The decision by Liz Truss had taken the City of London completely by surprise. No one had expected her to go so far, to take such drastic action with such wide-ranging consequences. Company and government finances had been dented as a consequence and the backlash was immediate. Soon, Truss would no longer be in her role and her successors would be left to try and resolve the situation.
This describes events that took place in early 2017, five years before Liz Truss was to become the UK’s shortest- serving Prime Minister, having experienced a similar sounding collision with financial markets.
Truss had been made justice secretary and lord chancellor, her second cabinet position, a year earlier. Her time in the role will be mostly remembered for a failure to criticise the Daily Mail for its infamous ‘Enemies of the People’ front cover, which attacked three divisional court judges.
Yet her most impactful decision on financial markets as justice secretary went largely unnoticed by the public. In February 2017, Truss signed off on a decision to significantly change the Ogden Discount Rate (ODR), a multiplier used to calculate UK insurance claims.
Changing the rate from 2.5%, as it had been for more than 15 years, to -0.75% was described at the time by the Association of British Insurers’ director-general as a “crazy decision” and “reckless in the extreme”.
With insurance payments for accident victims rising by more than 90% in some instances because of the rate change, insurers were forced to increase premiums and NHS liabilities rose.
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Within a month, a review had been launched into the rate change and within two years it had been partly reversed. By then Truss had been moved on to a more junior position within government.
Yet the debate over the ODR and how it should be set continues.
Given Truss’s resignation as prime minister, following the fallout from her disastrous mini-budget, how much of the clumsy decision-making that scarred her short-lived leadership was foreshadowed by her ODR decision?
Did she cause this early market tumult through her often-stated desire to act decisively, or was she, like her predecessors in the Justice Ministry, just trying to delay finding a long-term solution to a devilishly complex problem?
What is the Ogden Discount Rate?
The ODR is the mechanism used to decide how much people suffering long-term injury can claim from their insurance. Insurance companies use ‘Ogden tables’ to calculate the likely life expectancy and care costs of victims. This is then multiplied by an annual rate meant to represent the likely return the claimant would make by investing the insurance payout.
It is a very complicated thing to calculate, requiring assumptions not just on the lifespan of claimants but also their long-term care costs, future economic conditions and how they are likely to invest their money.
Between 2001 and 2017, the discount rate remained unchanged at 2.5%. That meant that any lump-sum payment would be reduced by an annual 2.5% to reflect the likely returns a claimant would make from investing that money.
With interest rates staying historically low for more than a decade after the global financial crisis, the UK government, which sets the Ogden rate, was under pressure for it to better reflect investment realities. Given the average claimant was unlikely to earn a 2.5% return on investment, the ODR should have been lower and awarded sums higher to reflect this.
Mohammad Khan, a member of the ODR working party for the Institute and Faculty of Actuaries, says: “The reason the Ogden Discount Rate was changed was due to pressure from claimant lawyers as settlements were occurring at the then prevailing rate of 2.5% and our understanding is that it was felt that actual settlements at the time were generating a lower effective investment rate given market conditions.”
By the time Truss became justice secretary in July 2016, the government had already conducted a market consultation in 2012 and commissioned an expert report in 2015 to assess what should be done with the rate.
The 2012 consultation reflected claimants’ concerns that the assumed interest made on lump sum awards did not reflect the realities of those suffering long-term injury. Respondents were concerned that discounting awards did not offer claimants enough financial flexibility, particularly in the immediate period after an award had been made, before any interest could be earned.
The report also reflected concerns from the insurance industry about regularly changing the rate to reflect current market conditions, as this would seem like a lottery to claimants and make it difficult for insurers to plan long term.
While there was evidence to suggest that the rate needed to be amended, and possibly the whole structure of how to calculate payments revised, no one in government enacted a change to the ODR, until Truss became justice secretary.
According to Khan, by 2017, the pressure was growing on government to revise the ODR as “some claimants lawyers were threatening a judicial review”.
The existing 2.5% rate had been set based on the rate of return from government bonds in 2001. At the time that Truss changed the rate, average yields on three-year average index-linked gilts were -0.83%, so she decided, based on the advice of the government’s actuaries, to stick to precedent and round this to -0.75% for the amended rate.
This decision assumed that the average claimant would be ultra-risk averse and invest their awarded settlement in the safest asset possible, which at the time offered negative returns.
Not only was this subsequently criticised as not reflecting the realities of what claimants would likely do with their awarded settlements (most likely stick them in the bank, which would not provide a negative rate of return), but it also came as a huge shock to the UK insurance market.
Even a small change in the ODR makes a big difference to claimants, insurance customers and insurers.
Francisco Sebastian, who is also a member of the Institute and Faculty of Actuaries working party on the ODR, says that for every 1% increase in the Ogden rate, indemnities to people with life expectancy assumed at about 45 years would decline by around 20%.
A rate change of more than 3% therefore had a significant material impact on the claims exposure for insurance companies, leading to much higher premiums for many.
“When the rate changed to -0.75%, it did have the effect of more than doubling insurance premiums for very young drivers and very old drivers and increasing the NHS critical illness liabilities,” says Khan.
At the time, insurance broker Dennis Watkins & Co estimated one scenario where a young man suffering a serious head injury could see his awarded settlement rise 94% from £15.1m before the rate change to £29.3m.
AXA estimated the overall cost of the rate change to insurers for existing claims would be £7bn, and £1.2bn every year thereafter.
Immediate review to the ODR change
A backlash from the insurance industry led to another consultation period, launched the following month from when Truss made the rate change. The results of this consultation found “virtually all respondents… said they did not believe claimants were advised to invest all of their lump sum in index-linked government securities”.
Most comments from insurers said they would advise claimants to take a mixed portfolio approach to investing, and “the main argument from a claimant perspective was that claimants were obliged to use a mixed portfolio under the previous discount rate in order to secure adequate returns”.
It made clear that insurers wouldn’t advise just investing in index-linked government bonds and the claimant would be unlikely to do so.
In the letter explaining her decision to change the rate, Truss acknowledged the “mixed portfolio” arguments “have some merit” but added that she was “not persuaded by them”.
Legally, she may not have thought she had much choice. As Khan says, she was facing a potential judicial review if she kept the rate the same, but if she strayed from precedent in her rate change, she was also likely to face legal challenges.
Truss could have chosen to face these challenges, having used previous market consultations to devise a fairer framework for deciding lump-sum payments. Instead, it seems like she chose the path of least resistance, despite the market shock it created. Rather than indulge in the impulsive decision that characterised her brief time as prime minister, she simply ducked the opportunity to find a creative solution to a complex problem.
What happens next with the ODR?
One of the positive outcomes from the market tumult of 2017 is that it led to an update of the law underpinning the ODR. This legislation was introduced by Truss’s successor, David Lidington, in June 2017. Among other things, it established the requirement for a review of the ODR every three years at the most.
In 2019, the rate was increased to -0.25 under the then Justice Secretary David Gauke. Insurance companies have expressed concerns over regular changes to the ODR and how that might require a change in the systems used and data recorded in relation to claims.
Some advocate for a move to a dual or multiple-rate system, dependent on life expectancy, although any change to the ODR must contend with daunting complexities.
“The current [single] Ogden overcompensates those with a high life expectancy and undercompensates those with a low life expectancy,” says Sebastian. “Switching to a dual rate would mitigate some of this over and under-compensation. It would, however, increase the complexity of calculating the Ogden Discount Rate and assessing claims.”
He adds that the existing hypothetical investment portfolio used by government actuaries to calculate the rate is built on significant assumptions.
Perhaps the most problematic aspect of the calculation, however, is inflation. The higher long-term inflation expectations are, the lower the ODR would be. Yet the rate has historically been based on the Bank of England’s long-term inflation target of 2%, which is currently much lower than real or expected inflation as measured by the retail prices index.
If forecasts of long-term inflation – which are currently volatile – remain significantly above 2% this will need to be reflected in a re-estimated ODR. However, given that the Ogden rate does not need to be re-estimated until 2024, the forecasts of long-term inflation may revert back to the Bank of England long-term target of 2%.
The ongoing challenges of setting a fair ODR show how difficult a decision Truss faced in 2017. She is perhaps guilty of kicking the can further down the road, however, at a time when there was greater scope to reform the rate than today, when inflationary pressures are far greater than when she was justice secretary.
She was boxed in due to legal challenges, had to make a decision, and leant on advice from the government’s actuaries. Yet she chose the easiest decision available to her, without fully appreciating the blowback it would create.
Perhaps that is better than the reckless boldness that marked her later approach to the wider economy. Or maybe getting away with this clumsy decision, without it stymying her political rise, helped embolden her to be bolder – a boldness (in spite of significant market opposition) that would have disastrous consequences once she had risen, briefly, to the top of British politics.