Repairing the discount rate for fairer compensation
The Ministry of Justice (MoJ) has accepted that the current discount rate of -0.75% and supporting methodology overcompensates personal injury claimants and should be reformed. However, from a compensator’s perspective the proposed timescales for any rate change are disappointingly slow.
Published on 7 September 2017, the MoJ has provided its post-consultation response to how the rate should be set in future – with reference to the three core issues: what should the guiding principles be, how often should the rate be set and who should set the rate?
The main components of the MoJ’s conclusions are:
- Assumptions made by the present law on the setting of the discount rate as to how claimants invest are unrealistic and may produce significantly larger awards than provide 100% compensation.
- The discount rate should be based on expected investment returns from a low-risk diversified portfolio, rather than solely on very-low-risk ILGS (index-linked government stocks) as at present.
- The government will introduce amending legislation “as soon as parliamentary time permits”.
- The Lord Chancellor will then start an initial review of the rate within 90 days of such legislation coming into force, to be completed within a further 180 days after taking advice from the Government Actuary.
- Thereafter the rate will be reviewed “at least” every three years by the Lord Chancellor and an independent panel chaired by the Government Actuary and comprising four members with experience as an actuary, investment manager and economist, as well as in consumer investment affairs.
- Following such reviews, any new rate will take effect on a date to be fixed by the Lord Chancellor.
In reaching its conclusions, the MoJ analysed a range of economic factors including that:
- In relation to actual investment practices, claimants frequently opt for a low-risk diversified portfolio offering higher returns than ILGS.
- It commissioned economic modelling by the Government Actuary’s Department (GAD) which showed that most claimants are overcompensated at the current rate of -0.75%.
- It researched comparative jurisdictions and found that all safeguard claimants by assuming a defensive investment strategy, yet none have a negative rate.
Based on the evidence currently available the government would expect that if a single rate were set today under the new approach, the real rate might fall within the range of 0% to 1%, which would generate lower awards. However, the new framework will only apply if the proposed law is enacted and will not operate retrospectively.
The government is publishing draft clauses embodying these conclusions for further views. Following this pre-legislative scrutiny, it then intends to introduce legislation to enact these proposed changes to the law into parliament as soon as parliamentary time permits.
Once enacted the changes will be brought into force on a date to be specified by the Lord Chancellor, who will initiate a review of the rate (which will be the last rate under the previous law) within 90 days. This review will be completed within 180 days of the beginning of the review. 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 is unlikely to occur before autumn 2018.
Whilst reassurance around revised methodology and process is welcomed, the timescale to achieving a new rate may be relatively slow.
In the interim period, claimants could therefore benefit from the windfall of overcompensation. A substantial number of ongoing cases will be listed for trial beforehand, especially as some claimant firms have deliberately been commencing proceedings early with the aim of forcing resolution under the current generous rate.
In that context, it is to be hoped that the Lord Chancellor and Government Actuary will expedite the initial review not requiring an independent panel, when much of the relevant analysis has already been done as part of the consultation itself.
If or when the proposed reforms are ultimately enacted, the retention of the Lord Chancellor as ultimate decision-maker (rather than delegating that power to an independent panel) should reassure compensators. Public and political factors should continue to be factored into rate decisions, such as the potential impact on taxpayers via higher insurance premiums.
The three year cycle of rolling reviews should provide greater certainty than the current arbitrary review timescales. However, it may also inadvertently encourage tactical behaviours in the run-up to the next review, by parties seeking to accelerate or delay trial dates depending on expected review outcomes. Compensators will need to stay alive to behaviours that may develop in that regard.
The revised process will also oblige both sides to carefully review Part 36 offers whenever approaching any rate change, including from the compensator's perspective to potentially accept any claimant offers before an expected fall in the rate, or withdraw any defendant offers before a rise.
Whilst many commentators focus on an expected single rate for all cases, the response makes clear that the MoJ retains the flexibility to impose different rates for different cases if fairness requires, including for different heads of loss; size or duration of award. Again however, that structure risks inviting tactical behaviours by claimants modifying their case to try to qualify for the most favourable rates.
The courts already have a discretion under Subsection 1(2) of the Damages Act 1996 to 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”. In practice, the most suitable opportunity for a different rate is likely to be where the claimant lives and receives care outside the UK and will be investing locally. The comparative law research commissioned by the MoJ revealed various higher rates, from 6% in the Australian State of Victoria to 3.5% in Spain.
The previous longstanding methodology operated on the basis of a theoretical assumption about ILGS investment returns and did not require scrutiny of actual practices. The consultation has rightly exposed that in reality most claimants do not invest solely in ILGS and achieve higher returns from low-risk diversified portfolios.
That overcompensation potential is reinforced by the high proportion of respondents who admitted that an important factor in choosing a lump sum settlement over periodical payments is the ability to leave an inheritance for your family, when strictly the compensation principle requires that a fair award will be exhausted at the end of the relevant period.
At the claims level, both claimants and compensators have in any event been pragmatically negotiating settlements within the 0% to 1% range since February 2017, regardless of the prevailing -0.75% rate, in anticipation of further reforms. The new methodology may therefore lead to a new rate within a similar range to that widely adopted by the market anyway.
Separate legislation is required from the Scottish parliament to change the discount rate in Scotland. If the Scottish government works independently of the MoJ, we may see a different rate in Scotland to the rest of the UK, which may be more favourable to claimants.
The consultation response floats the novel concept of a higher rate (and lower lump sum) where the defendant has offered but the claimant has refused periodical payments. Whilst such an idea is probably unlikely to be enacted during the current timescale, the MoJ could in future decide politically to try to incentivise greater adoption of that form of award via a differential discount rate, to minimise compensation risks such as uncertain inflation or life expectancy.
Regardless of whatever rates are ultimately fixed, the more rigorous methodology proposed in the draft reforms, including periodic reviews and independent expertise, will hopefully avoid future controversy and ensure a fairer process.
Related item: Bringing the discount rate in the real world