Periodic payment orders PPOs The threats the opportunities

  • Slides: 15
Download presentation
Periodic payment orders (PPOs) The threats, the opportunities and the controversies; and the scope

Periodic payment orders (PPOs) The threats, the opportunities and the controversies; and the scope for some fresh academic thinking Especially in relation to the appropriate assets to hold, how much of them, and how to think about accounting and solvency Martin White, ATRC conference Edinburgh December 2014 PPOs and other issues M G White ATRC Edinburgh 2014 1

PPOs – some preliminaries • This presentation is entirely my own responsibility, not speaking

PPOs – some preliminaries • This presentation is entirely my own responsibility, not speaking for employer or any other organisation. • I see PPOs as an existential threat for some insurers and a likely embarrassment for any compensation funds • This ATRC event is my first presentation on the investment challenges of PPOs. Much work (see GIRO papers) has been done on PPOs, but I am not aware of anyone else arguing for investing in equities, even in part, to meet the liabilities. • I will make a fuller discussion available online following the event, at www. whototrust. org. uk (email [email protected] com ) • These slides merely outline the issues as I currently see them and a possible way forward; in the event, the short ATRC session did not use the slides much and I have included some material from the discussion with attendees on the day. • It is difficult to convey and also debate the asset valuation concepts touched on here in a short session; these will be the subject of further work and articles, on which any collaboration will be welcome. PPOs and other issues M G White ATRC Edinburgh 2014 2

Some suggested reading, mostly free • Julian Leigh’s October 2013 SIAS paper: “an introduction

Some suggested reading, mostly free • Julian Leigh’s October 2013 SIAS paper: “an introduction to periodical payment orders” can be downloaded from: http: //www. sias. org. uk/siaspapers/listofpapers/view_paper? id=SIASSept 2013 Pap er • Andrew Smithers’ book “Wall Street Revalued: imperfect markets and inept central bankers”, for details see http: //www. smithers. co. uk/files/Wall_Street_Revalued_info. pdf (highly recommended purchase!) • Slide 34 from Andrew Smithers’ SIAS presentation on Sept 24 on “the need for change in economic theory”, can be downloaded from : http: //www. sias. org. uk/siaspapers/listofpapers/view_paper? id=SIASSep 2 014 PPT • Warren Buffett’s memorandum of 14 October 1975 regarding “pitfalls of pension promises”, can be found towards the end of http: //www. berkshirehathaway. com/2013 ar. pdf along with the chairman’s letter which refers (p 21) to the pensions memo. PPOs and other issues M G White ATRC Edinburgh 2014 3

Pre-session abstract • Periodic Payment Orders (PPOs) are a commercial challenge to the long

Pre-session abstract • Periodic Payment Orders (PPOs) are a commercial challenge to the long term survival of individual motor insurers, and also a regulatory and political headache. The need for them (caring for severely injured people for the rest of their lives) is clear, and more awarded by the courts every year. As well as implications for the insurance industry, the impact on the future cost of the NHS is not widely understood, as PPOs are being awarded against the NHS as well. One could therefore argue that PPOs are an “elephant in the room”, both politically and commercially. • The liabilities are ultra-long term and are pension-like in nature – a portfolio of life annuities indexed to the cost of care for group of “pensioners” with a very long combined life expectancy. Rather than arguing “unfair”, this paper presents the author’s personal view that the industry should instead provide for PPOs properly, and discusses what “properly” might mean. The implications of this are immense, as well as technically interesting, so the scope for research is considerable. PPOs and other issues M G White ATRC Edinburgh 2014 4

PPOs – the challenge for insurers • Real liabilities, impaired life annuities ordered by

PPOs – the challenge for insurers • Real liabilities, impaired life annuities ordered by courts, most extreme case is newly born baby who may need lifetime care until say age 90. • Longevity is uncertain and generally improving, and medical advances can be dramatic, especially for impaired lives – e. g. potential of stem cell technology. (NOT looking at longevity here. ) • My focus today: It is the real nature of the liabilities, and the fundamental principle of using the most appropriate assets available, given the type and term of the liabilities. To me that means equities as the core asset, and I will argue that the conventional way of thinking about balance sheets, accounting, solvency, capital requirements all need to change. • The thinking I believe may be needed is so foreign to the conventional approach (though there are common themes with the UK DB pension world of 30 years ago) that I cannot see companies rushing to study it - hence the scope for some interesting academic challenge and input. PPOs and other issues M G White ATRC Edinburgh 2014 5

Conflicts – research challenges to the status quo • Research must be unconstrained to

Conflicts – research challenges to the status quo • Research must be unconstrained to be worthwhile (no “market for excuses”) • For example, the accounting world is beset with company management wanting – – To look good To declare steady profits, with a high return on equity To hold minimal assets To give shareholders a comfortable message • Honesty and open enquiry about PPOs won’t please everyone – Policyholder / claimant interest must always come first, before shareholders – The solvency 2 “one year view” is nonsense for PPOs – Delivering super long, super real liabilities with a high level of confidence means allocating shareholder funds to support them – a combination of lower profit declarations, lower dividends, higher premiums perhaps. – Shareholders may not understand the scale of the issue – are all motor insurers telling their shareholders enough? – Are all insurers already reserving enough, especially given their asset strategy? PPOs and other issues M G White ATRC Edinburgh 2014 6

Why do PPOs need real assets • To be durable, the liability carrier must

Why do PPOs need real assets • To be durable, the liability carrier must be able to survive periods of high inflation • “Real” government debt is not available at the durations and the quantities needed • Most approaches currently advocated involve rolling forward relatively short term instruments – this approach could come unstuck in times of crisis • Assets need to provide a real income stream; market fluctuations need dealing with rather than being regarded as a “show stopper” • However, whilst “real” assets might seem a no-brainer, there are many good reasons why this view is not widely accepted. Just as another asset type may fail in inflationary times, “real assets” are not a direct hedge and market fluctuations can in some circumstances be impossible to cope with PPOs and other issues M G White ATRC Edinburgh 2014 7

How to tolerate market fluctuations? • With sufficient real assets, a large proportion of

How to tolerate market fluctuations? • With sufficient real assets, a large proportion of annuities cash flow is met out of dividend income • We have to focus on a “closed fund” position – the insurer has stopped acquiring new PPOs and the existing assets have to be enough to pay the annuities in the 50 years and more ahead. So long as a fund stays “open”, it’s much easier. • Sales of assets will be needed as well as the dividends – need to be able to cope if market prices crash. So you can’t forget market values altogether, especially as the annuitants age • Insurers may be able to cope – but only with – Change of mind set, especially re thin capitalisation – Change of accounting approach – Change of solvency approach PPOs and other issues M G White ATRC Edinburgh 2014 8

What real returns to assume? (no conferring!) • What long term real return (say

What real returns to assume? (no conferring!) • What long term real return (say w. r. t. consumer prices or RPI) would you feel a) realistic and b) suitable for prudential policyholder purposes – For typical current strategies: government debt, corporate debt, swaps – For equities • For each of these, discuss what you think real returns have been over the last say 80 years, and how you would expect the next 100 years to compare. • NB: “prudential”: think as if you were the regulator / actuary expressing an opinion on the maximum permitted rates of return to assume PPOs and other issues M G White ATRC Edinburgh 2014 9

Results of straw poll on real long term returns at ATRC Modern “Conventional” Expected

Results of straw poll on real long term returns at ATRC Modern “Conventional” Expected return Equities Note: not everyone voted on each question for each asset type and some abstained altogether 2% 2 votes 6% 2 votes 1. 5% nil 5% 4 votes 1% 5 votes 4% 3 votes 3% 4 votes 0% 3 votes 2% 2 votes 1% nil -1% 2 votes 0% nil 2% 1 vote 3% 1 vote 2% 1 vote 1. 5% 1 vote 1% 1 vote 1% 3 votes 0% 6 vote -0. 5% 1 vote 0% 2 votes -1% 1 vote <-1% 1 vote <0% 4 votes Regulatory permitted assumption PPOs and other issues M G White ATRC Edinburgh 2014 10

Andrew Smithers on long term returns • (this is MGW interpretation – read slide

Andrew Smithers on long term returns • (this is MGW interpretation – read slide 3’s references for yourselves) • Equities with dividends reinvested over the decades – hindsight “true” values that the market “should” have been are assessed using the real returns that have applied over the decades • Market value of real assets can go way above or below a “true” value; e. g. at times of low interest rates we get overvaluation (like today) • Smithers: you can make a reasonable estimate of the “true” value – both a “q” (based on the cost of replacing the assets) and a CAPE (cyclically adjusted price earnings ratio) can be used - see slide 34 from Smithers’ SIAS presentation (see link on slide 3). • There is plenty of scope for us to think about this further and Smithers’ hypothesis hasn’t been subjected to much discussion, certainly not in actuarial circles. PPOs and other issues M G White ATRC Edinburgh 2014 11

Sounds like old-fashioned pensions? • Pre the late 80 s pension actuaries projected the

Sounds like old-fashioned pensions? • Pre the late 80 s pension actuaries projected the dividends on the asset portfolio, notionally investing the assets in the all-share index. • They applied consistent assumptions on inflation, earnings growth, long term return on new contributions, etc. • Balance sheets assessed on this basis were largely unaffected by market value upwards and downwards shocks (provided they moved in line with the all-share) • BUT, when balance sheets were presented the “calculated” value of the assets could vary wildly from the market value. • Actuaries gave up explaining why this made sense, and when markets rose they capitulated and put higher values on the assets, but without much adjustment to the liability assumptions. The rest is history. PPOs and other issues M G White ATRC Edinburgh 2014 12

Asset-liability management for PPOs • This is not ALM in the sense of “protection

Asset-liability management for PPOs • This is not ALM in the sense of “protection against short term volatility”. We are focusing on long term durability. • Simplistic presentation to illustrate the points (nothing sacrosanct about the assumptions) – Note: ignoring the “easy” problem of longevity! – Assume long term real return post expenses: say 1. 0% (prudential, defines funding requirement, accounting and solvency), but we might perhaps plan / expect to get 2. 5% real in practice (this is way below what’s been achieved in the past – but is the past repeatable? ) – We need a “MV adjustment factor”. Order of magnitude, from Smithers’ analysis (his SIAS slide 34) has log(market/”true”) around 0. 5 to 0. 6. exp(0. 5) is 1. 64, so assume that to get “true” value, we have to divide current market values by 1. 65. This adjusted base value is going to be the core of our valuation and projection basis. PPOs and other issues M G White ATRC Edinburgh 2014 13

PPO ALM contd • Important to note the core assumption – That there is

PPO ALM contd • Important to note the core assumption – That there is a “true” value of the assets, and the (unknown) long term return will be based on this. (This is a newish idea, and not necessarily widely accepted) – But the market cost of buying the “true” assets is today over 150% - so in the long term you must expect to get the real return rate on 2/3 rds of today’s market value. Sadly, as a long term investor you want asset prices to be low, not high. In the worst case, you invest in high markets and disinvest in low markets. • Running projections suggests the following – With a real return on the underlying fund above the prudential “funding” bases, surpluses will emerge – Some of the surplus needs to be held back in case of market value way below the “true”, as the need to sell assets at cheap prices can outweigh the benefit of the real return margin – When the remaining fund duration falls, the amount of surplus you need to hold back rises as a proportion of the prospective liability – Plenty of scope to play with the sensitivities / simulation to determine the “free” assets needed to give sufficient assurance of the fund not running out at the end – For a fund where the liabilities are being “refreshed” – an ongoing motor insurer for example, the disinvestment problem is not a concern, and an equity strategy will be lower risk, relative to a declining/run off portfolio. Like DB pension funds until they closed to new accrual. – Can supply crude spreadsheet to anyone interested PPOs and other issues M G White ATRC Edinburgh 2014 14

Recap / final comments – PPOs represent an existential threat to motor insurers in

Recap / final comments – PPOs represent an existential threat to motor insurers in particular, as they are likely to represent around 50% of their balance sheets over time, and if their new business falls or stops the PPO liabilities will dwarf everything else. – To survive / stay long term solvent, I suggest a REAL (probably equity) portfolio may be essential, but that prospective solvency needs a “real return” view of the world that appropriately reflects market behaviour – Andrew Smithers’ work seems to suggest a potential solution here. BUT……. . – Whilst it should be possible to be relatively relaxed about market value fluctuations, it becomes much trickier when the fund starts to decline sharply – so it is necessary keep back a higher risk margin above the prudentially set asset requirement towards the later years of the fund. Lots of thought needed! These concepts may be relevant to personal financial planning too. – PPOs are the longest and the most real liability stream I can think of, longer and more real than pensions (many accident victims are young), yet general insurers’ business model and attitude is normally: • Relatively thinly capitalised (the solvency II one year target is a joke in this context) with minimal market risk in shareholders’ assets. • Focused on “return on shareholders equity” rather than long term stewardship / maximisation of shareholder wealth. – I think all this needs to change, or companies will go bust with nasty consequences. No easy solution – much thinking needed, therefore. PPOs and other issues M G White ATRC Edinburgh 2014 15