The motor insurance market says new compensation payment rules will severely hit profits, which will likely lead to higher premiums for customers to help offset the costs.
Hit by a series of government measures to better reflect the investment environment and the needs of injured claimants, the insurance industry experienced a £3.5bn hit to earnings in 2016, a report by consultancy group EY claims.
Net combined ratio
The most used metric in the insurance industry is the net combined ratio (NCR) – an insurer’s losses and expenses divided by earned premiums.
This suffered a severe negative impact when insurers applied the new "Ogden" rate to outstanding claims in their 2016 figures.
In February, the government announced it was changing what was previously the Ogden discount rate, which stood at 2.5%, to a drastically reduced -0.75%, effectively making it a premium rate.
Motor insurance NCR hit 109% in 2016 when the new Ogden rate was applied, compared with 100.5% in 2015.
A combined ratio above 100% means an insurance company is paying out more money in claims than it receives in premiums – although the profit it makes from investment is not included in the NCR.
Cost to insurers
According to a report on Wednesday by EY, the change in the rate will cost the insurance industry £3.5bn across all lines of business based on market announcements and its own research.
Approximately £2.4bn of losses have been disclosed publically to date, following the 27 February decision, the EY report says.
EY's insurance market lead Tony Sault says: "The impact of the Ogden rate change to the motor insurance industry has been considerable at around £3.5bn. While a reduction was certainly on the cards, virtually no-one anticipated the extent of the drop."
What is the Ogden rate?
When victims of life-changing injuries are granted lump-sum compensation payments, the amount they receive is adjusted to take into account the amount they would likely earn in interest by investing it.
Thus, under the previous 2.5% Ogden rate, to cover a claim on a £1000 loss an insurer would need to pay out £975:
1000 x 0.025 = 25
1000 - 25 = 975
Under the new rate the insurer would have to pay £1007.50 to cover a £1000 claim:
1000 x 0.0075 = 7.5
1000 + 7.5 = 1007.5
The Ministry of Justice, which set the new rate said that claimants must be treated as risk averse investors, "reflecting the fact that they are financially dependent on this lump sum for the duration of their life".
To reflect the fact that interest rates have been at historical lows for so many years, the Ogden rate has been reduced.