UK: PPOs And The Long-Term Guarantees Package

Last Updated: 22 August 2013
Article by Sarah MacDonnell and Theresa Chew

Executive summary

A large number of UK general insurance (GI) companies now have material exposure to annuity-type liabilities in the form of periodical payment orders (PPOs). This means that many will need to understand and engage in the issues surrounding the 'Long-term Guarantees (LTG) package' proposed for Solvency II.

What is the LTG package?

Under current Solvency II guidance, annuity-like liabilities (in this discussion, PPO liabilities) will be required to be valued using a risk-free discount rate for capital valuation purposes. The impact of this, is that some companies are likely to have to hold additional, possibly onerous, amounts of technical provisions than under current regulations. Mitigation options do exist, such as the matching adjustment (MA). However, the application of this adjustment, the final nature of which is as yet undefined, is likely to be complicated and the relative benefits of adopting it would need to be assessed by companies informed by their own particular set of circumstances.

The LTG package debate has been raging in the life insurance industry for some time and has been one of the principal reasons behind delays in the Solvency II timetable. With PPOs rising in significance for many UK GI companies, affected organisations would be well advised to monitor and participate in this debate.

Background to the LTG package

The increased volatility of balance sheets for long-term insurance business under Solvency II has been a difficult and contentious issue for all stakeholders. At the heart of the debate is the very important issue about what discount rate to use in valuing the long-term liabilities.

To address this, the co-legislators (collectively the 'Trilogue' that is: the European Parliament; the Council; and European Commission) have constructed the 'Long-Term Guarantees (LTG) package'. The package is intended to stabilise the 'artificial volatility' of companies' solvency positions and aims to reflect both the market-consistent objectives of Solvency II and the nature of insurance companies' liabilities.

Why does it affect me?

PPOs involve the award of a portion of a large insurance claim, typically involving a severe bodily or brain injury, as inflation-linked annual payments rather than as a single lump sum. They were first introduced in the UK in 2005, and since 2008 the number of awards has been steadily rising.

Towers Watson estimates that PPO liabilities may already account for around 10% to 15% of motor reserves in the UK. That proportion will only continue to increase as more and more of these long-term liabilities accumulate on company balance sheets. Why? Because the mean term of PPOs is 40 years, each year more PPOs will be added onto the reserves than drop out, hence PPOs will become an increasingly larger proportion of the liabilities for many years to come, even if the propensity of claims settling as PPOs remains constant.

Another consequence of liabilities with such long terms is that a small change in the discount rate used can have a large impact on the value of the PPO liabilities – for example, a 0.5% pa addition to the discount rate would reduce liabilities by around 15% for a 40-year duration PPO claim.

Figure 01 shows an estimate of the proportion of settled PPOs to total motor market reserves. In this graph, incurred but not reported (IBNR) PPOs, such as known claims not yet settled as PPOs, are not included. If they were, then the lines would effectively be shifted to the left by around six years. Note the two alternate scenarios based on different inflation, investment, longevity and propensity assumptions, which also serve to illustrate just how uncertain and difficult to quantify these risks are.

Whilst the figures illustrated in Figure 01 relate to motor liabilities, it is worth remembering that PPOs also impact other lines of business such as employer's liability, public liability and medical malpractice. But whichever line of business PPOs fall into, the long-term nature of the liabilities involved means the LTG assessment is directly relevant.

What can GI companies do?

1. Take part in the LTG Assessment. EIOPA is carrying out an impact assessment on the LTG package with a deadline of the end of March. This is the UK GI industry's opportunity to make its views heard.

There is no specific requirement for UK GI insurers to participate in this assessment, which will be dominated by the life insurance industry. However, UK GI companies with PPO liabilities can use the assessment to present a representative picture of the issue to EIOPA and to use the process to understand the potential impact of the proposals on their own business, and what the best course of action is likely to be, such as whether it will be worth taking advantage of the matching adjustment.

2. Participate in the LTGA exercise but not within the demanding timescales, so as to understand how the different options might impact them (in the same way many firms did the QISs for internal purposes but did not actually formally do them in submission timescales).

3. Familiarise themselves with the issues and start planning now for how to deal with them. For example, start thinking about how the different elements of the Long-Term Guarantees package could affect the investment strategy backing the PPOs. This could include evaluating the trade-off between constraining the investment strategy to be eligible for the matching adjustment against adopting an unconstrained asset allocation but with no Solvency II benefit from the matching adjustment. In addition, the implementation of a strategy consistent with the requirements of the matching adjustment needs some thought given such requirements as the ring-fencing of assets and for them to be separately managed.

References to other sources of information on this topic are included at the end of this article.

Technical appendix

For those charged with understanding the technical detail of the LTG assessment, the following section provides a brief guide – annotated with some additional observations from Towers Watson on the challenges that the various elements of the assessment present.

How will the risk-free discount rate be calculated?

The risk-free rate is the sum of:

  • Basic risk-free interest rate term structure (BRFR)
  • Matching adjustment (MA), where applicable
  • Counter-cyclical premium (CCP), where applicable

Basic risk free rate (BRFR) and extrapolation

For the purposes of Solvency II, the basic risk free rate (BRFR) for insurance liabilities is based on the mid-market swap curve less a swap credit spread. However, for some currencies, the swap market is not very liquid at longer durations. Where this occurs, companies will be required to extrapolate the swap curve to an ultimate forward rate of 4.2%. For the Euro, the extrapolation will start after 20 years and for Sterling (GBP) swaps, after 50 years. (According to the PPO GIRO Working Party 2012 Survey, a third of all PPOs are expected to last more than 50 years.) The central assumption for the speed of convergence from the last liquid point to the ultimate forward rate is 10 years, but EIOPA is also testing the impact of a 40-year convergence rate.

""The stricter the liquidity criteria used to determine the last liquid point, the earlier it will apply and the less market information that will be used to determine risk-free rates."

Towers Watson comment: Extrapolation is intended to deal with the issue whereby liabilities have significantly longer durations than the last liquid point for risk-free assets. The stricter the liquidity criteria used to determine the last liquid point, the earlier it will apply and the less market information that will be used to determine risk-free rates. This could cause practical matching issues as it will mean that the long-dated assets that are available will be less of a match for liabilities. The implications of extrapolation are more significant for currencies which are deemed to have relatively short last liquid points (for example, the Euro as compared to GBP).

For the purposes of the LTG assessment, the same swap credit spreads are applied to all currencies for each reporting period (varying between 10 bps1 and 35 bps in these scenarios) and no credit risk adjustment is applied to government bonds. These assumptions will have a material impact on companies' balance sheets but the methodology is still under development at this time.

Matching adjustment

The matching adjustment is intended to minimise volatility that does not reflect the nature of insurance business, that is, that insurers are able to invest for the long-term and can largely avoid short-term volatility in the asset markets.

The level of the adjustment relates to the spread between the expected return on assets backing the liabilities and the BRFR but also adjusting at the same time for the likelihood of the assets defaulting and the impact of credit rating downgrades.

Significant constraints are imposed on the assets that can be used to back the liabilities to which the matching adjustment will be applied in terms of their characteristics, riskiness and closeness of cash flow matching. This asset portfolio would need to be ringfenced, managed and organised separately.

Two forms of adjustment are being tested in the LTG assessment – the 'classic' and the 'extended' matching adjustments. We expect the extended matching adjustment to be relevant to PPO liabilities.

With the extended matching adjustment a further reduction factor is applied which is derived from the extent of the potential mismatch between the assets and liabilities and is prescribed within the technical specification.

Companies will be required to assess the materiality of any mismatch in relation to criteria set out within the technical specification. For the purposes of the assessment, the maximum cash flow shortfall is set at 15% of the best estimate liabilities. However, it is the intention that the actual threshold should be much smaller upon implementation of Solvency II. A complication with PPOs is that they tend to be longer-term than most life company LTGs and are linked to earnings inflation rather than the Retail Price Index. This means it may be more difficult to find assets to match to PPO liabilities and hence to meet the matching criteria.

Towers Watson comment: The matching adjustment, subject to the extent of any reduction factor, should be effective in mitigating the impact of short-term credit spread spikes and as such, could be of great benefit to insurers. However, there are also a number of key concerns relating to the constraints that may be imposed on investment policy. In addition, some of the most challenging aspects of the proposals are not directly addressed here. In particular:

  • The requirement to ring-fence, organise and separately manage the assets backing the matching adjustment is an onerous one, with potentially significant set-up and on-going cost and organisational implications.
  • The definition of assets that may be allowed is limited and potentially excludes a large proportion of assets such as callable bonds, hybrid debt, floating rate notes, equity release mortgages and mortgage bonds. Within the LTG assessment, there is an opportunity for insurers to justify the appropriateness of some of these assets to back their liabilities and companies should use the opportunity to make their case.
  • Companies are further restricted in the assets that they may use to calculate the matching adjustment and the yield that they can take into account in the calculation due to the rules on minimum credit ratings of allowable assets (no assets below BBB; BBB limited to 33.3% of total non-sovereign assets). This goes against the risk-based approach to capital adopted elsewhere in Solvency II.
  • The limit for cash flow mismatch is expected to be much lower than that allowed within the LTG assessment, which recognises that companies have not yet modified their investment strategies to allow for Solvency II. There is some concern that the actual limits may be overly strict and difficult to manage.

The above constraints could have a major adverse impact on insurers' investment and hedging strategies. The more constrained an investment policy is, the more likely it is to be sub-optimal. The impact of this would ultimately have to be passed on to consumers.

In the short-term, the asset constraints could result in asset market price movements as insurers switch in and out of assets that are more or less favourable under the matching adjustment proposals. There could also be longer-term implications for the wider economy and growth prospects if they concentrate insurers' investments into a smaller pool of assets.

""The matching adjustment, subject to the extent of any reduction factor, should be effective in mitigating the impact of short-term credit spread spikes and as such, could be of great benefit to insurers."

Countercyclical premium (CCP)

The CCP is intended to counter circumstances whereby the markets are 'stressed', where 'periods of stress' are to be determined by EIOPA. The CCP is only applied where there is no matching adjustment. As a result and, assuming the matching adjustment will be appropriate for PPO liabilities anyway, we do not think the CCP is likely to apply to UK GI companies. However, as discussed above, we acknowledge it may be difficult to find assets to match PPO liabilities and hence to meet the criteria required by the matching adjustment.

Transition arrangement

In order to avoid a severe discontinuity in companies' balance sheets upon implementation of Solvency II, it is proposed that companies are allowed to phase in the Solvency II discount rate over a period of seven years. However, we do not think that this is likely to apply to UK GI companies with PPO liabilities.

LTG assessment – details and tips

The LTG assessment seeks to test a range of different approaches under different economic conditions in order to understand the effects on consumers, insurance companies, supervisors and the financial system as a whole.

The conclusions and decisions made following the LTG exercise could have major implications for companies' financial strength, risk management, investment and hedging strategies, and also product design and pricing under Solvency II. This applies especially to life companies but will also be important to some GI companies.

The companies required to participate in the exercise are selected by their respective national supervisors. Companies not formally participating in the quantitative exercise may also be asked to submit qualitative information to assist in the understanding of the practicability and expected burden of the proposals.

Participants are required to provide information in respect of their solo undertakings, by type of obligation and by country where these are considered to be useful. They are asked for results on a standard formula basis, but they may also additionally submit internal model results.

Participating companies are asked to provide Solvency II balance sheets on 13 scenarios, each testing a combination of the various aspects under investigation. These are defined as the economic conditions at three dates, in some cases as proxies for specific conditions:

  • 31 December 2011 (reference date)
  • 31 December 2009 (stressed market conditions to test volatility impact)
  • 31 December 2004 (quasi normal market conditions)

The scenarios, in summary, are shown in Figure 03 overleaf.

The reporting templates request a large amount of information, split into fairly granular levels, for example:

  • Asset information, split by asset class, currency, credit quality and duration
  • Technical provisions, split to an appropriately granular level. Cash flows to run-off are also required
  • Own funds, split by capital tiers
  • Solvency capital requirement (SCR), split by sub-module and minimum capital requirement (MCR)
  • For liabilities that qualify for the matching adjustment, companies are asked to provide detailed information on the liability cash flows, as well as the assets and cash flows within the ring-fenced portfolio backing those liabilities, split to an appropriately granular level
  • Corresponding Solvency I balance sheet and capital requirements at the reference date

Towers Watson comment: The work that will be required for the assessment is reasonably onerous due to the large number of scenarios and the level of granularity requested, even though UK GI companies will probably not need to undertake all scenarios, for example such as those which relate to the CCP or transition arrangement. In the worst case, more than 13 scenarios will be required as further sensitivities are requested within some scenarios. (For example, scenarios which include 100bps CCP, a subset of information is requested with no CCP, although these may be approximate.)

Companies will need to make assumptions on the interpretation of some of the other outstanding contentious issues, such as contract boundaries and look-through approaches. As practices can vary between companies, this will lead to some inconsistency between the results.

Some parts of the detailed specification appear to be worded similarly to documentation prior to the October 2011 Draft Implementing Measures. This is likely to create some confusion within the industry as regards what is the most recent view from the legislators in regard of some issues, as they prepare to implement Solvency II.

Qualitative questionnaire

Companies are asked to fill in a qualitative questionnaire covering a wide range of questions about the feasibility of the proposals, how they would react to them and the methodologies they use.

Towers Watson comment: There is a lot at stake as a result of this assessment and companies will need to emphasise the key issues arising. Regardless of the questions asked in the questionnaire, we believe that the industry should take the opportunity to feedback the opportunities and concerns that they have about the LTG package and, where possible, to illustrate these effects.

Overall, the opportunity to analyse some of these contentious issues using concrete data is to be welcomed. Some of the issues are currently expected to be embedded in primary legislation, which will be very difficult to change once signed into law. Given the financial significance to the insurance industry as a whole, it is important that companies provide good and robust data for the purposes of informing the legislation.

Process and timelines

On 28 January 2013, EIOPA published the final part of the technical specifications and reporting template. Companies were given nine weeks to complete the assessment with a submission deadline of the end of March 2013. EIOPA and the national supervisory authorities will then perform their analyses and EIOPA will submit its findings to the Commission in June 2013. The Commission, in turn, is to provide its final report to the Trilogue by 12 July 2013. In the interim, participants may be required to respond to further questions and challenge from EIOPA and their national supervisors.

Towers Watson comment: From a practical perspective, the exercise runs at a fairly inconvenient time for many companies as it coincides with most companies' year-end reporting periods. However, the issues under consideration are among some of the most contentious within Solvency II and due to the significance of the issue for many insurance markets, it is important that legislators get an accurate picture of the potential impact upon which to base their decisions.

Conclusion

Amidst all the pages of documentation associated with Solvency II, the LTG assessment is of fundamental importance for general insurers. Insurers, even those with relatively few PPOs on their books at present, would be unwise to dismiss it as of little value to them.

The number of PPOs is continuing to grow which will result in them progressively accounting for a larger and larger proportion of GI companies' reserves. Keeping this fact in mind, it is worth UK P&C companies considering the LTGA impact assessment on balance sheets in 5, 10, and 20 years' time, as just taking into account the current position will understate the impact.

Other information sources

The EIOPA webpage for the LTG assessment

https://eiopa.europa.eu/consultations/qis/insurance/long-term-guarantees-assessment/index.html

Towers Watson

Solvency II

http://towerswatson.com/en-gb/Services/your-businessissues/preparing-for-solvency-II

LTGA Webinar

http://events.towerswatson.com/events/17354

PPOs

http://towerswatson.com/en-gb/services/services/periodical-payment-orders

Investment advice

Towers Watson's investment specialists have a strong track record in helping investors with long-term liabilities such as pension funds and insurance companies construct efficient asset strategies to manage these liabilities with an acceptable return. In addition, in combination with Towers Watson's P&C insurance experts, the capital implications of different investment strategies backing the PPO liabilities, including the effect of the matching adjustment, can be factored into the design of the backing assets providing a complete solution.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.