The Discount Rate in Compensation Claims - Why Does it Matter?
What is 'The Discount Rate'?
When an injured party is awarded compensation for their injury, it is intended that the compensation should return the person to the financial position they would have been in had the injury not occurred. They should not suffer financially because of their injury, but neither should they benefit. Past and future loss of income should be recovered and fair costs of care, as appropriate, should be allowed for.
It is recognised, however, that, if the injured party receives a lump sum, they may choose to invest the money and thereby earn interest on the sum. This could effectively increase the value of the lump sum. In order to allow for this, a discount rate is applied, adjusting the initial lump sum amount to allow for the possibility of the injured party earning interest.
The rate assumes that, because the injured party is dependent on their compensation, they are unlikely to indulge in high-risk investment. Therefore, the rate has been based on the likely income from investment in index-linked government stock.
It also takes into account the impact of inflation on costs that are likely to be incurred by the injured party, such as the employment of carers.
Why is it currently in the news?
Since 2001 the discount rate has been set at 2.5%, reflecting a period of strong financial growth and optimism at that time. However, the reality is that, in recent years, interest rates have fallen dramatically and investments have not been producing the returns which might have been expected around 2001.
Thus it would seem that, also taking into account the effects of inflation, some claimants have been under-compensated. Investment of their lump sum has not actually produced the anticipated interest, therefore potentially leaving them with insufficient funds.
The setting of the discount rate is currently within the remit of the Lord Chancellor and in February 2017, Elizabeth Truss, then Lord Chancellor, announced that the discount rate would change as of March 2017 to - 0.75%.
This meant that, instead of lump sums amounts being revised down in order to allow for investment income, they would be revised up to allow for the fact that, interest rates are currently so low (current Bank of England base rate is 0.25%), that, once inflation over a period of time is taken into account, the claimant could be out-of-pocket - even though they had invested their money.
From (+) 2.5% to (-) 0.75% is a significant change and, in some cases, will result in dramatically larger sums being demanded of defendants.
For clinical negligence cases, this will put an even greater stress on an already cash-starved NHS.
For personal injury cases, such as road traffic accidents, it may require higher pay-outs from insurers. This is likely to lead to higher insurance premiums.
Therefore, the Lord Chancellor's announcement has caused some outcry in those quarters whilst being welcomed by claimants and their legal representatives who have, for some time been arguing that claimants have been disadvantaged by the existing discount rate.
What is the purpose of the Government consultation?
Recognising that this is a controversial issue and that, given the vagaries of financial markets, especially with the current uncertainty of Brexit, applying an accurate and fair discount rate is both difficult to achieve and yet vitally important in terms of legal and financial fairness, the government has issued a consultation paper focussing on the following questions:
- Who should set the discount rate?
- How often should the rate be set?
- What principles should guide how the rate is set?
The consultation period ended in May 2017 and the government initially stated that the response would be published in August 2017 but this appears to have been delayed by the general election and formation of a new government - and appointment of a new Lord Chancellor - in June 2017.
Issues?
- Uncertainty as to the future of the discount rate and anger in some quarters regarding the level at which it has been set may make some defendants reluctant to settle in the hope that it will change
- Financial uncertainty globally and in the UK specifically at present - in terms of interest rates and inflation - makes setting a fair discount rate difficult
- Further political change may make decisions about such issues and the introduction of legislation to support such changes protracted
- Whilst the Association of British Insurers has argued that victims of injury are not necessarily averse to high-risk investment, thereby potentially increasing the value of their lump sum beyond expectations, it would not be fair to expect or require such victims to undertake those types of investment in order to be properly and fairly compensated
Solutions?
- Instead of compensation awards being administered via a lump sum, there may be an increased use of periodical payment orders where compensation is delivered at agreed intervals over the lifetime of the award. This may be particularly appealing to defendants but would not be appropriate to all situations. For example, where an injured party requires completely new accommodation, or substantial changes to existing accommodation, a significant up-front lump sum may be required.
- It may be appropriate to apply different rates to different aspects of a claim according to the nature of the need.
- It may be appropriate for the discount rate to be assessed more regularly in order to take account of uncertain economic times
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