One day earlier this month while in London we glanced at a headline in the newspaper that said car insurance for young drivers could increase by 1,000 GBP annually.  We confess that, we didn't take particular note of the story until later in the day when we connected the dots of the Lord Chancellor's decision to revise the discount rate calculation used for lump sum insurance claims based on the so-called "Ogden Tables". The Ogden tables are the shorthand name for the official name --"Actuarial Tables with explanatory notes for use in Personal Injury and Fatal Accident Cases" --as Sir Michael Ogden was the chairman of the working party for the first four editions of the tables. 

You may have been reading about the effects of the "Ogden decision" on insurers and reinsurers.  In some cases the revised discount rate meant that certain risk bearers saw financial results swing from a profit to a loss.  In most cases the increased costs to insurers were surprisingly large numbers. When we saw headlines such as "Reinsurers to absorb bulk of 5 bn GBP to 7 bn GBP Ogden loss" we looked more closely at the Ogden decision.

The Ogden tables provide the actuarial backing used in the United Kingdom to compute the discount rate applied to lump sum cash awards in personal injury and fatal accident cases. UK courts have previously ruled that the discount rate be based on the assumption that any such claimant receiving an award would invest the lump sum in a "risk free" environment.  A risk free environment in the UK means --much as it does in other countries-- investment in inflation protected government bonds.  

The theory behind this assumption is understandable.  If an insured suffers a personal injury requiring lifetime care, with all the attendant costs that come with it, policymakers want to ensure that the insurance settlement covers the expected life span of the injured party and most important do not want to put the burden on the insured to be forced to seek a higher investment return to meet future medical costs.  Thus the assumption requires calculation of the award based on the premise that the insured would invest their entire lump sum amount in inflation-protected government bonds.

The discount rate had been set at 2.5% since 2001.  The rate hadn't been changed for 16 years. Keeping in mind a brief history of interest rates since '01 you may be able to guess what has happened.  Here's a clue.   Neil Sugarman, head of the UK Association of Personal Injury Lawyers  told the Financial Times that "We think the 2.5% rate has been wrong for many years. It assumes a far greater return than people are able to achieve, so they are in grave danger of running out of money." To be fair, Sugarman's group would likely say that as they represent plaintiffs seeking higher awards.

If you have been seriously injured in an accident, and a court determines that you need care which it has calculated will cost for example a million pounds, the insurer has been able to discount that amount by 2.5% as the Ogden rate (as set in 2001)  assumes that the claimant will safely see an investment return of that discounted amount by investing in an inflation protected government bond.

Last summer the yield on an inflation protected UK government bond was -1.72.  That's a 4.22% swing down from the +2.5% discount rate used to compute the amount an insured receives from a lump sum award. If you had incurred lifelong medical bills as a result of an injury, but had received a lump sum payment discounted by 2.5% this -4.22% swing was very bad news.  It meant you were likely to run out of money to pay for your care if you managed to live for the length of your predicted lifespan.

Everyone, it seems, knew that there was going to be a downward adjustment to the discount rate of 2.5%.  British insurer Direct Line had been reserving for a rate of 1.5%. Novae, Axa, Ageas and Zurich had reserved for a rate of 1%. The notable exception is reported to be Swiss Re that "appears to have been caught off guard" by the adjustment and supposedly had been maintaining its reserve at the 2.5% level.

On February 27 the new rate was set at -0.75%.  The rate had been reduced by 3.25% down to negative territory.  The new rate was based on a three year average of real returns on Index Linked (to inflation) government bonds.  The rate is to become effective March 20.

The change to the discount rate caused an immediate reaction.   The change will increase the size of lump sum payouts and insurers naturally were required to respond immediately. This is not small change. Aviva, for example, indicated it will take a $478 million charge to its profits after tax as a result of the change in the rate. Direct Line said the reduced rate will impact 2016 pre-tax profits by as much as $286 million. Novae said that it stands to see an approximately $70 million impact; Markel estimated an $85 million charge; Admiral estimated a $135 million profit hit; and Axis estimated a $50 million reserve charge.

For reinsurers the perspective is grim. It is what is known as an "asymmetrical loss".  As Adam McNestrie in Insurance Insider observed "the impact of the Ogden rate change will be more unevenly distributed through the reinsurance market than many other losses, with some reinsurers having bet heavily on UK motor reinsurance while others eschewed the market entirely." How big a loss could reach the reinsurers?

Again, McNestrie provides an estimate: "With a loss of £5bn-£7bn ($6.1bn-$8.6bn) projected for insurers and around 80 percent of that expected to hit the secondary market, reinsurers are looking at a loss of around £5bn ($6.4 bn) from what is effectively a casualty CAT."

Let's get some perspective on this from the insured losses for two well known property CAT events. US insured losses from Hurricane Matthew are estimated to be about $4 billion. Insured losses from the Ft. McMurray Canadian wildfires are estimated to be about $2.8 billion. 

Finding similar equivalents for casualty CAT events isn't easy.  We reviewed records of claims associated with mass pharmaceutical torts but understood that we weren't comparing apples to apples. Next, we thought of the total payout of claims for US asbestos losses which are currently at about $100 billion. Again, we decided that this wasn't quite a useful comparison either so we ceased and desisted. We were left with the words of Andrew Newman, president, global head of casualty and CEO of alternative strategies at Willis Re, who said "the current market practice for evaluating liability risk could be 'arcane' and result in a sub-optimal outcome."

As we were mulling over how to put the effect of the discount rate change in perspective we noticed howls (a little used word in the context of insurance) from the industry criticizing the decision.  We noticed, too, that the rate change decision came with the invitation from the government to begin discussions with the insurance industry about future rate adjustments, if not on outright modifications to how the discount rate is formulated.  In fact the Association of British Insurers met the Lord Chancellor the day after the decision was announced. In a joint statement following the meeting the industry and the government said "The government will progress urgently with a consultation on the framework for setting future rates, and bring forward any necessary legislation at an early stage. The industry will contribute fully to the upcoming consultation, and the government will carefully consider all evidence and arguments submitted."  

Then we remembered something we had read in a note from BLM Law, the UK law firm, which exhorted the industry to use the consultations with the government "to seize that opportunity to influence the underlying methodology and in particular the link to Inflation Indexed Government Securities."

The BLM Law note had included a quote from The Times Financial editor Patrick Hosking saying "no accident victim in their right mind would invest their entire lump sum in inflation-protected government bonds."

And just in case the reader still didn't get the point the BLM note goes on to say the real challenge of discussions with the government "must be to ensure that responses make an irresistable case for breaking the Index Linked Government Securities link so that the calculation of awards properly reflects how they'll be invested --doing anything else is a very expensive fantasy."

These kind of man-made tempests are always challenging for the industry. We're reminded of the billions incurred by the industry to comply with Solvency II.  We've all read articles discussing possible costs the industry could incur as it reacts to the UK government's Brexit plan although thus far a "hard" cost number is hard to pin down because the outline of the plan hasn't yet been agreed to. Both Solvency II and Brexit though are "costs", and not claims. They do not affect underwriting ratios but a change like Ogden will end up an underwriting loss. 

Predicting claims frequency and severity are part of insurance. It can be a difficult science especially when variables such as regulatory intervention exist. An insurer can formulate a near exact estimate of losses associated with motor insurance medical claims, for example, but as we see with the Ogden rate change it's liable to be usurped by an external act.

Excess of Loss reinsurance contracts play a significant role in motor reinsurance.  Naively we wondered whether there was not some clause in the Excess contracts that might relate to a material change in how the discount rate is formulated that might allow a reinsurer to pay based on the older discount rate, the rate in effect at the time of contract.

From the few contracts we have seen the reinsurer remains obligated despite the discount rate change.  We surmised as much. People far smarter than us operate reinsurance companies and we've yet to see a public utterance about "material change" and questions about obligations to pay the new amounts.  In fact articles, even in advance of the ruling, noted that primary carriers who had significantly availed themselves of reinsurance purchases would be in better shape than those which hadn't.    

Then we noticed that "UK excess-of-loss (XoL) motor reinsurers are targeting rate rises of 50 percent off the back of a projected £5bn ($6bn) hit from changes to the Ogden rate, as they look to secure rapid payback after the shock loss." The Insider article goes on to describe possible effects of "vultures" entering the market to take advantage of hoped-for rate increases as well as the need to maintain market discipline if the sector as a whole is to benefit from the premium rise.

We suspect we will see more articles written, noting prospective vultures and the need for maintenance of rate discipline. When the inevitable major earthquakes and hurricanes hit the property CAT markets the industry reaction to Ogden could offer an indication as to how the larger market could react when a larger loss strikes.

Finally, the word "asymmetrical" kept churning away in our heads. In the instance McNestrie used the word it referred to those reinsurers exposed to the UK motor insurance market as being most exposed. Peers who did not have UK motor exposure could be relatively unaffected.  

However, from one perspective the whole premise of the Lord Chancellor's ruling could be viewed as trying to correct an existing "asymmetry".  Surely insurers and reinsurers do not maintain more than one penny more of the minimum required capital in low interest government bonds, or worse, in very low yield inflation protected government bonds. 

There are other higher paying investment securities that risk bearers can place their money in to maximize investment return.  Even under Solvency II's new "risk based capital" investment guidelines insurers still have ample investment choices beyond the "risk free" investment criteria UK case law demands be afforded to those awarded lump sum medical claims.

Once the Lord Chancellor conceded that the standard of a "risk free" investment had to be maintained for the insured --any change in that standard would be possible only through the courts or Parliament --the ruling was probably inevitable. The discount rate simply had to be priced to the inflation indexed government bond. However, and this is the silver lining we suppose, the ruling came with an invitation to the industry to join a consultative process to reform the rate setting mechanism. Presumably even the Lord Chancellor realizes that, as The Times noted, "no accident victim in their right mind would invest their entire lump sum in inflation-protected government bonds." 

Certainly few awardees would invest the sum in a speculative investment but they may, and probably already do, invest the funds in higher paying instruments than inflation protected government bonds.  The insurance industry however is bound to pay all such claims under the assumption that all of them will invest in the most "risk free" and lowest return investment.  

One more point to ponder.  Lloyd's and the modeling firm Arium have launched something called "a probabilistic model for long-tail liability exposures". You can read the article here but the report issued by Lloyd's and Arium indicates that the new model "allows insurers to assess liability risk in the way they do when modelling property catastrophe - i.e. using annual average losses, exceedance probability curves and heat maps that allow a visual identification of risk clusters." 

If this is true it not only could mean the elimination of the need for surprise reserve actions by insurers but could provide an important missing predictive link for casualty risks that might  entice non-traditional capital to enter the market in a significant way.  

New models, of course, create new data challenges. Reams of data that have been poured through property CAT models over the years are beginning to become better organized and validated. Whether the same can be said about what may be even larger amounts of data required for casualty models is doubtful. Why should casualty related data be in any better shape than property data was?  Tools such as Data Vera, which cleans and validates data and then drops it into a designated model can certainly help. 

The Ogden rate change decision was unrelated to the work being done by Lloyd's and Arium. One would think that both Arium and Lloyd's recognized that the timing could hardly have been better to release news of their "probabilistic model for long-tail liability exposures."  We'll see what happens next but we'd be surprised if ILS managers aren't already pouring through the Lloyd's-Arium data looking for a way to put their money to work.

There was a conference in New York on February 3rd hosted by Artemis. The conference, ILS NYC 2017, was attended by over 200 people.  We attended too and before we go on to other news wanted to mention a few points we jotted down as we listened to the presentations.  After learning about the Lloyd's-Arium casualty model, and thinking through its alternative capital implications, one of the notes we jotted down made more sense.

Frank Majors, co-founder of Nephila Capital, was on the first panel. Frank stated that for every dollar of alternative capital currently in the market he estimated that there is still $5 dollars outside the market waiting to come in.  That's an astounding estimate and it's offered by someone who would know.  Currently there is $78 billion in alternative capital in the market. Majors statement that means that as much as $390 billion in alternative capital remains on the sidelines waiting to come into the market.  The entire reinsurance market is currently capitalized at $595 billion. If Frank is correct there is an amount that's 65% the size of the entire current market capitalization that is available, when the timing is right, to underwrite risks.

Separately, as if to confirm Majors' view, analysts at Peel Hunt have also noted that despite the slowdown of ILS inflow into the market that "What we anecdotally sense, is that a significant amount of capital is sitting on the sidelines waiting to be deployed post a major event."

We're used to hearing big numbers in connection with alternative capital. That it was Frank Majors making the 5:1 observation however meant something more than unattributed sources quoted in news articles. He's about as close to the proverbial "horse's mouth" as one can get on this subject. Still, though, people these days (ourselves included) can become accustomed to big numbers. 

Then we began to think about that pot in connection with potential losses stemming from the Ogden decision. And we began to think about that possible pot of $390 billion in connection with a sound casualty model (Lloyd's-Arium) that has thus far been described as a significant step forward. In fact as Catrin Shi in Insurance Insider observed  "a s casualty modelling grows in maturity, it could dramatically alter the way the underwriting community views long-tail risk - leading to improved capital management, increased reinsurance spending and even the launch of new products to deal with this better-understood exposure."

This all could become a very big deal, very quickly.  Thus far alternative capital has nibbled around the edges of casualty but as was discussed at an industry panel in Monte Carlo last September "capital markets investors appear willing and able to assume insurance and reinsurance-linked exposures outside of the property catastrophe space, and as the investors become more knowledgeable and the risks are better understood, it's possible that ILS could play an important role in areas like casualty, cyber and even terror."

What could be better, to help capital markets investors gain a better understanding of casualty risks than a casualty model embraced by Lloyd's? Other casualty models have appeared in the past year as well. If Frank Majors is right there is at least $390 billion sitting on the sidelines. The property CAT market, the popular destination for alternative capital, already seems saturated with coverage choices. But if a consensus is developed on the validity of the casualty models we could soon see a rush from the sidelines onto the field.

The annual Warren Buffett letter was made public earlier this month. When Buffett speaks about insurance one is duty bound to closely read it as Berkshire controls so much of the market.  We'd also note that last week former President Obama stopped in Omaha to have lunch with Mr. Buffett and we wondered if Obama, who's taste in food is reported to be notoriously eclectic, shared his host's normal lunch of a " hamburger and fries, followed by vanilla ice cream, strong on the chocolate syrup."  But, alas, Mr. Buffett stuck to a salad while Mr. Obama enjoyed a taco salad.

Everyone knows how much Warren Buffett values so-called float, the "collect-now, pay-later model (that) leaves P&C insurers holding large sums --money we call float--that will eventually go to others. Meanwhile insurers get to invest this float for their own benefit." The Berkshire total float amount now exceeds $100 billion.  

We probably repeat this quote every year and will do so again. On page 8 of Buffett's letter he writes: "If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money - and, better yet, get paid for holding it."

Lest you think that Berkshire's investment returns are masking poor underwriting results Buffett notes that the company has operated at an underwriting profit for 14 consecutive years and that "disciplined risk evaluation" at Berkshire is a religion -- "Old Testament style" as Buffett puts it. 

Underwriting discipline at Berkshire is serious business. We've had Berkshire underwriters positively bristle at us if we've even gently hazarded a murmur to them of their great good fortune to be sitting atop such an investment-return generating powerhouse. They bristle with good reason. Buffett goes on to observe that unlike Berkshire many insurers "simply can't turn their back on business that is being eagerly written by their competitors."

A good example of Buffett's strategy seems to be unfolding in London at Berkshire Hathaway Specialty Insurance where the former Lloyd's Performance Management Director Tom Bolt is now the CEO of BHSI's UK and Southern Europe operation.

Bolt has been in place at BHSI since June, 2016 and is in "the market to build long-term relationships with brokers and insureds gradually." He seems to be moving with deliberation and has recently hired three London-based underwriters and plans to expand into Ireland and Spain later this year.  Bolt believes that there remains attractive risks to insure in Europe but that they were becoming harder to find.

Obviously Bolt is possessed with that "Old Testament" view of underwriting required by Buffett. Less disciplined shops, resting on a Berkshire-sized balance sheet, could be having a field day if simple premium generation was the goal.

Bolt's caution attracted comment from Adam McNestrie in the Insider who noted that Tom Bolt's last eight years as Lloyd's Performance director had given him the "best possible vantage point on the Lloyd's market. Nothing moved that he didn't see."  McNestrie went on to observe that when "somebody who knows the market inside out, who has had that uniquely farsighted perspective, decides that it is best to wait patiently, the market should take notice."

Maybe.  We suspect though that Bolt is simply doing exactly what Peter Eastwood and Warren Buffett expected him to do when they welcomed him back to the Berkshire fold --he is being judicious and adhering to form. Profits are down at Lloyd's but there are still profits to be had and BHSI is not underwriting at Lloyd's anyway. 

Assembling a quality team, and patiently working with brokers and clients, while searching for attractive risks to underwrite seems a sensible policy to us.  If we were in Tom Bolt's position it would seem that doing anything other than that would risk some major "Old Testament" style wrath from above -- parting of the Red Sea and such, and that's not anything anyone would want.