On 27 February 2017, The Rt Hon Elizabeth Truss MP, Lord Chancellor, announced her decision to reduce the discount rate from 2.5 per cent to -0.75 per cent, sending shock waves through the personal injury arena. Whilst a reduction in the discount rate had been anticipated, the magnitude of the reduction surprised both claimant and defendant representatives and insurers. The decision was based on the completion of the review of the discount rate commenced by her predecessors in November 2010 and it was announced the new discount rate was to come into force on 20 March 2017. Despite this, at the same time the new discount rate was announced, the Government pledged to launch a further consultation, before Easter 2017, to consider whether there is a better or fairer framework for both claimants and defendants, with the Government bringing forward any necessary legislation at an early stage. This article considers the reasoning behind the Lord Chancellor’s decision to set a negative discount rate and whether a discount rate based on Index Linked Government Stock (“ILGs”) represents a fair framework for the assessment of damages in personal injury claims.
In the announcement of the new discount rate made by the Ministry of Justice, the Lord Chancellor said: “I am clear that this is the only legally acceptable rate I can set”. A strong message. The question is therefore, what was her reasoning and was it indeed the only legally acceptable rate that could be set.
In the statement setting out her reasoning, the Lord Chancellor indicated that the decision had been based on a “lengthy and extraordinarily thorough” review of the issue, including the responses to the two public consultations, the report of the expert panel constituted in 2015 as well as the responses of statutory consultees, HM Treasury and the Government Actuary.
The legal framework for the decision remains the straightjacket of the reasoning of the House of Lords in Wells v Wells. The 100 per cent principle, that the injured party should be placed in the same financial position as 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 risk and market risk.
The Lord Chancellor took the view that a portfolio consisting 100 per cent of ILGs, comprising of stocks spread across a range of redemption rates which guarantees the injured party investor an inflation adjusted income, known with certainty at the time the award is made, best meets those guiding principles. She noted that this was consistent with the approach taken both by the House of Lords in Wells but also the Lord Chancellor, Lord Irvine, who set the first statutory discount rate in 2001 which her decision replaced.
The Lord Chancellor acknowledged the criticisms of such an approach, namely that it did not reflect a realistic or appropriate basis for the discount rate to be set, in part due to changes in economic circumstances, and a mixed portfolio approach would be more appropriate and realistic; and that ILGs themselves created different risks, for example the risk of not being able to meet unexpected capital needs. She, however, dismissed these criticisms, concluding that “faithful application of the principles in Wells v Wells leads to the 100 per cent ILGs approach as the best way” to protect against inflation and market risk, and any risk of such investment portfolio ought to be capable of effective management so that such risk is outweighed by the risk associated with a mixed portfolio approach.
The Lord Chancellor continued to follow the approach taken by Lord Irving, setting one rate for simplicities sake with an element of rounding, albeit to the nearest 0.25 per cent rather than 0.5 per cent, to ensure that the rate is one that is easily applied, with the Ogden tables being updated to reflect the new discount rate.
In terms of the calculation itself, the Lord Chancellor followed Lord Irving’s, and indeed the House of Lords in Wells, approach of using the simple average gross real redemption yields of ILGs over three years, excluding stocks with less than three years to maturity. She noted that the yields of ILGs have steadily declined since 2001, but, whilst acknowledging there may be a case for departing from the three year average to limit the impact of historical trends, declined to so at this time.
The average yield on that basis, as at 30 December 2016, was -0.83 per cent. The Lord Chancellor indicated that the only reason to round down to -1 per cent would be to account for tax and management fees incurred by injured parties in ILGs. However, tax liability on ILGs is lower than when the discount rate was set in 2001 due to the low coupons that new ILGs are issued with and management fees were described as modest. Thus, the Lord Chancellor concluded the discount rate be rounded up to -0.75 per cent.
Lord Chancellor did not take the further step that Lord Irving took in 2001; she did not take into account any other factors which may have affected the rounding of the rate. Lord Irving looked to the fact that the Court of Protection at that time invested in multi-asset portfolios and the likelihood that a claimant with a large award of damages would, if properly advised, invest in a mixed portfolio in which any investment risk would be very low. It was for this reason he determined that setting the discount rate at 2.5 per cent would not place an intolerable burden on claimants to take on excessive risk in the equity market.
Notwithstanding this, the Lord Chancellor considered that a discount rate set on the basis of Wells was “the only acceptable rate” she could set. Why was this?
Made available at the same time the new discount rate was announced was the response to the first consultation: Damages Act 1996: The Discount Rate — How should it be set? and also the report from the expert panel consisting of Dr Paul Cox, Richard Cropper and Ian Gunn of PFP Ltd, and Dr John Pollock, which was constituted due to the lack of consensus in the responses to the first consultation.
The remit of the expert panel was solely to consider the discount rate within the constraints of the first consultation; namely setting the discount rate within the prevailing legal framework of Wells. For the majority of the panel, this was a discount rate based on the theoretical framework of an investment portfolio of ILGs held to redemption in an adequately structured portfolio. It was clarified in a subsequent response document to questions raised by the Ministry of Justice on the report that the majority of the panel consisted of Dr Cox and Richard Cropper and Ian Gunn of PFP (the latter two making up one member of the panel), who are well known in the world of personal injury. This portfolio, described as a “market consistent approach” producing a risk free nominal discount rate, was said to be reflective of standardised actuarial practice for setting discount rates, which does not look to actual assets that might be held to meet the cash flow liability but values such liability in nominal terms. The panel points out that this is the approach used by insurers to comply with the requirements of Solvency II, as well as inferring this from the data produced by the PPO (periodical payment order) Working Party, and suggests that the House of Lords in Wells in adopting the guiding principles anticipated the subsequent developments in actuarial practice.
However, the minority of the panel, comprising Dr Pollock, said that a mixed investment portfolio, described as a “financial economic approach”, would also meet the legal framework set out in Wells and the formula adopted by the Lord Chancellor in 2001. Despite this, the terminology used within this section reveals the bias towards a discount rate based on ILGs—reference is made to ILGs versus an “optimum mix of risky investments”. This is potentially improper syntax; reference should have been made to a mixed portfolio of investment. The need to repeatedly refer to this as risky was inappropriate and partisan.
Two portfolios were considered. One with an even split between ILGs and a mixed portfolio of investments and the second split 75 per cent in favour of ILGs. Both portfolios were considered as potentially appropriate for a very low risk, but not risk free investor. The latter portfolio was considered acceptable to the panel if injured parties were forced to accept some risk but a portfolio consisting of less than 50 per cent ILGs was considered by the whole panel to be inappropriate. Whilst Dr Pollock accepted that even a very low risk tolerant investor may at least be expected to assume some investment risk, this was not accepted by the majority who deferred to the Lord Chancellor as whether it was appropriate to depart from the risk free framework.
Conspicuous by its absence was a post-consultation response to the second consultation: Damages Act 1996: The Discount Rate—Review of the Legal Framework. Whilst the Lord Chancellor stated she considered the responses to the second consultation, this was not made available to the panel of experts and the decision to set the discount rate at -0.75 per cent was based upon the parameters of the current legal framework.
Instead, a further consultation was pledged and has now indeed been launched to consider how the personal injury discount rate should be set in the future only 10 days after the discount rate was reduced. The consultation paper proposes that a number of core issues should be considered, namely, what principles should guide how the rate is set, what investment returns should be taken into account, how often should the rate be set and who should set the rate? Evidence will be obtained on how damages awards are actually invested.
The launch of the new consultation begs the question why change the discount rate at all? There is a widespread assumption that the discount rate will be changed again. The Lord Chancellor’s announcement has attracted widespread criticism. It was expressed in defensive terms and as such has introduced uncertainty rather than produced certainty. Why not wait until the outcome of the further consultation was available? What was the outcome of the prior consultation on methodology?
Whatever the answers to these questions at least the new consultation will address these issues now. So, is the current methodology appropriate for the future? The answer is no.
The judgment in Wells was handed down in a very different legal framework than exists today. The advent of PPOs allows for the transfer of the risks of 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. This challenges the assumption that injured parties should be considered completely risk adverse.
As well as a change in the legal world since Wells, the global economy has gone through an extensive period of financial instability. It was simply not envisaged in Wells that there would be any possibility for negative returns on ILGS. ILGS was considered to be effectively risk-free and inflation-proof. In reality ILGs are not the risk free investment that was envisaged by the House of Lords. Whilst the Lord Chancellor, drawing on the report of the expert panel, concluded that the “mismatch risk” of investment in ILGs was outweighed by the risk of a mixed portfolio, this is on the basis that the risk can be successfully managed on behalf of injured parties. A fundamental principle of investment is a diverse portfolio so as to spread the risk; successful management is therefore likely to involve investment in products other than ILGs.
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 40–50 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 consequent upon the crisis in many parts of the Euro zone. As a result, ILGs have become disproportionately more expensive in comparison to alternative low risk investments. The rate of return on ILGS does not reflect a pure and undistorted measure of the real rate of return that the market would afford to investments of minimal risk in the long term. By a faithful application of the Wells methodology, the Lord Chancellor has therefore set a discount rate that is not valid for any long-term period.
Whilst a theoretical portfolio is necessary to base the discount rate on, account must be had to the realities of the situation. Investment solely in ILGs in the manner assumed in Wells is impossible; setting the discount rate on that basis is artificial. Injured parties cannot purchase ILGs at source and, when held as part of a portfolio of investments, do not hold them to redemption, rather they are traded to ensure the best returns are achieved and provide protection against risk of capital erosion which their financial advisors are duty bound to ensure.
The stark contrast between an ordinary prudent investor and the special category of investor that injured parties are placed within, is wrong; the reality is that is that injured parties pursue a strategy very much in line with an ordinary prudent investor. Research undertaken by the Ipsos MORI Social Research Institute in October 2013, although limited in scope, confirmed that the assumption underlying Wells of 100 percent investment in ILGS was, in practice, erroneous. It demonstrated that whilst generally risk averse, injured parties did invest in a mixed portfolio of investments and that 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 the principle of 100 per cent compensation, no more, no less. The Lord Chancellor should take into account all the available evidence to ensure that the court can make use of a fixed discount rate to calculate as best it can the sum of money which would be adequate to provide a sum equal to an injured party’s estimated annual loss over the whole period that the loss is likely to continue, but that does not leave him in a better financial position than he would have been but for the accident. This ought to include regard to the historical patterns of investment by or on behalf of claimants. Whilst it is not controversial that how an individual injured party chooses to spend, or invest, their damages award is irrelevant, this principle should not be persuasive when fixing a discount rate to be applied to all claims and a thorough examination of the actual investment practices of injured parties should be undertaken.
The purpose of the discount rate should not be to protect spendthrifts or punish the careful majority. It should be based on the reality of general investment practice by injured parties. In not doing so, the discount rate tips the balance heavily in favour of injured parties in litigation, to the detriment of defendants. A low level of risk should be permitted; it is clearly fair that defendants are entitled to assume that claimant will adopt a prudent investment strategy rather than a notional, unrealistic strategy. Setting the discount rate should be undertaken with a view to imposing a tolerable burden on claimants in terms of future investment risk whilst ensuring fairness to defendants.
It is disappointing that the Lord Chancellor believed she was bound to follow Wells to the letter, notwithstanding that her predecessor approached the decision unfettered from such constraints. The further consultation does, however, provide a further opportunity to put forward the case that Wells is not a fair and just basis on which to set the discount rate. A thorough and transparent investigation into the actual investment practices of claimants needs to be undertaken. Only when the methodology used to set the discount rate is grounded in reality can justice as between claimants and defendants be achieved.