Bringing the discount rate into the real world

The law which empowers the Lord Chancellor to set the personal injury discount rate does not need to change, but the assumptions underlying it do to reflect the reality of investment today.

In Kennedys’ response to the Ministry of Justice on how the discount rate should be set in the future, we reiterated the impact of the Lord Chancellor’s decision on 27 February 2017 to reduce the rate from 2.5% to minus 0.75%. As well as dramatically increasing damages awarded to all claimants receiving future loss awards, other consequences may follow, including claimants seeking lump awards rather than periodical payments (PPOs).

We have stressed the strength of feeling among compensators that the legal basis for setting the discount rate should be changed to reflect how actual claimants invest their awards.

At the moment, in setting the rate, the Lord Chancellor assumes that the claimant is not prepared to take any risk and so invests in (low-risk) index-linked government stocks (ILGS). However, there is nothing in the Damages Act 1996 that prevents the Lord Chancellor from altering this assumption.

To ensure accuracy, the Lord Chancellor should set the discount rate based on how claimants actually invest their damages, i.e. in a mixed portfolio of investments. Claimants should not be assumed to be ‘special investors’ but ‘ordinary prudent investors’. To do otherwise results in over-compensation.

A prudent investor

We appreciate that the Lord Chancellor is following the guidance set by the House of Lords in Wells v Wells [1999] – accepting the importance and exclusivity of ILGS. Consequently, the new rate reflects the fact that investments in ILGS currently result in a net loss relative to inflation.

However, that is not the outcome expected by even the most risk-averse investor. Such risks can be addressed by investment in a mixed portfolio of investments tailored to the needs of the claimant and dependent on his life expectancy. Indeed, even in Wells, Lord Lloyd said that a minimum of 70% equities and 30% bonds is what “the prudent investor would do”.

We support the Lord Chancellor continuing to take the decision in future, albeit following advice from an independent expert panel, whose members should include an actuary, a financial expert, an investment adviser and an economist.
We have also backed the consistency and simplicity of a single rate.

There are circumstances where PPOs are not appropriate, and our view is that their availability should not affect the discount rate, while claimants should not be penalised if they opt for a lump sum. Claimants should have a choice as to the form of award. Whilst we accept that opting for a lump sum rather than a PPO for future losses suggests a claimant may have a greater appetite for risk, we do not consider this should be a determining factor. Claimants should be given the option to choose the form of award.

Flawed methodology

Mark Burton, the Kennedys’ partner leading the firm’s work on the discount rate, says:

“The Lord Chancellor’s decision to introduce a negative discount rate demonstrates how flawed the current methodology is – when in the real world claimants are achieving positive returns from low-risk investment strategies.

That has to change if the government is to balance the importance of fully compensating injured people with the profound difficulties that the recent change have caused compensators in both the private and public sectors, as seen by a string of stock market warnings.

The enormous increase in claims costs caused by the new rate risks a number of adverse outcomes. Will we see the loss of any potential benefit from other measures aimed at reducing whiplash claims and motor insurance premiums as a result? Indeed, might premiums now continue to rise instead?

At a claims handling level, we predict that settlements may now be delayed while awaiting the consultation outcome, and that some cases will become more entrenched as compensators are forced to argue smaller points because the financial stakes have been raised so high.

Such outcomes do not benefit anyone. However, we believe that by adjusting the methodology, the government can deliver fairness to all sides.”

Related item: Discount rate reduction after 16 years

Read other items in the Personal Injury Brief - June 2017