Following an announcement the discount rate is set to increase, the Ministry of Justice has published draft legislation to create a fairer system for the setting of the discount rate.

The provisions, which have been welcomed by the ABI as ‘a sound basis for setting the rate in the future’, insert new sections to the Damages Act 1996. The amendments specify when the rate should be set, by whom and the review mechanism.

How the rate should be set

The rate is to be set by reference to expected rates of return on a low risk diversified portfolio of investments, rather than very low risk investments as at present.

In assessing those rates, the actual investment practices of claimants and the investments available to them must be considered. This will ensure the rate more accurately reflects how claimants invest their awards in practice and should be applauded. The MoJ has indicated that if the rate was calculated now on the basis of the new methodology, it may be between 0 and 1%.

It will continue to be possible to set different rates for different types of cases, including by reference to the length of the award. Only one rate, covering all cases, has been prescribed to date.

There will probably be a range of portfolios and rates of return that might be used in setting the rate. It will be for the Lord Chancellor to apply the legal principles set out in the legislation to decide where in the range of low risk the rate should be set. This will necessarily allow room for argument and may lead to some uncertainty for insurers.

When the rate should be reviewed

The proposed legislation provides that the rate is initially to be reviewed promptly after the legislation comes into force and, thereafter, at least every three years, with that period being re-set when the rate is changed.

The initial review is to be commenced within 90 days of the provisions coming into force. All reviews will be completed within 180 days of starting.

A new rate will then be set if a change is considered by the Lord Chancellor to be appropriate. The new rate will come into force on a date to be fixed by the Lord Chancellor. This will avoid overlong delays between reviews, which should make changes in the rate more predictable and manageable.

If a full three year review period is routinely utilised, insurers will need to monitor returns of applicable low risk diversified portfolios to predict how the rate is likely to change. Where it is likely there will be a change in the rate, negotiation tactics are likely to be seen from both parties prior to the point of review, with either party potentially seeking to delay settlement until following the review.

Who should set the rate?

The draft legislation provides that the rate is to be set by the Lord Chancellor after consulting an expert panel (other than on the initial review which will be by the Lord Chancellor with advice from the Government Actuary).

The panel will be chaired by the Government Actuary and include four other members having experience as an actuary, an investment manager and an economist and in consumer investment affairs. The expert in consumer investment affairs is an addition member to the previous three expert panel constituted for the Consultation.

Next steps

The Government has invited comments on the draft legislation, although it provides no timeframe for responses. The legislative timetable hasn't been prescribed, with the Government noting the provisions will be enacted as soon as parliamentary time permits. In view of competing legislative priorities flowing from Brexit, it could yet be as long as 12 months before the proposals become law.

On the basis of current rates of returns the Government has forecast the discount rate may increase to in the region of 0–1%. The vagaries in determining the new rate in the legislation suggests this is probably the level the Government is aiming to reach, although this may change depending on the prevailing economic climate over the next 12 months.

For the immediate future, insurers should continue to push for settlements at a 1% discount rate. In our experience this approach has been accepted by the majority of claimant practitioners since the discount rate reduction in February, save for those cases where a trial was imminent.

As the applicable discount rate to be applied by the court will remain -0.75%, where claims are likely to proceed to trial in the next twelve months, claimants are unlikely to be advised to settle on the basis of a higher discount rate.

Insurers should utilise opportunities to delay the Court timetable where possible. However it is unlikely the court's view on adjournments solely because of an anticipated change in discount rate will change. In other cases, where trial is a more distant prospect, insurers may wish to adopt a higher discount rate for settlement negotiations.

Whilst it is a matter for each insurer as to how they wish to reserve, it would seem sensible to continue to reserve at -0.75% until a new rate is set, given the lack of certainty as to what the new discount rate will in fact be.

The provisions are, to a certain extent, good news for the market, but there remains the possibility the Lord Chancellor will not go far enough, particularly given the indication that, on present rates of return, the discount rate will increase to 0-1%. Insurers will need to be vigilant in respect of the implementation of the new methodology, to ensure the legislation actually achieves fairness when setting the rate and prevents claimants from continuing to be overcompensated.