What even are Ogden Rates anyway?
The Ogden tables are tables of annuity factors, published by the Government's Actuary Department, which are used to calculate court awards for claimants who have had life changing injuries or a fatal accident and are eligible for a payout from their insurance policy.
For example, consider a 50 year old, male, primary school teacher who suffers a car accident which means that they will not be able to work for the rest of their life. The Ogden Tables will be used to calculate how much they should be paid now to compensate them for their loss of earnings. Suppose the teacher is earning a salary of £33,000 when they have the accident, then under the Ogden Rates prior to March 2017, the teacher would be paid a lump sum of £33,000* 20.53 = £677,490 where 20.53 is the factor from the tables.
How did the Government's Actuary Department come up with these factors?
The factors in the table are based on two main pieces of information, how long the person is expected to live, and how much money they can earn from the lump sum once they are given it (called the discount rate). It's this second part which has caused all the problems between the Ministry of Justice and the Insurance Industry.
The discount rate should be selected to match the return generated on assets. For example, if the claimant puts all their money in shares then on average, they will generate much more income than if they put the lump sum in a savings account. So what should we assume our school teacher will invest their lump sum in? Since the school teacher will not be able to work again, and therefore will need to live off this money for the rest of their life, they will not want to risk losing all their money by investing in something too risky. In technical terms, we would say that the claimant is a risk adverse investor.
In order to mimic the investment style of this risk adverse investor, when the Ogden tables were first set, it was decided to assume that the investor would put all their money in index-linked bonds. There are a couple of reasons to assume this, many risk adverse institutional investors do purchase a lot of index-linked bonds, and also, the average discount rate for these bonds is readily available as it is already published by the UK DMO.
At the time the tables were set up, this seemed like a great idea, but recently it has made a lot of people very angry and been widely regarded as a bad move.
What are Index-linked bonds again?
In the 1981 the UK government started issuing a series of gilts which instead of paying a fixed coupon, paid a floating coupon which was a fixed percentage above the rate of inflation.
The UK Debt Management Office is responsible for issuing these bonds, and the following website has details of the bonds that are currently in issue. It's quite interesting to see how it all works:
The basic principle is if you purchase a bond that pays 2% coupons, if inflation is 3%, they would pay 3%+2%, if inflation was 5%, then they would pay 5% + 2%. Due to the fact that these bonds always gave a fixed real return (2% in this case), institutional investors really like them. Because there is no inflation risk, on average index-linked bonds cost more than fixed coupon bonds once you account for the effects of inflation. Pension Schemes in particular purchase a lot of these bonds,
Why do Pension Schemes like these bonds so much?
Most pensions are increased annually in line with inflation, due to this Pension Schemes like to hold assets that also go up in line with inflation every year. In order to get real returns on their investments, Pension Schemes traditionally held a mix of shares and index-linked bonds, the shares gave better returns, but the bonds were more safe.
This all started to go very wrong after the financial crisis . A huge drop in interest rates and investment returns, combined with soaring life expectancy lead to more and more pension schemes winding up and the remaining ones have funding issues. As the schemes started winding up they became more and more risk adverse and started to move away from the more volatile assets like shares and moved towards index-linked bonds instead.
This table from the PPF's Purple Book shows the move away from shares into bonds.
Pension Schemes like these assets so much in fact that Schroders estimated that 80% of the long term index-linked gilts market is held by private sector pension schemes as the following chart shows.
Does it matter that Pension Schemes own such a high proportion of these gilts?
The problem with the index-linked gilt market being dominated by Pension Schemes is one of supply and demand. The demand for these bonds from Pension Schemes far outweighs the supply of the bonds. Another chart from Schroder's estimates the demand for the bonds is almost 5 times the supply.
Here is a chart showing the yield over the last 5 years for a 1.25% 2032 index-linked gilt.
So what does this have to do with Ogden Rates?
So now we are in a position to link this back to the recent change in the Ogden Rate.
Because the yield on index-linked bonds has traditionally been used as a proxy for a risk-free real return, the yield is still used to decide the discount rate that should be used to calculate court award payouts.
Because Pension Schemes have been driving up the price of these bonds so much, we have the bizarre situation that the amount that insurance companies have to pay out to claimants has suddenly jumped up considerably. In the case of a 20 year old female for example, the amount that would be paid out has almost tripled. As these pay outs are already considerable, the financial impact of this change has been massive.
So what should the Government do?
There is no easy answer, if the Government doesn't use the yield on index-linked gilts to calculate the Ogden rate then there is no obvious alternative. I think the most reasonable alternative would be to use a weighted average of returns on the types of assets that an average claimant would hold. For example, we might assume the claimant is going to hold 50% of their lump sum in cash, 30% in shares, and 20% in bonds, and we would then calculate the weighted return from this portfolio.
The issues with doing nothing is that the additional cost from these increased pay outs will inevitably be passed on to the policyholders through higher premiums. So ultimately there is an issue of fairness whereby people who are receiving payouts are being paid a disproportionate amount of money, and this is being subsidised by policyholders other policyholders.