compensation. The discount rate set by the then Lord Chancellor in 2001 was based on yields generated by index-linked government securities (ILGS) and was calculated at 2.5 per cent. The current Lord Chancellor confirmed he is reviewing the discount rate in early November 2010, following pressure from the Association of Personal Injury Lawyers.

4 Impact on the insurance industry and its customers

4.1 Any reduction in the discount rate will have an immediate effect on the settlements made by the industry. Reducing the rate from the current level of 2.5% would lead to a smaller discount being applied to compensation payments and, therefore, significant and immediate increases in settlements which would have both a retrospective (i.e. claims filed but not yet settled) and ongoing effect. These substantial and immediate increased costs on insurers are likely to be passed onto consumers through higher premiums.

4.2 ABI members have provided us with actuarial calculations estimating the potential impact of a change to the discount rate. This information has enabled us to estimate that a reduction in the discount rate will result in immediate and ongoing extra costs to insurers amounting hundreds of millions of pounds. As we indicated in our earlier submission (see paragraph 2.6), last year motor insurance made an underwriting loss of £1.5 billion - the 15th successive year the industry made an underwriting loss. Against this background, it is difficult to imagine the industry not passing on the increased costs associated with reducing the discount rate to consumers through increased premiums.

4.3 It is important to recognise that these are only the potential costs to the insurance industry. Any rate reduction would also apply to compensation payments made by Government, in particular through the National Health Service and the Ministry of Defence.

5 Calculation of the discount rate

5.1 The ABI is not aware of any objective evidence demonstrating that claimants are under-compensated. In the vast majority of claims, future losses are settled on a conventional lump sum basis, despite the facility for parties to agree, or the courts to order, periodical payments, suggesting there is a general acceptance by all parties that opting for a lump sum approach does not result in an award which is too low.

5.2 In addition, average yields from the investment of lump sum awards are, in practice, likely to be higher than the conservative returns on which the calculation of the discount rate is currently based. This suggests the discount rate should be calculated on wider classes of assets than the current focus on ILGSs. Doing so would bring payments into line with how claimants actually invest their compensation. This would also align the UK more closely with other European countries – for example, both Germany and Luxembourg have a 4% discount rate.

5.3 Although rates of return on ILGSs are currently depressed, they can be expected to rise in time. This may mean that ILGS yields over recent years provide an inaccurate basis for the future projection of a net rate of return. Given the current volatility of international financial markets and overall economic conditions, the ABI believes that it is not possible to make any accurate predictions about valuing future returns.

6 Conclusion

6.1 The ABI is not aware of any objective evidence demonstrating that claimants are under-compensated. Any reduction in the discount rate will lead to increased costs for consumers, including motor insurance premiums. We, therefore, urge the Committee to recommend that the Government not reduce the discount rate.

December 2010