In Sempra Metals Ltd v IRC [2007] UKHL 34, the House of Lords concluded that the time has come to recognise the court’s jurisdiction to award a claimant compound interest for the restitution of money paid as a result of a mistake. Significantly, the court has jurisdiction to award interest, both simple and compound, as damages on claims for non-payment of debts as well as on claims for breach of contract and tort. The impact of this landmark judgment is likely to be far-reaching and felt by insurers when setting case reserves.

The Sempra case

Sempra, a UK subsidiary of a German parent company, was part of a group action to recover advance corporation tax paid to the Revenue prematurely by mistake. The tax had been paid according to UK legislation, which was contrary to EC law, and Sempra’s claim was for the time value of the money paid to the Revenue, to the extent the Revenue had been unjustly enriched.

The Revenue had enjoyed the benefit of this windfall for several years (in some instances, up to 10 years) and did not dispute its liability to pay interest on the premature payments. It did, however, dispute the method of calculation. The real battleground over how much interest should be paid and how it should be calculated came down to whether simple or compound interest applied.

Although compound interest is the norm in the commercial world, the Revenue argued that simple interest would be an effective legal remedy. The court disagreed. It said that the rule which had previously prevented claimants recovering interest on a compound basis in circumstances such as this did not reflect current commercial practice. Lord Nicholls said:

“We live in a world where interest payments for the use of money are calculated on a compound basis. Money is not available commercially on simple interest terms. This is the daily experience of everyone, whether borrowing money on overdrafts or credit cards or mortgages or shopping around for the best rates when depositing savings with banks or building societies. If the law is to achieve a fair and just outcome when assessing financial loss, it must recognise and give effect to this reality.”

Why the difference matters

Does it really matter to insurers whether they are liable to pay interest on a simple or compound basis? The difference between calculating interest on a compound basis as opposed to a simple basis is illustrated below:

Example A – Simple interest at 8% on £50m over five years. The interest amounts to £20m, giving a grand total of £70m

Example B – Compound interest at 8% on £50m over five years. Instead of a straight increase of £4m interest per annum, the interest accrues approximately:

Year 1 £4m

Year 2 £4.32m

Year 3 £4.66m

Year 4 £5.04m

Year 5 £5.44m

This gives a total interest figure of £23.46m and a grand total of £73.46m, an increase of £3.46m over the simple interest calculation. The longer the period involved, the more advantageous compound interest will be for the claimant and the more disadvantageous for insurers. Insurers may therefore find it necessary to increase reserves on current claims as claimants now look for compound rather than simple interest.

The loss suffered

The rate of interest claimed may also vary, as it is open to claimants to plead and prove actual interest losses caused by late payment of a debt. These losses would be recoverable, subject to the principles governing all claims for damages for breach of contract, such as remoteness and failure to mitigate.

As the court explained in Sempra, the loss may, for example, be the loss of an opportunity to invest the promised money or the ordinary commercial cost of borrowing money. In the second case, that cost may include having to pay interest on a compound basis when borrowing funds. If so, the claimant will seek to recover on the same basis.

Each case will depend on its own facts and the court will not assume that delay in the payment of a debt will, of itself, cause damage; in each case the claimant must prove its loss. This could mean that simple interest is likely to be the more appropriate remedy if the claimant does not have to borrow money to replace the debt or if the interest period is short.

Possibly expensive outcome

It remains to be seen exactly what the implications are for insurers following this decision. But if the claimant can prove and compound its lost interest claim, the outcome for insurers could prove more expensive in the long run. Insurers might therefore need to review whether any claim is made for compound interest and to reserve appropriately.