Image copyright Getty Images

Average car insurance premiums could increase by up to £75 a year as a result of a government ruling, industry experts have said.

A new formula for calculating compensation payments for those who suffer long-term injuries has been announced by the Ministry of Justice.

But the Association of British Insurers (ABI) called the decision "crazy".

The Ministry of Justice said it had no choice under the current law, and said it would consult on possible changes.

Shares in insurance companies fell, with some saying that profits would be hit by millions of pounds.

The change is due to take effect from 20 March.

How compensation works

Accident victims are paid compensation in a single lump sum, which in serious cases is supposed to support them for the rest of their lives.

But someone who receives that lump sum can actually increase that amount by investing it, and getting a cash return.

So to be fair to insurance companies, the payout is reduced accordingly.

For the past 16 years the discount rate, as it is called, has been set at a typical rate of 2.5% - making the payout that much smaller.

Now the Ministry of Justice has decided to reduce the discount rate from 2.5% to minus 0.75%.

That will result in more money for the victim, but a higher cost for the insurer.

The change was ordered because the formula assumes the victim were to invest his or her money in government bonds.

By the time inflation is taken into account, real returns on such bonds have become negative.

'£1,000 increase'

Reducing the discount rate to minus 0.75% was a "crazy decision", said Huw Evans, director-general of the Association of British Insurers (ABI).

"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," he said.

"We estimate that up to 36 million individual and business motor insurance policies could be affected in order to over-compensate a few thousand claimants a year."

Image copyright Getty Images Image caption The change will mean accident victims are likely to receive higher pay-outs

Experts said higher insurance premiums could cost drivers under the age of 22 up to £1,000 a year.

"We anticipate an increase of £50-£75 on an average comprehensive motor insurance policy, with higher increases for younger and older drivers - potentially up to £1,000 for younger drivers, and a rise of up to £300 for older drivers," said Mohammad Khan, UK general insurance leader at accountancy firm PwC.

Older drivers includes anyone over the age of 65.

However, accident victims are set to benefit as they will receive higher pay-outs.

Lawyers who had campaigned in favour of the changes welcomed the news.

"People already coping with the most severe injuries have been deprived of the help and care they need for years," said the Association of Personal Injury Lawyers.

Consultation

A number of insurance companies said their finances would be hit as a result of the changes.

Direct Line said it expected its pre-tax profits to be reduced by as much as £230m.

Where negligence claims are made against the NHS, the bill could rise by £1bn, the Treasury said.

But the NHS Litigation Authority will be compensated for any extra cost, the government promised.

The Ministry of Justice will now launch a consultation on how the system can be made fairer.

It said it would bring forward any necessary legislation "at an early stage".

In the meantime, it has made it clear it had no choice but to change the discount rate, according to the existing law.

"The law is absolutely clear - as Lord Chancellor, I must make sure the right rate is set to compensate claimants," said Liz Truss, the Lord Chancellor and Justice Secretary.

"I am clear that this is the only legally acceptable rate I can set."