PFP's views on the discount rate decisionMar 6th, 2017
This is the first of a series of posts about the Lord Chancellor’s decision to reduce the discount rate used in assessing lump sum awards in personal injury claims to minus 0.75%. As some have already observed, what was a discount is now an uplift.
Few, if any, were betting on this outcome: although we have been saying for some time that ILGS yields are negative, and negative discount rates have been adopted by the NHSLA and the MIB in reserving for future liabilities, not many actually heard the message.
The published information shows that only three sources of evidence were drawn upon in reaching the decision, although the decision itself had to be considered by HM Treasury and the Government Actuary.
They were the work of Dr John Pollock, an actuary, Dr Paul Cox, an academic, and us as independent financial advisers (Richard and myself). The panel’s report has now been published, along with supplementary questions from the MoJ, and our responses, which can be found here: documents.
Our opinions were not unanimous, which we are now free to say, and to explain why. The views expressed here are our personal ones, and must not to be taken as representative of those of the panel or any other member of it.
It became apparent to us at an early stage that the panel needed legal opinion from the MoJ about the fundamental legal principles established in Cookson v Knowles, later adopted in Wells, and the Roberts -v- Johnstone calculation.
Formal advice was provided to the panel in clear terms that the discount rate applies after the multiplicands have been identified by the court, according to the applicable legal principles, specifically:
- Multiplicands can only be the figure proved as representing the loss at current prices at the date of the trial. Inflation is built into the multiplier, and the mechanism for doing that requires that a rate of interest be arrived at as the notional return on investment to be earned on a lump sum over the period in question; and
- General improvements in living standards, and qualitative improvements in an element of the claimant’s loss over time are irrelevant to the task of setting the discount rate, and neither should therefore be taken into account; and
- Claimants are to be regarded as very risk-averse investors.
The pivot around which everything turns is the recognition that if investment returns on real assets are taken into account, then the assessment of the discount rate will fall foul of the second condition above.
Real assets on which investment returns can reflect general improvements in living standards, such as would typically be found in a mixed investment portfolio. In contrast, the return on ILGS is linked to the RPI. Price indices, including the RPI, are constructed to remove so far as possible qualitative change over time, and interest rates do not rise with general improvements in living standards – otherwise they would now be at astronomic levels rather than close to zero.
Having reached that conclusion, the majority view was therefore that the only choice was to base the discount rate on the yield on ILGS. The minority view was that a mixed asset portfolio was capable of providing better returns at a tolerable level of risk, but the majority view was that such an approach would foul the legal principle outlined above and, furthermore, after allowing for costs and adjusting for risk, the discount rate could have been even lower than that set by reference to ILGS.
Having considered the evidence, the Lord Chancellor has clearly rejected the minority and accepted the majority view.
When our report was concluded in 2015, the average yield on ILGS with more than five years to maturity was minus 0.80%. Since then, yields have slipped further – in September 2016 the average had dropped to minus 1.80%, a fact we drew to the attention of the MoJ. The Lord Chancellor has in fact chosen to base the average over a period of three years, and to include all stocks including those with less than five years to maturity.
In many cases, the form of award is not a free and open choice, and no claimant has a right to either a lump sum or periodical payments. However, for too long, there has been a misalignment between the discount rate and investment returns in the real world, which has incentivised insurers to prefer lump sum settlements.
The Lord Chancellor’s decision has levelled the playing field. If insurers genuinely believe that beating the discount rate is like falling off a log, they must put their money where their mouth is. Let them take the risks and rewards of investing capital, and offer claimants periodical payments.