Discount rate consultation offers opportunity to achieve certainty and fairness for all
With effect from 20 March, Liz Truss's bombshell announcement made on 27 February has become reality and injury claims for future loss must now be dealt with on a minus 0.75% discount rate. This has resulted in very significant increases in the valuation of catastrophic and serious injury claims by virtue of the very significantly increased multipliers which come into play as a result of a negative discount rate.
An example makes the point clear. A 30 year old male with unimpaired life expectancy would now see his lifetime losses dealt with on the basis of a multiplier of 71.43 as compared to the previous multiplier of 29.60 based on a 2.5% discount rate. Any claims to which that new multiplier applies are therefore now worth nearly two and a half times their previous valuation.
The claimant lobby will query why an insurer or indeed any defence interest should be surprised by this change in the discount rate given that, in their view, all that the Lord Chancellor has done is to apply the letter of the House of Lords' decision in Wells v Wells, given back in 1999, to the reality of the current financial landscape.
The reality of course is that nobody on either side was openly predicting a discount rate set as low as this. Even optimistic claimant lawyers were talking about a 1% or 1.5% discount rate. It is the extent of the change to a negative rate which has caused much of the current concern as well as unnecessary practical issues in the handling and settlement of the most serious injury claims, pending the outcome of the consultation to review how the rate should be set which was published on 30 March and which remains open till 11 May.
A significant impact – financially and on claims handling practices
The shock to the current system for settling these serious claims arises primarily for two reasons.
First, it comes against a background of previous stability and certainty in the valuation of these claims over many years since the 2.5% rate was introduced. This in turn has allowed the creation of mutually beneficial claims handling processes, agreed between claimants and defendants, which can be operated quickly and efficiently so that these claims can be settled with the minimum fuss and delay.
The new significantly increased rate adds a higher degree of uncertainty into those processes whilst the rate remains where it currently is: the negotiating positions of both claimants and defendants must now be reconsidered, and settlement rates may well fall as the parties struggle to re-evaluate where claims values now stand.
Secondly, the change in the rate is being made at a point in time where over recent years we have seen the worst financial conditions in decades, which have caused a very significant impact on insurers, on re-insurers and on government finances.
Against that background, the news of the negative discount rate will add to those problems. It will also be bad news for the general public who will be facing very significant increases in insurance premiums to fund the increased value of claims. Who knows, unless the rate can be changed from where it is now there may even need to be tax rises to meet the additional costs to the public purse. At the very least, valuable funding which could have been put to good use within the NHS will be diverted into the resultant black hole in the public finances.
Uncertainty a compounding factor
The problem did not end with the extent of the reduction in the discount rate. Not only did the Lord Chancellor deliver that particular bombshell, but in delivering it she also created a period of uncertainty, because she simultaneously indicated that there would be a reconsideration of the methodology by which the discount rate is arrived at.
That consultation has now been issued, and indeed was published only 31 days after the announcement on 27 February, suggesting that the issue is rightly receiving priority within the Ministry of Justice. As expected, it is a short consultation with responses due within 6 weeks and so by 11 May. The effects of the current negative discount rate may prove to be short lived if the consultation process results in a different approach to the setting of the discount rate and it can be implemented promptly by legislation.
Considerations for the forthcoming consultation
There are three elements to be consulted upon:
By reference to what principles should the rate be set in the future? What investment returns should be taken account of? It is commonly accepted, even by many of those who represent claimants, that fixing the discount rate by reference to the risk free investment that ILGS provides does not properly reflect the reality of how compensation payments are in practice invested. In passing it is worth noting that it is surely odd to describe an investment such as that implied by the new negative rate as 'risk free' when it self-evidently and with absolute certainty currently loses the investor money. It seems to us that the definition of 'risk' should be the possibility that an investment reduces in value rather than increases. Indeed that would seem to fundamentally highlight the absurdity of the current position.
With what frequency should the rate be reviewed going forward? Both claimants and defendants want certainty but does that necessarily mean the certainty of having a rate fixed in place for many years regardless of the financial and economic circumstances prevailing in the country at the time?
Who should set the rate? Should it still be the Lord Chancellor or should it be someone else such as an independent panel?
The way forward?
As to the level of the discount rate after the forthcoming consultation, the unsuitability of the current position involving the use of a negative discount rate must be evident to all concerned. It is surely beyond any reasonable viewpoint that claims which may involve losses running over decades should be valued on the basis that throughout those decades, the sums invested, even in ILGS, would lose money year on year.
It is therefore clearly time to accept that there is an acceptable level of risk, which we would describe as being of a modest level, which should be applied to the setting of the discount rate, and that this should reflect a mixed basket of investments which, as a combination, provide that acceptable modest risk which a prudent investor would accept.
It may be that there is an argument for different approaches to the degree of acceptable modest risk and therefore to the discount rate depending on the period for which the compensation is intended to cover. One could see a legitimate argument for having a lower discount rate for claims where the future loss is limited to say five years or less, and a higher discount rate for claims at the other end of the scale with decades left to run.
There are also other models to consider, for example, those which provide for a lower discount rate and therefore a higher multiplier for the earlier period to enable a fund to build up, and then a higher discount rate and a lower multiplier for a later period.
As to the frequency with which the rate should be reviewed in the future, this causes real difficulty. The 16 years between 2001 and 2017 over which the 2.5% rate lasted was clearly too long as has been evidenced by the chaos that has resulted from this change. However, what is an appropriate period?
Annual reviews could equally lead to chaotic outcomes with parties potentially hedging their bets against what is likely to happen at the next review depending on the direction of the prevailing economic circumstances.
One possibility would be to review the discount rate more regularly even than that. It could be reviewed quarterly as occurs with the Bank of England base rate, weekly or even on a daily basis according to a precise formula based on an acceptable investment risk level.
While an advantage of this type of approach would be that the fluctuations would be so small that in realistic terms they would make little difference to how claims are conducted and settled, in fact it seems unlikely that this type of approach will be adopted by government. There are practical issues with this, not least of which would be the need for tables which contain many more columns that those currently provided, and even though those problems might be surmountable, it is more likely that the perceived advantages of certainty over longer periods will prevail.
What the outcome from this consultation should be seeking to achieve is an approach to the discount rate which fairly reflects the interests of all stakeholders. It is the cornerstone of our system for paying compensation that claimants must be fairly compensated, but this means fairness to both sides including defendants and their insurers, and the current negative rate is clearly causing unfairness.
The interests of the other stakeholders, insurers, the public purse, and the premium paying general public must also be taken into account and it has throughout the period since 27 February been our hope that this consultation would at last adopt a holistic approach in securing a discount rate set at an appropriate level.
Recent experience has shown that the government will benefit from the input of all key stakeholders in the consultation process so as to ensure that on this occasion a more suitable outcome is achieved. The decision announced on 27 February may well have been rushed under the threat of litigation: the decision this time round needs to be both correct and also one capable of enduring.
The consultation in principle
There are positive signs from the consultation document. Liz Truss in her foreword to the paper accepts the need to achieve fairness, and to have a rate which is fair not only in terms of compensating claimants properly, but which is also fair to consumers, business and taxpayers.
The negative impacts to date as assessed both by the Office for Budgetary Responsibility and also by PwC in terms of impact on insurance premiums are noted, as are the specific effects which have been reported on insurers' reserves and operating profit.
There is to be a report prepared as part of the consultation process by the British Institute of International and Comparative Law as to what happens in 7 other jurisdictions including Hong Kong, where their use of a "term structure" is remarked on. Their rate is minus 0.5% for terms up to 5 years, 1% for terms up to 10 years, and 2.5% for terms exceeding 10 years.
The consultation accepts that across the board claimants will pursue a range of investment strategies, but if they are not using ILGS then there is a risk that they are being overpaid, and that instead a degree of investment risk could be allowed for, which if not unacceptably high, could achieve a fairer balance as between claimants and defendants.
The consultation – an alternative approach
While not formally expressing a preference at this stage, nevertheless an alternative approach is set out which looks more appropriate than the current position. It is built on making an allowance for actual returns which claimants are likely to obtain on their investments, alongside the availability of PPOs which might cover some of the loss.
The consultation queries the continued use of the assumption that claimants are very risk averse investors, and while reference is made to Wells v Wells, it is to the earlier Court of Appeal judgment in that case in which it was considered that prudent investment required the choice of a basket of investments.
This same proposition is advanced through the consultation, which is that it might be appropriate to set the rate by reference to the returns from a mixed portfolio of investments, managed by professional investment advisers, so as to produce a higher discount rate.
The potential use of PPOs is also put forward in the consultation as part of the argument in relation to the level of the rate. The point is noted that if a claimant wants to adopt a lower risk profile than assumed, then they could elect to go for a PPO instead, but if a claimant passes up that opportunity, then they clearly cannot be as risk averse as the current discount rate implies.
This leads the consultation into consideration of the use of PPOs themselves, though it is accepted that the area is only indirectly linked to the discount rate. While we detect no momentum on the part of government to act in this area, the potential for steps being taken to encourage parties towards greater use of PPOs by guidance or rules of court is noted.
Who to set the rate and when to review it?
The consultation contains no suggestion that the Lord Chancellor is keen to retain the role. The recent controversy makes a clear case for a change. The possibility of using an independent panel is to be consulted on.
Also consulted on is when the rate should be reviewed. 1, 3, 5 or even 10 years are mentioned. There may be momentum behind a number of years within the centre of this range. Should there be a mechanism that triggers a review within an otherwise specified period, and should there be transitional provisions when the rate changes? All are being considered.
The early issue of the consultation, the short response period, and most importantly the terms of it give room for cautious optimism in favour of reform in this critical area.
If the reality of the position is that claimants cannot invest in ILGS as that type of investment is in fact not available to them, then it can fairly be assumed that the earlier judgment of the Court of Appeal in Wells v Wells, that prudent investment required the choice of a basket of investments was entirely realistic and reflects current practice. In turn therefore, the returns from that type of investment, should be used when calculating a level of discount rate which is fair to all parties, as Liz Truss now seeks to achieve.
From the conclusion of the consultation the government needs to continue to move forwards with as much speed as is appropriate in all the circumstances. The Prisons and Courts Bill which deals, amongst other issues, with the establishment of new processes which can be used by an Online Court, as well as with whiplash claims reform, received its second reading in the Commons on 20 March and is now in Committee. This Bill may well be a suitable vehicle for change and which can provide the primary legislation which is expected to be needed to provide a meaningful solution to the discount rate issue.
In the meantime, it is incumbent on stakeholders to try to work together. It is in the interests of all that we arrive at a fair approach to the setting of the discount rate and that the process that results from this consultation is one that gives all those involved in making and responding to claims the certainty that enables those claims to be resolved in a timely manner and as consensually as possible.
The same collaborative approach to the settling of claims which has developed over recent years needs also to continue, seeking to overcome the difficulties and uncertainties raised by the current negative rate. The government needs to play its own part by ensuring that the period over which the current uncertainty has to be managed is as short as possible.
This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.