First published in Insurance Day (9 April 2017)
The new discount rate to determine the size of personal injury awards in the UK, which has tipped the balance heavily in favour of injured parties to the detriment of insurers, is not grounded in reality.
February’s decision by the Lord Chancellor, Liz Truss, to reduce the discount rate used to calculate future losses in personal injury claims from 2.5% to -0.75% sent shockwaves through the industry. A reduction had been anticipated but not of this magnitude, wrong-footing claimant and defendant representatives and insurers alike.
The decision was based on a review of the discount rate commenced by Liz Truss’ predecessors in November 2010. The new rate came into force on March 20, 2017.
In the announcement about the new rate, the Lord Chancellor said: “I am clear this is the only legally acceptable rate I can set.” It is a strong message.
The legal framework for the decision remains the reasoning of the House of Lords in Wells v Wells (1999). The principle that the injured party should be placed in the same financial position but for the accident – no more, no less – was set out as the objective of the award of damages. That objective was to be met by applying a discount rate based on the rate of interest of a risk-free investment, which protected the injured party against inflation and market risk. The Lord Chancellor took the view that a portfolio consisting 100% of index-linked gilts (ILGs), comprising stocks spread across a range of redemption rates, best met the courts’ guiding principles as it guaranteed an injured party an inflation-adjusted income.
The Lord Chancellor acknowledged criticisms that changes in economic circumstances meant this no longer reflected a realistic or appropriate basis on which the discount rate should be set. A mixed portfolio approach, it was argued, would be more appropriate and realistic. ILGs also create their own risks – for example the risk of not being able to meet unexpected capital needs. Truss, however, dismissed these criticisms, concluding that “faithful application of the principles in Wells v Wells leads to the 100% ILGs approach as the best way”.
In terms of the calculation proper, the Lord Chancellor used the simple average gross real redemption yields of ILGs over three years, excluding stocks with less than three years to maturity. The average yield on that basis, as at December 30, 2016, was -0.83%, which the Lord Chancellor rounded up to -0.75%, acknowledging tax and investment fees would be modest. In announcing the new rate, the Lord Chancellor pledged further consultation on whether the methodology is appropriate for the future.
So, is the methodology appropriate for the future? We believe not.
The judgment in Wells was handed down when there was a very different legal framework to that which exists today. The advent of periodical payment orders (PPOs), where annual index-linked payments are made to claimants over their lifetimes, allows for the transfer of the risk’s investment, inflation and life expectancy, from injured parties to insurers. Despite this, PPOs have not become the principal form of damages award in high-value claims, which challenges the idea that injured parties should be considered completely risk adverse.
As well as changes in the legal arena since Wells, the global economy has gone through an extensive period of instability. It was simply not envisaged in Wells that there would be any possibility for negative returns on ILGs. In reality, ILGs are not the risk-free investment envisaged by the House of Lords back in 1999.
Further, to take an average rate of return of investments from the previous three years and then apply it to long-term losses, which could last for upwards of 40 to 50 years, is simply not representative. Real yields of ILGs continued to suffer from the depression caused by policies of quantitative easing and a flight to quality. As a result, ILGs have become disproportionately more expensive than alternative low-risk investments. By faithfully applying the Wells methodology, the discount rate set is not valid for any long-term period.
The stark contrast between an ordinary, prudent investor and the special category of investor within which injured parties are placed is wrong. The reality is that injured parties pursue a strategy very much in line with ordinary, prudent investors. Research undertaken by the Ipsos Mori Social Research Institute in 2013 demonstrated that, while generally risk-averse, injured parties invest in a mixed portfolio of investments. This would have remained their investment strategy had they received larger awards as a consequence of a more favourable discount rate.
Ignoring the realities of the situation, therefore, leads to the potential erosion of the principle of 100% compensation – no more, no less. The Lord Chancellor should take into account all the available evidence to ensure the courts can make use of a fixed discount rate to calculate the sum of money that would provide an annual sum equal to an injured party’s estimated annual loss, but which does not leave him in a better financial position than if the accident had not occurred. By not taking reality into account, it tips the balance heavily in favour of injured parties in litigation, to the detriment of defendants. A low level of risk should be permitted; defendants ought to be entitled to assume claimants will adopt a prudent investment strategy, based in reality, rather than a notional, unrealistic strategy.
It is hoped the further consultation, launched on March 30, 2017, will provide an opportunity for a thorough investigation into the actual investment practices of claimants based upon which a new methodology, not constrained by Wells, can be developed to set a discount rate grounded in reality so that justice can be achieved.