Discount Rate – Disaster or Result?

April 20, 2017

By Bill Braithwaite QC

On the 27th February, the Lord Chancellor announced a reduction in the discount rate from 2.5% to minus 0.75%. That was followed by a further consultation, now concluded, on whether the legal parameters defining how the rate is set should be changed, and on whether there is a case for encouraging the use of periodical payment orders instead of lump sum payments. Interestingly, on the first issue there have been “widely diverging views expressed and overall the responses demonstrated very little consensus on whether the current legal parameters were appropriate.”! The insurance industry has mobilised its forces, and is mounting a major campaign of, in my opinion, misinformation, in order to pressurise the public, and through them the Government, to change the system of calculating future expense for severely injured claimants. As a major figure in that industry said in a letter to MPs “The Government now has a clear choice and should move quickly to change the law to help keep costs for motorists and businesses as low as possible.”. No mention of justice for claimants!

However, this change is long overdue, and I can’t help thinking that a sensible insurer, knowing that the first consultation has been going on for years, would have managed his reserves appropriately, taking account of the risk of a reduction in the rate – isn’t that what insurers do – manage risk? I’m told that the NHSLA has been doing it for some time, using a discount rate lower than 2.5%.

The basic facts are that the methodology of calculating the discount rate was set by the House of Lords, which was then our supreme court, in 1998. When people suffer serious injuries and are awarded compensation for future losses, the discount rate is used to take into account the return expected when a compensation payment is invested – the House of Lords declared that the calculation should be based on a claimant not having to run any investment risk. That was fundamental to the decision, because claimants should not be expected to run risks with money which a judge has declared is essential to their future health and wellbeing.

The object of personal injury compensation is to put a claimant as nearly as possible into the position he or she would have been in, had the negligence not happened.  In serious injury claims that is difficult as claimants have frequently had their lives destroyed by the carelessness of another, and restoring quality of life can be difficult.

If the compensation runs out, the injured person will suffer in many different ways – essential support will vanish, because the State cannot provide the appropriate level, the home may have to go because it is too expensive to run, therapies and medical review may be too expensive – in other words, every aspect of quality of life, which compensation made more achievable, will vanish. Almost every penny of compensation is allocated to a specific need in the future.

It is worth remembering that the injury was caused by the carelessness of a person or organisation which has paid insurance premiums to cover precisely this type of expense.

The scare-mongering by the insurance industry is based, I think, on the notion that all major claims are paid out as lump sums, which is simply not true. The recent consultation paper suggests that about 200 to 250 claims are paid out in periodical payments, but my experience (I finalise about £50 million of claims annually) is that most claims are settled by periodical payments. That part of the compensation is not affected by the change in the discount rate.

A recent settlement demonstrates both points. We settled for £5.4 million, of which most was in periodical payments. Using the lump sum equivalent, though, the new figure would have been £12.3 million – that’s the headline that the insurer would use. However, when you strip out annual payments, the lump sum reduces to £1.6 million.

All the insurance industry has to do is to make sure that as much of the award as possible is paid in this way, reducing the size of the lump sum to which the discount rate applies. That will mean that the change in the rate will have a minimal effect. As always, a powerful insurance lobby is trying to mislead the public in order to maximise profit. For years they have been resisting periodical payments, because they knew that the discount rate was far too high, and that it was more cost-effective to insist on a cheaper lump sum.

Of course, the Lord Chancellor’s declaration of the new rate does mean that, for some years, claimants have been compensated on a basis which was contrary to the methodology set out by the House of Lords – that itself is an injustice of mammoth proportions.

The whole point about the discount rate is that, when a judge used to use 2.5% (or when claimants were forced to use that rate in negotiations) he or she was declaring that the claimant can and should invest the money so that they receive an investment return of 2.5% after the deduction of tax, and after taking account of inflation. It has been impossible to achieve that return for many years, unless one chooses to run significant investment risks. That is why the House of Lords decided in Wells v Wells in 1998 that Index Linked Government Securities should be the standard by which investment by catastrophically injured claimants should be judged.

I’m not hopeful about the outcome of the new consultation because the insurance lobby is very powerful. Insurers argue (without evidence?) that claimants don’t invest in gilts, but that could be, if it’s true, because they know (I always tell them) that the compensation has been calculated on the basis that they have to run risks in order to achieve lifetime compensation.

A complication to the whole debate about the rate is that, when it is set and used, it amounts to a declaration that a claimant will achieve that net real rate of return on his or her money for life. This is a really important point to consider, which I think ought to be the focus of sensible debate – the rate under discussion is the average rate of investment return spread over the predicted life span of the claimant. That could mean 50 years or more, and predicting that far ahead isn’t easy, particularly with major events such as Brexit on the cards. That raises another interesting question, namely whether you can predict the investment future from the past!

I’m very keen on alternative dispute resolution, and have been for some years – I qualified as a mediator many years ago, but I now see ADR as a much wider tool for managing issues and disputes. What a pity that the two warring sides in the discount rate war won’t be able to harness ADR, and avoid giving control of the problem to the Government. I suppose, though, that the insurance industry knows that the rate can’t get any worse, only better, which is my prediction for the future. How much better I wouldn’t like to say, but I fear a positive rate. I don’t agree with that as a result, but I’m pragmatic!