UK: The Lord Chancellor’s Review: The Discount Rate – How Should It Be Set?

Last Updated: 6 September 2012
Article by James Dadge, James Dadge and Mark Hemsted

Executive Summary

  • On 1 August 2012 the Ministry of Justice published the Consultation Paper "Damages Act 1996: The Discount Rate – how should it be set?"
  • The purpose of the Consultation Paper is to canvass views, not on the level of the discount rate itself, but the methodology by which the discount rate is set
  • Two options are proposed; an Index Linked Government Stocks ('ILGS') based methodology and a mixed portfolio methodology
  • It is our view that defendants need to champion and provide evidence that a mixed portfolio is the most appropriate basis for setting the discount rate both in terms of risk and return
  • The Consultation Paper will require a significant amount of work not only from insurance claims teams, but also from actuarial resources too, in order to assess not just the impact on open claims, but the longer term implications for pricing models, investment returns and reserving
  • We are actively involved in cases involving discount rate arguments in foreign jurisdictions where the Damages Act does not apply. As a result we have already taken steps to identify appropriate experts to report on all material issues, including likely rates of return from investing in a mixed portfolio strategy, and are happy to share our expertise on the issues to assist you in preparation of responses to the consultation

Background

The discount rate, the formula used by the courts in the UK to calculate a lump sum award for personal injury damages, was, in 2001, fixed by the Lord Chancellor at 2.5%.

The Lord Chancellor set out the following principles which underlay the setting of the discount rate:

  1. An award of damages for future losses is to place the claimant as near as possible in the same position he or she would have been in but for the injury.
  2. Claimants should not be treated as ordinary investors.
  3. The court does not have to reach any conclusion as to what an individual claimant will actually do with the money received.

In setting the current rate of 2.5% the Lord Chancellor reached three conclusions:

  1. He would set a single rate to cover all cases.
  2. The rate was to be set to the nearest half per cent.
  3. The rate should last for a reasonable period into the future.

When fixing a rate he followed the House of Lords in Wells v Wells and used a real rate of return based on the average gross redemption yields on ILGS, considered a very low risk investment, over a three year period.

He also took into account additional factors, such as the Court of Protection continuing to invest in multi asset portfolios and the likelihood that claimants with a large award of damages would, if advised, invest in a mixed portfolio, in which any investment risk would be very low.

The Lord Chancellor concluded that setting a 2.5% discount rate would not place an intolerable burden on claimants to take on excessive (that is moderate or above) risk in the equity market.

The consultation

Whilst ILGS remain available as an investment, it is recorded that the three year average yield has declined from 2.46% in 2001 to 0.2% in mid-2011, both before tax. It is further noted that, whilst periodical payments are available to claimants, the majority of awards still are in the form of a lump sum payment at the conclusion of the claim. It therefore is described as a risk that the current discount rate, given the decline in ILGS yields, is too high to give effect to the principle of 100% compensation and so it is appropriate the rate should be reviewed.

In light of advice from the Government Actuary and HM Treasury the Lord Chancellor has now decided to review, and consult upon, the methodology to be used in fixing the rate. Two potential options are identified:

  1. To use an ILGS based methodology applied to current data; or
  2. To move from an ILGS based calculation to one based on a mixed portfolio of appropriate investments.

In considering the options above the Lord Chancellor will be looking for a methodology that produces the most accurate discount rate. Consultees' views are also invited as to whether the discount rate should be set by reference to another approach.

The aim is for the chosen methodology to produce a discount rate which will be applicable for the foreseeable future, whether that be a single discount rate, or two or more rates.

The general approach

The paper indicates that the purest solution would be individual discount rates in individual cases based upon the yields available on the day of settlement or the damages award. However, to encourage settlement and simplify litigation, a general discount rate is required.

In setting any new discount rate, the Consultation Paper confirms the Lord Chancellor will be guided by Wells v Wells so the claimant will be treated as a low risk investor guarding against inflation.

The paper points to two types of investment risk: market risk, arising out of the volatility or uncertainty in the price or income of investments; and mismatch risk, which is related to the intended use of investment returns by a specific investor. It suggests that in a portfolio of ILGS there is very little market risk but there is still a mismatch risk. For example, the longest dated ILGS available may redeem before the life expectancy of the claimant and there is no guarantee that further suitable ILGS will be issued.

The question is posed as to whether ILGS is a less cost effective way to protect a claimant against future cost inflation than investment in a similarly low risk mixed portfolio of investment.

The options

Option 1 – ILGS based approach applied to the current data

This option retains the use of ILGS as the basis of a portfolio but opens for discussion every other detail of how a methodology constructed around ILGS might work:

  1. Previously it was assumed that ILGS would be held until maturity to protect the claimant from the volatility of the market. However, this may be impossible. Should the claimant be assumed to hold all ILGS until redemption? If not, what alternative assumptions should be made?
  2. The calculation for the current discount rate was based on a simple three year average of ILGS real yields. However, are current yields, or forward rates, the best predictor of future returns and an accurate discount rate?
  3. It is suggested that using the simple average gives too much weight to short term ILGS. Should short dated ILGS of less than five years be excluded? Or should average yields be weighted by maturity?
  4. Should an index more specifically related to care costs be used, rather than RPI?
  5. What considerations should be applied to the rounding up or down of the discount rate? Should rounding be restricted to one half per cent?
  6. What allowances should be made for investment expenses and tax?

Option 2 – mixed portfolio applied to current data

This option identifies three possible types of assumed portfolio, other than ILGS, based on the ABI's Life Fund Classifications that might be considered adequately low risk. These are:

  1. Mixed Investment 0-35% shares
  2. Sterling Fixed Interest
  3. Money Market

These investments might be combined with one another and ILGS. The composition of the mixed portfolio used as the basis for the methodology is open to discussion.

It is of interest that the paper also invites interested parties to submit evidence on the choice of investment strategy actually pursued by claimants.

Other considerations

Notwithstanding the focus of the consultation being on the methodology behind setting the discount rate, consultees are invited to give their views on the appropriate level of the discount rate.

The consequences for defendants in paying awards are not a matter to be taken into account in deciding the discount rate and its methodology. However the impact of the choice of methodology on small businesses is considered. It may be that the consequent increase in premium levels as a result of higher awards of damages is best argued in terms of its effects on small businesses.

The Impact Assessment

The impact assessment is of interest in that it indicates the following:

  1. It is assumed the discount rate will be lower if an ILGS based approach is retained.
  2. It is assumed the stability and simplicity of the discount rate will be lowest by using a mixed portfolio.
  3. It is assumed a mixed portfolio is capable of greater accuracy in reflecting the investment preferences of a risk averse claimant.
  4. As creating the methodology using a mixed portfolio will be more complex than retaining an ILGS based approach, moving to a discount rate based on a mixed portfolio may require expert financial and investment advice more often to achieve the rates of return consistent with the discount rate. If such costs arise an allowance can be made in compensation awards for defendants to pay investment management costs.
  5. A lower discount rate will lead to increased awards of damages with the consequent effect on defendants, which may lead to increased insurance premiums and an extra burden on bodies such as the NHS. This is, however, an indirect effect of the change in methodology and is not one that is deemed to be relevant in the setting of the methodology.
  6. It is reiterated that it is not compulsory for the court to use the prescribed rate although challenges to the usual rate are rare.

As a pure illustration, but demonstrating the potential discount rate if it were set now based upon either ILGS or relevant mixed asset portfolios, it is indicated that the respective rates could potentially be as follows:

  1. Using a pure ILGS portfolio and the same methodology, but applying current data, would produce a discount rate of about 0.2%.
  2. Using a pure ILGS portfolio, but revising some or all of the existing methodology, would result in a derived discount rate either side of around 0.2%.
  3. Using a mixed portfolio, the discount rate would be lower than 2.5% but higher than using a pure ILGS portfolio.

Next Steps

The deadline for responses to the Consultation Paper is 23 October 2012.

Absent seismic change in the economy, when the methodology is finalised using as its basis either of the proposed options, the rate is likely to be less than 2.5%. A best estimate is either 0% or 1.0%. This will have the consequence of increased awards to claimants.

The door is open to the split multiplier, potentially reducing wage related costs to -1.5% or below. It is, however, noteworthy that the Consultation Paper continues to use the phraseology of "discount rate" despite the comments of the Privy Council in the Guernsey case of Helmot v Simon that multipliers should be adjusted, but not necessarily discounted, to take into account accelerated receipt.

The Consultation Paper provides the insurance industry the opportunity to champion a methodology not based on ILGS but on a mixed portfolio reflecting the reality of claimants' actual investment strategies, thus minimising any decrease in the discount rate and the consequent impact on the value of awards. Immediate steps to achieve this include:

  • Identification of the impact of a reduction in the discount rate on small and medium sized business insureds should be considered as a way of bringing into the consultation information about the affect that larger awards will have on premiums
  • Insurers should also consider the prospect of settlement of cases on a periodical payment basis, given the lack of risk on claimants in terms of investment, mortality and inflation, and the risks associated for insurers with periodical payments may be outweighed by the costs associated with a lower discount rate
  • In the meantime insurance claims teams need to identify all cases that can reasonably be compromised now on a 2.5% basis and seek to do so. We anticipate a reluctance on the part of claimant advisors to settle now given the prospect of a lower discount rate and the 10% uplift on general damages due to take effect in April 2013
  • Conditional settlements based upon future adjustment to the discount rate should be avoided. We have successfully defeated such arguments in the past

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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