Insurers warn of 'soaring' car premiums after discount rate cut

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This drop means that, rather than being given a 2.5% discount, insurers will instead have to pay out the full sum awarded in court to an insurance claimant, plus an extra 0.75%.

The Association of British Insurers (ABI) have responded to this rise by claiming that 36 million individual and business motor insurance policies will go up as a result, with young drivers in particular facing the prospect of having to pay an extra £1,000 a year.

However, the move primarily reflects the fact that claimants who receive compensation now earn a negative return if they invest it in Government bonds, which means that on top of losing money, they and other insurees are being threatened with increased premiums.

Bonds and yields

To understand just how this has come about, the Ministry of Justice were encouraged towards their decision after Government bonds began yielding insignificant or even negative returns in the second half of last year.

This was because the Bank of England missed their targets in a bond buying programme intended to stimulate the economy. Because they failed to find enough sellers, demand for bonds went up, and so too did prices.

With bonds, higher prices result in lower yields, with some bonds maturing in 2019 and 2020 yielding returns of - 0.1%, even before inflation was taken into account.

This is important for insurance claims because, historically, the Ministry of Justice have assumed that those receiving compensation - particularly those who suffer serious injuries - will invest their money and profit from the interest.

The insurance industry have therefore been awarded a discount on the basis of this assumption, benefiting from a Discount Rate of 2.5% since 2001, when bond yields were higher.

Now, however, the Lord Chancellor, Liz Truss, has decided that since yields are lower, and since other forms of investment aren't especially profitable due to low interest rates, the insurance industry should no longer be receiving this discount.

This is why she announced that it would be reduced to -0.75%, requiring insurers to pay an extra 0.75% of the compensation, as well as the compensation itself.

Impact

Unsurprisingly, the insurance industry were aghast at this decision.

In a statement, the Director of the ABI, Huw Evans, said, "Cutting the discount rate to -0.75% from 2.5% is a crazy decision by Liz Truss. Claims costs will soar, making it inevitable that there will be an increase in motor and liability premiums for millions of drivers and businesses across the UK".

Other voices were similarly critical, with the UK general insurance leader at PricewaterhouseCoopers, Mohammad Khan, predicting "an increase of £50-£75 on an average comprehensive motor insurance policy".

He went on, forecasting "higher increases for younger and older drivers - potentially up to £1,000 for younger drivers (18-22 year olds) and a rise of up to £300 for older drivers (over 65 years old)".

Worse still, he claimed that the Government's planned cap on whiplash payouts won't be enough to mitigate the impact of the Discount Rate's reduction, particularly when this fall will be coupled with further increases to the Insurance Premium Tax.

In order to gain a sense of just how deep the impact of the reduction will be, it's worth noting that between 2014 and 2015, car insurers received 4.3 million claims, paying out an average of £2,160 to 99% of these.

In total, this works out roughly as £9.2 billion. However, without a discount of 2.5% being applied, it would come to a much higher figure.

For instance, the average individual compensation would rise to the £2,232, which would bring the total payout for 99% of 4.3 million claims to about £9.43 billion.

This represents a loss of £230 million over two years, which makes for sobering reading in light of how, in 2016, the motor insurance industry turned a profit for the first time since 1994. What's more, this profit amounted only to £33 million.

More frequent reviews

Still, as damaging as it looks set to be for car insurers, it's hard to hold too much sympathy for an industry whose profit margin and business model appears to be predicated on receiving discounts from the Ministry of Justice.

What's more, the MoJ have opened a consultation on their decision, in which they're open to the rate being "set by an independent body" in the future and to "more frequent reviews".

Given that frequent reviews are on the table, and given that insurers met with the Chancellor of the Exchequer yesterday to discuss such reforms, it's likely that the Discount Rate will be moved back up as soon as the returns on bonds recovers.

And if that does happen, it will be interesting to see whether motor insurers push their premiums back down in response.