Monday 27 February 2017 3:28 pm

Government cuts discount rate: Experts react to move by justice secretary Liz Truss and warn on implications

The government's decision to slash the insurance discount rate caught most of the sector's largest firms by surprise this morning.

In particular, large motor insurers such as Direct Line (shares dropped by more than six per cent) and Admiral (down more than two per cent) were hit.

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What is the discount rate?

The discount rate is set by government and applied to personal injury payouts. It has been at 2.5 per cent since 2001 and the dramatic reduction to -0.75 per cent was lambasted by many in the sector.

In effect, the changes mean claimants can expect more cash from a lump sum payout upfront, than they would otherwise get if the payout were stretched over a period of time.

How did the City react?

Insurance experts highlighted a number of side effects arising out of the surprise rate move:

1 – Surprise, surprise

"Today’s discount rate is lower than some companies had expected, with Esure for example budgeting for a fall to zero per cent," said Nicholas Hyett, an analyst at Hargreaves Lansdown. "That will negatively impact full year results for 2016 as well as affecting the loss rates on any business written up to this point."

Russ Mould, investment director at AJ Bell said: “The consensus was looking for a drop to 1.0 per cent."

Simon McCulloch, a director at Comparethemarket.com agreed, he said:

The Ogden discount rate has been changed in a far more drastic way to what insurers had been expecting.

Mohammad Khan, PwC's insurance leader, added: "The Lord Chancellor's announcement on the Ogden [Discount] rate change to -0.75 per cent was not anticipated by the insurance industry."

2 – Switching

However, Hyett highlighted price comparison sites could be given a boost by today's decision. He said:

If prices in markets such as motor insurance, which has significant exposure to personal industry claims, do start to increase then it’s a potential windfall for the price comparison industry, which should benefit from the increased switching that usually accompanies rising prices.

Ian Hughes, chief executive of Consumer Intelligence, said: “This is going to cause a massive jump in shopping around as this is the first year that insurers are going to have to be upfront about premium changes."

3 – Young drivers

Insurance premiums are costly enough for teenagers who have just passed their tests. And the changes will likely weigh even heavier on the bank balances of parents looking to give their offspring some freedom by paying for their car.

Big Four beancounters PwC predicted up to an extra £1,000 could be added to the premiums of 18-22 year olds.

“Consumers will end up paying the cost of this decision through increased premiums as the sector raises prices to reflect the increased compensation payouts," said Hyett.

4 – Absence of meaningful studies

The whole idea of the discount rate is compensate those taking a lump sum for the time value of money.

"The rate of 2.5 per cent, set in 2001, was based on returns generated by index-linked government stocks," said David Johnson, a partner at Weightmans.

"It’s disappointing that this radical change has been made in the absence of any meaningful studies into how damages are typically invested and the rates of return they can expect to receive."

In reality that is not how the vast majority of claimants choose to invest the damages they are awarded – and that needs to be understood if we are to identify a fair rate.

5 – La La Land

Picking up on last night's gaffe at the Oscars, insurance law firm BLM drew an interesting comparison.

Alistair Kinley, a director of policy and government affairs at BLM, said:

The government is living in La La Land if it thinks that injured people actually put their compensation into the negative returns delivered by index-linked government securities.

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Confusion in Hollywood (Source: Getty)