The discount rate review: fairer compensation or fundamentally flawed?
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Will the government’s cut to the discount rate, which determines how much compensation insurers must pay to claimants who have suffered life-changing injuries, amount to a fairer system?
The discount rate hit the headlines when the Ministry of Justice announced a deep cut, the severity of which was unexpected by everyone affected. On 27 February 2017 Lord Chancellor Elizabeth Truss announced that the discount rate, also known as the Ogden rate, would be cut from 2.5% to minus 0.75%.
The discount rate
The discount rate is a calculation applied by the courts to determine the amount of compensation payable to claimants who have suffered life-changing injuries.
In personal injury cases, the court's aim is to put the claimant in the position in which they would have been had they not been injured. Compensation can therefore include items such as loss of earnings and lifetime healthcare costs. If the claimant opts to receive their compensation in the form of a lump sum, the court uses multipliers and actuarial tables, commonly known as Ogden tables, to calculate the amount of compensation. Once it has identified the amount which will achieve its aim, the court will adjust the figure by applying the discount rate.
The rate takes into account the amount of interest which the claimant could earn by investing the lump sum. A discount rate above zero will result in a reduction of the lump sum amount payable, reflecting the additional amount the claimant could gain from investment. A discount rate below zero, such as that announced by the lord chancellor, will require payment of an additional amount on top of the lump sum which is ordered.
The discount rate was created to ensure that the claimant is not overcompensated (by earning interest on the amount provided) or undercompensated (due to factors such as negative interest rates and inflation).
How the discount rate is set
Section 1 of the Damages Act 1996 states that the courts must have regard to the discount rate, which is set by the lord chancellor from time to time. The House of Lords' decision in Wells v Wells (1998) adopted the principle of full compensation referred to above and also held that the discount rate should be based on the return on investments in Index-linked government securities, in order to reflect that injured claimants are likely to be risk averse.
In Wells the House of Lords adopted the Index-linked Gilts rate at the time of 3%. In 2001 Lord Irvine, the then lord chancellor, reduced the rate to 2.5% by reference to a three-year average or real yields on Index-linked Gilts. The rate has remained at 2.5% until now.
Truss also used the three-year average of real returns on Index-linked Gilts to reduce the rate to minus 0.75%. The negative figure is explained as representing the impact of inflation on the real returns achievable by claimants from investing their lump sums in these investments.
Who the discount rate cut will affect
The new rate came into force on 20 March 2017. Absent any transitional provisions distinguishing between existing cases and those issued after the implementation date, the new rate will apply to all compensation payments ordered from 20 March 2017 onwards.
The rate will affect both claimants and defendants, and their respective representatives and financial backers, as well as wider market participants. There is a clear division of views between these parties on the announcement.
The new, lower rate will result in additional compensation payments to claimants on top of the lump sum ordered by the court.
The Association of Personal Injury Lawyers (APIL) has repeatedly campaigned for the rate to be reviewed on the basis that the previous rate no longer reflected the real returns on Index-linked Gilts and this was therefore leaving claimants undercompensated. In 2010 the then lord chancellor announced that he would review the rate following the threat of judicial review proceedings by APIL. This review did not materialise and APIL subsequently issued judicial review proceedings in 2011, which were rejected.
Following this, the Ministry of Justice undertook two consultations: the first in 2012 on the method used to calculate the rate and the second in 2013, on the legal framework for setting the rate. In 2014 the lord chancellor at the time appointed a panel of experts to review the issue. The results of these consultations and of the experts' conclusions have not been published.
As a result of this, APIL issued pre-action correspondence in relation to judicial review proceedings on the grounds of delay. Truss responded to this correspondence in December 2016, stating that an announcement would be made by the end of January 2017. The announcement was subsequently delayed until February 2017.
Claimant lawyers have widely heralded the announcement as a success for claimants. Many assert that the rate will result in fairer compensation payments by bridging the gap which had been created between what claimants were held to be able to achieve under the previous rate and what they actually achieved in a time of historically low interest rates. APIL has commented that the cut is long overdue and will ensure that claimants are provided with sufficient means to support themselves for the rest of their lives.
For defendants, the rate cut will require a supplement to be paid in addition to the lump sum ordered by the court.
In many personal injury claims, the defendant will be covered by an insurance policy. For example, in relation to injuries caused by a car accident, the defendant will often be covered by a motor insurance policy. Providing the claim is covered under the policy, the compensation will be paid by the insurer. Insurers are therefore being heavily affected by the discount rate cut.
When Truss announced that the new rate would be decided in early 2017, the Association of British Insurers (ABI) issued its own judicial review proceedings. It argued that the consultation process should be completed and the framework for setting the rate reformed prior to a new rate being announced. The proceedings were rejected by the Administrative Court and the ABI was refused permission to appeal.
The ABI, and many in the market, consider that the framework used to set the rate is fundamentally flawed, as it does not consider that claimants may choose to invest their compensation in a mixed portfolio of assets, as opposed to wholly in Index-linked Gilts. If claimants do this and achieve a rate higher than that returned on Index-linked Gilts, they will be being overcompensated, thus not achieving the court's aim and the purpose for which the discount rate was created.
The insurance industry expected and accepted that the rate would be reduced, and that this was necessary to ensure that claimants were receiving the correct amount of compensation. However, the severity of the cut and the absence of transitional provisions have sent shockwaves through the market.
Immediately following the announcement, many insurers announced significant cuts to profit predictions and delays to financial reporting while claims reserves were recalculated. Direct Line announced a profit reduction of between £215 million and £230 million, and Admiral's shares fell by nearly 9%. In an already uncertain market, the level of these cuts has raised concerns that some smaller insurers will be unable to absorb the increased payments.
In addition to the negative impacts on insurers, the NHS and the armed forces are likely to be affected. In particular, the increased compensation costs for clinical malpractice claims will be an additional pressure on the already-stretched NHS budget. In her announcement, the lord chancellor pledged to ensure that the NHS Litigation Authority would receive appropriate funding to assist with the change and that the Department of Health would work closely with GPs and medical defence organisations to ensure the same. The amount of increased funding is likely to be significant and only time will tell whether the "appropriate funding" pledged will be sufficient.
The wider market
Increased compensation payments represent an additional financial risk for insurers and will therefore be factored into the calculation of premiums. The ABI estimates that 36 million business and motor insurance policies could see their premiums increased as a result. This risk will be particularly associated with those statistically more likely to cause life-changing injuries, such as young drivers, who are therefore likely to see the biggest increase in premiums.
However, it is not only drivers who will be affected. Businesses' public liability policies may also increase. This will result in an escalation of overheads for businesses which will be an additional burden, particularly on small businesses. Taxpayers are also likely to see the effects of this change as the additional funding pledged by the lord chancellor will have to be raised or appropriately redirected.
Is that the end?
In her announcement, Truss pledged to hold a further consultation before Easter 2017 to consider the framework for setting the rate and to bring forward any necessary legislation. The consultation could consider whether the rate should in future be set by an independent body and whether more frequent reviews would improve predictability and certainty for all parties. Importantly, the consultation will also consider whether the current methodology of assuming that claimants will invest their lump sum solely in Index-linked Gilts is appropriate.
The publicity which has surrounded the recent change should mean that the upcoming consultation receives contributions from across the market. These responses – and contributions to the previous consultations – should be used by the Ministry of Justice to conduct an in-depth review of the effectiveness of the current system. Since 2001, the market has experienced significant changes and it is clear that the rate which was set so long ago may no longer be appropriate. It seems to follow, however, that if the rate may no longer be appropriate, the methodology which was created even before that should also be reviewed. In particular, research should be conducted into how claimants actually invest the sums which they receive. If a mixed portfolio of assets is commonly used, the discount rate should reflect the rate of returns on these assets.
Finally, as the rate is linked to interest received, the consultation should consider whether a mechanism can be incorporated into the framework to take account of future interest rate rises. This could be, for example, an interim review within a set period of a rise.
Any significant changes arising out of the upcoming consultation will require primary legislation. Now that Article 50 has been triggered, it may be difficult to find sufficient space within the legislative timetable. Nevertheless, the financial effects for all concerned of changes to the rate make clear that this is not a process which should be rushed. Certainty for all will be best achieved by a well-evidenced and robust methodology producing a fair rate for both claimants and market participants.
Rebecca Taylor is a trainee solicitor at RPC.