Analyzing The Discount Rate

Introduction:

This essay will discuss the discount rate and the relevant factors that are considered while arriving at discount rate.The discount rate provides present values for future losses withan overall aim of placing the Claimantback at the original financial position had the personal injury never occurred. This essay will discuss the rationale behind arriving at thediscount rate. This essay will critically evaluate the new2019 rate and its goals with regard to compensating Claimantsfor future financial losses. While doing so, this essay will discuss different circumstances connected with setting a discount rate, including future earnings, life expectancy, arguments of affected third parties and relevant procedure. This essay will critically evaluate whether using a discount rate leads to fair compensation for future financial losses. It will discuss certain principles around fairness in order to evaluate the manner in which discount rate is used, derived or assessed. This essay will conclude with a general observation in context of the notes and arguments made in this essay.

Whether the discount rate appropriately considers varying factors

The discount rate is a mode of calculation used to adjust the final figure awarded to victims of life-changing injuries, who accept lump sum compensation payments. This rate will reflect interest that is expected to beearned by investing the lump sum payment, taking into consideration the effects of tax, inflation and expenses on the interest. Calculation of loss differs depending on whether a future loss claimed by a Claimant would extend over a relatively short period or for a longer period. Such future loss could bealoss of earnings or thecost of future care. When calculating future loss certain factors are taken into account such as age, gender, future career path, life expectancy, pre-accident earnings, effects of inflation and duration of loss.For example, in O’Brien, the court discounted the earnings by 10 percent afterconsidering the uncertainties of the labour market and the fact that permanent and pensionable employment is no longer the norm. Likewise, in Murphy,the

calculation of future loss of earnings took into account the Claimant’sinability to return to her work because of her injuries. Compensation awards aim to capitalise a claim for future loss on the date of judgment by applying a multiplier to the Claimant’s net weekly loss. The multiplier takes into account many factors, such as the term and frequency of the loss, the real rate of return, or projected return on investment of the award by a prudent Claimant after some deduction. This deduction is known as the discount rate, which is made to reduce the award for future losses to present values.The discount rate and real rate of return may be used interchangeably and they indicate the interest or return that is expected to be made on investment of the award for thefuture minus the net of tax on the return.

Compensation awards using thediscount rate aims to put the Claimants in the same financial position had they not been injured. Awards includeloss of future earnings and costs of care.Various factors, as mentioned above, are considered while assessing economic loss due to personal injury. Selecting the most appropriate rate is open to critical discussion. The procedure used in selecting the rate may be unrealistic due to variance in investor ability and availability of investment media. It requires anunderstanding of economic significance in respect of the interest rate structures, the Claimant’s needs, and other factors.

In a personal injury case, the focus must be the security of the principal lump sum award and income. Using thediscount rate may be fair in principle, but given the complexity in deriving the appropriate rate itmay be unfair to the concerned parties. This kind of economic rationale for judicial treatment towards lost earnings in injury cases and wrongful death may not be arguably consistent with economic evidence and thebasic common law concept of compensatory damage. Damage determination might have failed to consider potential variation in the future earnings when the courts treat the future earnings as being risk free.

For example, a disabled person may claim damages including loss of future earnings, or damages may be awarded to beneficiaries of survivors in cases of wrongful death. In such cases, the damages may be in a lump sum payment where the estimated future loss is reduced to the present value.

The issue lies in the default assumption that the victim would have worked uninterrupted at a standard wage or salary until they reach a retirement age.These assumptions may be incorrect, and may affect all of the claimants who rely on the same set of actuarial multipliers. There may be uncertainty in regard to mortality and interest rate assumptions that would affect the accuracy of actuarial multipliers. In 2017 when the rate was lowered from plus 2.5% to minus 0.75%, it raised concerns with regard to Claimants being substantially over-compensated. This would lead to increased financial pressure on public services, which aresubject to large personal injury liabilities, and would create a knock-on effect on the tax-payer. On the other hand, it meant that Claimantswouldget higher awards as there would be lessmoney discounted from theircompensation awards.

The new discount rate of minus 0.25%

On 15th July 2019, the Lord Chancellor set the discount rate at minus 0.25% to bring abouta change in thecalculation of personal injury compensation payments. This rate aimed to bringabout a more balanced approach towards compensating personal injury claims.UndertheCivil Liability Act 2018, this rate is subject to a review afterevery five-year period.The rate is a result of the change brought about in setting the rate following the Act of 2018. The principle behindthe previous position was based on the case of Wells,where it was observed that Claimants, especially in serious personal injury cases, should be treated as very risk averse investors. They might be financially dependent on theaward of the lump sum payment, for a long period or for the durations of their lives. They were, therefore, considered different from ordinary investors, as they have to invest this payment to restore their previous financial position and secure themselves to that effect. In Cooke, it was argued that rate of cost of care will increase faster than that of inflation and so, the Wells’ method would leave

The principle behindthe previous position was based on the case of Wells,where it was observed that Claimants, especially in serious personal injury cases, should be treated as very risk averse investors. They might be financially dependent on theaward of the lump sum payment, for a long period or for the durations of their lives. They were, therefore, considered different from ordinary investors, as they have to invest this payment to restore their previous financial position and secure themselves to that effect. In Cooke, it was argued that rate of cost of care will increase faster than that of inflation and so, the Wells’ method would leave Claimants with asignificant future care component to their claim under-compensated. The severe impact of not reducing the rate was seen in the case of Harries.

Arguments with respect to the new order

The 2019 Impact Assessment conducted by the Ministry of Justice assumed that Claimants were‘low’ rather than being ‘very low’ risk investors. The discount rate is, thus, set with regard to real returns on a low risk mixed portfolio considering the taxation, costs of investment management and other relevant economic variables.New reforms introduced in the Civil Liability Act 2018 aimed to set the discount rate at a level to meet claimants’ expected financial needs and further avoid a high risk of significant under compensation whilstsimultaneously reducing theoverall amount of over-compensation. New methodology wasintroduced to ensure afairer outcome to both Defendants, which are usually insurers and the NHS, and wider society. At the same time, it intends to yield public savings and to secure more affordable insurance. The level of the rate has to be subject to appropriate statutory assumptions to reflect thefull compensation principle.

Different circumstances haveto be considered while setting a discount rate. In Thomas, it was observed that with respect to calculating loss of the future earnings, there may be room for discount. This cannot be applied to dealing with discount in respect to whole life multipliers with agreed expectation of life. If the case is about loss of earnings, the determination of the discount rate will work in favour of a Defendant. However, in case of life expectancy, it could be either in favour of the Defendant or the Claimant. The discount rate affects more than one party. For example, the increase in cost of motor insurance is linked to theamountof compensation awarded. TheABI (Association of British Insurers)hasopined that a reduction in thediscount rate could lead to higher payouts.Different arguments are posed by different parties involved in a personal injury case. For example, the arguments of Claimant groups are based on high discount rate, which would penalise claimants. One such conflict could be seen when discount rate was reduced from 2.5% to minus 0.75% in 2017. This led to

The discount rate affects more than one party. For example, the increase in cost of motor insurance is linked to theamountof compensation awarded. TheABI (Association of British Insurers)hasopined that a reduction in thediscount rate could lead to higher payouts.Different arguments are posed by different parties involved in a personal injury case. For example, the arguments of Claimant groups are based on high discount rate, which would penalise claimants. One such conflict could be seen when discount rate was reduced from 2.5% to minus 0.75% in 2017. This led to increase in claimant's damages and it reflected the likely erosion of lump sum by inflation instead of accruing interest through a prudent investment.Moreover, it has been reported that a high number of recipients of lump sum awards dissipate it prematurely before the expiry of preclusion periods. The inadequacy of the lump sum and such premature dissipation are not new events. Some of the factors contributing to dissipation are discount in lump sum payment, reduction on this sum on account of contributory negligence, legal fees payment, and other costs and expenses including funds management expenses. The argument of the insurance industry is against reduction of the rate as it would excessively increase the value of claims and thereby, increase in insurance premiums.Earlier in 2002, they had claimed that if the reduction fell to 2.5%, it would lead to additional rise of .5% in the motor insurance premiums, 1.1% in employers’ liability premiums and .4% in the public liability premiums. Ultimately, these costs are borne by the public at large.The choice of a discount rate may make key differences.It has been argued for having a lower discount rate. The National Institute for Heath and Care Excellence (NICE) had a 3.5% rate, which was argued to be high. Therefore, a lower rate was suggested. The reason being that the rate of 3.5 apparently values healthcare interventions, which treat present conditions significant higher levels than those that could prevent future conditions. A lower rate but higher than 0% would balance present and uncertain future health.

The manner in which thediscount rate ischosen and arrived at may also affect the parties in a personal injury claim. In the US, some of the courts may have a model instruction in respect to determining the discount rate, which may not subjectively consider the interests of the Claimant or the Defendant. The discount rate may be considered a question of fact. In the UK, the Civil Liability Act 2018, s.10(1)(2) provides that the courts could “take a different rate of return into account if any party to the proceedings shows that it is more appropriate in the case in question”. All these notions are associated with courts’ effort to deal with the principles of financial principles and reality. The root reason is the principle of putting the Claimants back at the original positions had the injury not occurred. This is the reason for involving expert evidence, which considers all aspects of the victim’s life and future needs, and arrives at more accurate monetary figures to meet those needs. They have brought changes in terms of actuarial tables to compute pecuniary losses, which factor in future mortality figures, potential earning of disabledClaimantsbased on higher discounts, etc. Because of this principle, there has been a significant increase in damages.However, any attempt to increase or decrease may lead to contrasting views amongst parties affected. Appropriate discount rate is chosen based on the rate of Index Linked Gilts Stocks (ILGS). This raised concerns in the insurance industry, as was seen in the 2012 consultation paper. This paper dealt with the issue of how to set the discount rate. The insurance industry was concerns by the prospect of a change in the discount rate. Their concern was based on the claim that Claimants do not invest in ILGS. This indicated that ILGS rate cannot be the rate to rely on for choosing the appropriate discount rate. They further claimed that the very question of a change may greatly affect defendants and the cost of the tort system. The argument was also posed in the response to the 2017 consultation paper. The insurance industry argued for full compensation without having any link with any particular investment model or index, specifically ILGS.

Fairness evaluation of discount rate

The primary principle of putting the Claimantsback at their original positions is behind the notion of discount rate. However, whether this notion is aligned with financial principles and reality on the ground is a question to determine. This also indicates that the primary principle occupies a fair place with respect to the purpose of discount rate in case it is aligned with the financial principles and reality. Appropriateness of a discount rate signifies that it is not arbitrary. It calls for applying economic theory and methods which will help in estimating lost earnings that represents a balanced compensation.The principle reason is to place the Claimantin hisor heroriginal financial position had the wrong never happened. However, the question is how to determine whether the discount is fair. Parties in a dispute have different opinions about the reasonability of discount rates. Low rates are preferred by Claimants and higher rates are preferred by Defendants.

Referring to principles around fairness, a fair outcome should consider all identifiable facts and information.This is reflected in the consideration of factors to arrive at appropriate discount rates, as seen earlier, such as duration of period in respect to future loss, future career path, life expectancy, pre-accident earnings, effects of inflation, or plaintiff’s inability to return to her work. According to the beneficial approach, all relevant process requirements and plausible adjustments must be considered to deliver a justice oriented solution. This could be stated for choosing and assessing the appropriate rate. However, the arguably unrealistic procedure to select the rate arising from variance in investor ability may violate this beneficial approach.If such unrealistic procedure exists, the outcome cannot be considered fair. Plausible adjustments may not even be possible if there is a lack of understanding of economic significance and hence, appropriate discount rate may be difficult to choose.

Conflicts evolve when parties have different expectations and particularly incompatible outcomes at the cost of a party. An existence of incompatible outcomes creates bias amongst the parties. Even if the parties seek the same goal, there may still be a conflict in judgment due to different approach towards the outcome. The goal of the new discount rate is to find a more balanced approach towards compensating personal injury claims. It also aims not to over-compensate the Claimant. However, this does not arguably dissolve the different level of expectations of the affected parties, as seen earlier. Together with this, the complexity in deriving the appropriate rate, which is an economic rationale for judicial treatment towards future loss may result in an unfair outcome. The adoption of a default assumption, which is favourable to the victims, makes the fairness principle subservient or a tool to achievea parties’ objective to gain maximised self benefit rather than maximise joint benefit.In case of discount rate, the principle seems favourable toClaimants, which will acceptable to Claimantsand not Defendants. Such incompatible outcomes cannot be termed a “more balanced approach”, in which the new low rate will only favourClaimants. This would otherwise have been a fairly balanced approach where interests of each of the parties affected, including arguments of insurance industry orClaimant groups, would have been considered and accommodated.

Conclusion

This essay has highlighted the various factors considered while assessing or choosing the appropriate discount rate. The constant question in the points noted in the essay is whether the manner on which the factors are reviewed and considered are sufficient enough to conclude that the use of discount rate in compensating a victim in regard to financial loss is fair. To a certain extent, it seems fair as it is based on a very strong legal principle of that of placing the Claimant back at the original financial position. Although the ground base is on the right direction, the components of and procedure related to the use of discount rate presents a variable observation. For example, consideration of factors directly related to Claimants such as age, gender, life expectancy, pre-accident earnings and external factors such as market stability, inflation, etc. could be considered a balanced approach, which the 2019 new rate attempts to achieve. Whereas, consideration of affected third parties, such arguments of the insurance companies, investors and their ability may convert the manner of choosing appropriate discount rate unrealistic. The significant relevance of understanding economic and other financial principles affect the credibility of the role of the judiciary, which may lack the concerned understanding, in respect to choosing the appropriate rate. This raises a question upon the credibility of the balanced approach that the rate tried to bring. Moreover, the new low rate could be considered a submission to the default assumption that the Defendant is wrong or the Claimantwill have uninterrupted financial stability out of his/her occupation or employment or financial standing in the future too.

On the face of it, it may seem a mechanical calculation, which in fact may be considered so as is seen with the involvement of expert evidence. However, consideration of various factors and existence of arguments from affected parties in the deduction of an appropriate rate is a testimony to the subjective nature of the judgment involved. Deriving from the fairness evaluation above, the use of the discount rate will not be fair unless it is aligned with the financial principles and reality; appropriate understanding and applying economic theory and methods; fair consideration of arguments of all affected parties; and compatible outcomes.

Robert H. Mnookin, Scott R. Peppet and Andrew S. Tulumello, Beyond winning: Negotiating to create value in deals and disputes (Harvard University Press 2000) 157.

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