Government discount rate announcement has strategic implications for compensators
On 7 September 2017 the Government issued an early morning stock market announcement, outlining how it intends to approach the issue of the discount…
On 7 September 2017 the Government issued an early morning stock market announcement, outlining how it intends to approach the issue of the discount rate for the calculation of future damages in personal injury actions, going forward. That announcement was swiftly followed by the issue of the Government’s response to the consultation that it issued on 30 March 2017 and a paper setting out its proposals for related draft legislation.
This development has been eagerly awaited by the insurance industry, following the former Lord Chancellor, Liz Truss, changing the discount rate to minus 0.75% in February of this year. That change has been viewed by many to have brought about an unjust and illogical windfall for claimants and to have caused significant financial prejudice to compensators, the public purse and the wider, premium paying public, without any good reason.
The Lord Chancellor and Justice Secretary, David Lidington MP, has tabled draft legislation that changes the way the discount rate is set and moves away from the existing approach, as stipulated in section 1 of the Damages Act 1996. The proposed key changes in the law are addressed below.
In addition to announcing those changes, the Lord Chancellor has also given an indication as to what he feels a single discount rate would be under the new approach, if set today. Specifically, he suggests that it might fall within the range of 0% to 1%.
The Lord Chancellor has also indicated that the rate will not have retrospective effect. Whilst that is entirely as expected and consistent with the previous approach, this does mean that the inflationary impact of the existing discount rate will be ongoing until the proposed changes in the law have been implemented and a review of the rate is carried out thereafter. The suggestion is the review will not be until Easter 2018 at the earliest.
The Lord Chancellor is to be commended for openly acknowledging that the present methodology for the calculation of the discount rate produces an outcome that in effect overcompensates claimants and is unrealistic in the assumptions it makes about how damages will be invested. He has further recognised the adverse affect on the public purse and tax payers, as well as businesses and individual consumers.
The Lord Chancellor has taken note of the fact that in all other jurisdictions, claimants are ‘given the benefit of a defensive investment strategy’, i.e. treated as low or no risk investors. However, it has equally recognised that no other jurisdiction applies a negative discount rate, as is currently the case in the UK.
Turning to the proposals for change, the Lord Chancellor has stipulated that there should be a review at least every three years and that each review should be completed within 180 days, giving a maximum period of 3.5 years between reviews. This would seem to incorporate an element of flexibility, enabling an incumbent Lord Chancellor to review sooner than three years beyond the last review, if he or she sees fit. With that comes a degree of uncertainty for compensators. However, it might reasonably be expected that absent any dramatic economic fluctuations, we will now start to see discount reviews on a three year cycle.
That cycle will begin following the first review carried out after the proposed new legislation comes into effect. The likelihood is that that will be around Easter next year, with the Lord Chancellor having immediately put draft legislation before Parliament and having committed not to delay if and when the legislation comes into effect.
There are already rumours afoot that the insurance industry will be pushing for an earlier change and there is certainly a case to be put for that. Given the acceptance by the Lord Chancellor that the current approach is both wrong and financially penalises large sections of society, clearly it is unjust that compensators should continue to have to pay out according to a minus 0.75% calculation of damages over the six months or more that it is anticipated will pass before the proposed changes are implemented. However, we anticipate that the Lord Chancellor will adopt the position that his views will require full Parliamentary backing before any change can come into effect and with Parliament’s time currently being dominated by Brexit issues, the prospect for the new legislation being ‘fast tracked’ would seem remote.
That first review will be carried out by the Lord Chancellor in consultation with advice from the Government Actuary. Thereafter, future reviews will continue to be carried out by the Lord Chancellor but with advice from an independent panel, which will be chaired by the Government Actuary and include another actuary, an investment manager, an economist and a consumer investment affairs expert (or at least individuals with experience in those fields). HM Treasury’s current statutory consultee status (as provided for within s.1 of the Damages Act 1996) will remain unchanged and so the MOJ will need to consult with the Treasury on each occasion that the discount rate is to be varied.
The Government’s response recognises that at the current time, the discount rate set by the Lord Chancellor can be departed from by the Courts in individual cases and the Government is not seeking to change that. Whilst that leaves open a degree of uncertainty for compensators, it must be recognised that in practice the Courts have only very rarely departed from using the discount rate when assessing future damages. The assumption must be that with the current status quo preserved in that respect, it will continue to be only in exceptional circumstances that an alternative rate will be used.
One of the key issues for compensators is likely to be how the Government decides upon a particular rate during future reviews. This is addressed at paragraphs 13 and 14 of the conclusion to the report. Paragraph 13 specifically references use of a ‘low risk diversified portfolio of investments’, rather than the ‘very low risk investments as at present’. That clearly signals a move away from setting the discount rate purely by reference to ILGS. As regards what portfolio will be referenced, paragraph 14 indicates that there are a range of possible candidates and that it will be for the Lord Chancellor to apply the principles set out in the legislation to decide ‘where in the range of low risk the rate should be set’.
In other words, the Government has chosen not to tie itself to a particular portfolio and to preserve flexibility for the Lord Chancellor and his successors. Again, that represents uncertainty for compensators and will make it difficult to predict the likely outcome of future reviews. There are also dangers for compensators associated with the Lord Chancellor retaining that degree of flexibility. Were a less ‘business friendly’ Government to come to power, that level of flexibility would make it easier for a new Lord Chancellor to contrive to find a way to impose a rate more favourable to claimants. However, it has to be acknowledged that the perceived inflexibility of the current law is what reputedly lead Liz Truss to arrive at the current minus 0.75% discount rate and compensators may take solace from the fact that any future Lord Chancellor will have to take note of the advice from the independent panel of experts.
The consultation response confirms no changes to the use of Periodical Payment Orders (PPOs). This is good news for insurers at least, and its significance should not be overlooked. Whilst the industry’s focus in connection with the Government’s March 2017 consultation has been squarely upon the discount rate, the questions about the promotion of PPOs set out within that consultation certainly gave rise to some concern in some sectors. Had the Government introduced draconian measures to bring about the greater use of PPOs, the administrative burden and capital reserving implications for insurers could have been significant. The lack of change will be less welcome by those who have championed PPOs as a more appropriate method of compensation.
Beyond the wording of the proposals, there are then the practical and tactical implications of the changes to be considered. On the information currently available, we have arrived at the following conclusions:
- The announcement vindicates the current approach of a number of compensators who have sought to negotiate deals that effectively ignore the minus 0.75% rate and are instead calibrated to alternative rates, such as 1%.
- In the short term, compensators will have to take a case specific approach to claims depending on whether they are likely to come to trial before Easter 2018. In respect of those that are destined for trial before then, compensators can try a 0% to 1% approach but the Court will be bound to assess damages by reference to the prevailing discount rate and thus any properly advised claimant will not settle on a 0% to 1% basis. Applications to adjourn are likely to be resisted and unlikely to find favour with the Court if based on the discount rate issue alone. Compensators might look at finding other reasons to adjourn in individual cases but need to be careful of their market reputation in that regard.
- In respect of cases that are not likely to come before the Court prior to Easter 2018, a compensator’s hand is strengthened in pursuing 0% to 1% settlements (or something in that ball park). The Government’s announcement adds significant weight to the speculation that the discount rate will be varied upwards next year and compensators should be capitalising on that fact.
- In relation to Court approvals, if a Judge declines to approve a settlement predicated on anything other than a -0.75% basis and invites the parties to agree a revised settlement on those terms, compensators should be considering declining that invitation, again assuming that if they walk away from the approval hearing without a settlement the case is not then likely to come before the Court before Easter 2018. Whilst there may be costs consequences to delaying the resolution of a claim, if large sums of future damages are involved, holding out until after the Easter 2018 review may still be the most sensible approach commercially, albeit this is predicated upon the proposed legislation being successfully implemented.
- Looking to the longer term, if the discount rate is to be reviewed every three years, compensators need to be well versed in how the rate will be set and monitor the performance of share portfolios with a view to anticipating likely variations. The tactical considerations outlined above are likely to be replicated on each occasion when, in advance of a review, it is anticipated that there will be a change in the discount rate. Compensators also need to be conscious that claimant representatives will no doubt be adopting similar tactics in reverse, in the event that it is anticipated that the discount rate will be reviewed downwards. The variation of the discount rate and its impact on claims negotiation has the potential to become a cyclical issue.
- Compensators also need to monitor the position regarding the possibility of a dual rate. At present, it looks as though the Government is giving itself the option to switch to that approach, but will not be doing so in the short term. A dual rate would increase the complexity of calculating future damages, albeit it modestly so. Whether it would also impact on claimant behaviours and the tactical approach to how claims are presented will depend on what the rates are and the parameters governing how they are applied.
- In terms of reserving, the Government’s announcement strongly points to variation to between 0% and 1% next year. That outcome cannot be considered absolutely certain however, with economic changes in the interim having the potential to bring about a different result and anticipated change assumes that the new legislation is passed successfully. Until such time as the revised rate is actually announced, there is an argument for continuing to reserve by reference to the prevailing rate, i.e. minus 0.75% but ultimately that is a policy decision for individual compensators. An alternative approach could be to identify those claims that are not due to come to Court before Easter 2018 and to adjust the reserves in respect of those claims by reference to an alternative discount rate, the obvious options being 0%, 1% or a compromise of 0.5%.
The Lord Chancellor’s response to the March 2017 consultation includes some interesting, if not altogether surprising analysis around the responses to the consultation that were received.
There appears to have been broad consensus about the need for change and that no claimant would actually invest their damages fund in the manner assumed by the current methodology for the calculation of the discount rate, i.e. 100% investment in ILGS.
Predictably, there was a lack of consensus over whether claimants should be considered risk free investors, as opposed to low risk investors, notably with a slight bias towards the latter approach. Although the Government’s response paper does not state so in terms, the presumption must be that claimant representatives predominantly advocated a risk free approach and defendant representatives and compensators advocated a ‘low but not no risk’ approach. That would be consistent with the make up of the responses to the consultation, circa. 25% having come from insurers and the rest from claimant and defendant representatives in broadly equal numbers.
There was further consensus that it should be the Lord Chancellor or another nominated person who sets the rate, with advice from a panel. The security of an independent panel issuing guidance but with the political accountability of a decision maker whose decisions can be challenged if necessary is clearly something valued by both claimant representatives and compensators alike.
The responses appear to have also reflected a common acceptance of the Wells v Wells 100% compensation principle, whereby the objective underpinning the setting of the discount rate and the approach to the quantification of damages generally is to match damages as closely as possible to losses and expenses actually incurred, leaving claimants neither over compensated or under compensated. Given how fundamental that is to the calculation of damages under the current system, that is perhaps unsurprising. However, given the manner in which damages in catastrophic injury cases have inflated over recent years, there must be a possibility that at some point in the future that consensus will come under challenge.
By way of a final observation, it is noteworthy that in explaining the imperative for change, the Lord Chancellor has made reference to discount rates in other jurisdictions and intimated that the range of such discount rates would seem to be circa. 3.5% to 6%. That still leaves the anticipated 0% to 1% future discount rate significantly below other jurisdictions and if the insurance industry and other compensators are looking for a banner under which to argue for a further upwards revision of the discount rate beyond 2018, that may perhaps represent a good starting point.
Can we help?
We will be keeping a watching brief as the proposed legislation progresses through Parliament and will report back as soon as there are any further developments. In the meantime, should you wish to discuss this in more detail, or would like assistance with any other matter, please do not hesitate to get in touch.
- David Johnson, Partner, firstname.lastname@example.org or 0207 822 7146
- David Holt, Partner, email@example.com or 0151 242 7921
- Kieran Jones, Partner, firstname.lastname@example.org or 0345 070 3851
- Dr Catriona Wolfenden, Professional Support Lawyer, email@example.com or 0151 242 6833