Discount Rate proposals – certainty and fairness for all?
The decision in February to cut the discount rate to minus 0.75%, after 16 years without a review, plunged the insurance industry and personal injury lawyers into turmoil. This was alleviated slightly by the swift launch of a consultation promising to find a solution to achieve certainty and fairness for all. Earlier this month we reached the latest key milestone in the ongoing saga when the Government responded to its consultation, setting out a new process for calculating the rate, and the Lord Chancellor has now invited the Justice Select Committee to review the proposals by the end of November.
The key elements of the proposals are:
- The rate will be set by reference to “low risk” rather than “very low risk” investments as at present.
- The rate will be reviewed at least every three years.
- The Lord Chancellor will consult a panel of independent experts when setting the rate.
Whilst there remains uncertainty about the eventual outcome, the willingness to adopt a new and different approach - and one which it is widely accepted will come much closer to representing the reality of how claimants manage their money - is to be welcomed. Not least it shows a recognition that the change brought about by the previous Lord Chancellor resulted in a wrong outcome and one which saw claimants significantly overcompensated. As always, the detail of the proposals will be critical, and this is contained in the draft legislation and additional material accompanying the consultation response. In this update we examine that detail and look at the next steps and practical considerations to see whether the Government has achieved its aim.
How should the rate be set?
The main issue here was to determine what should be the appropriate assumed investment risk profile for claimants. As we know, under the current law claimants are treated as very risk averse investors and, following Wells v Wells  1 AC 34 the discount rate was calculated on the basis of the percentage returns from a portfolio containing 100% ILGS. The crux of the argument from insurers was that ILGS were no longer the appropriate benchmark and that claimants should not be treated as very risk averse but rather as "low risk" investors. The claimant representative view was that there should be no change to the law and that claimants should continue to be treated as "very low risk" investors.
In opting for the "low risk" profile and therefore a change in the current law, the Government seems to have been persuaded by the evidence gathered in the consultation showing that claimants do not actually invest solely in ILGS, nor are they advised to, so that a rate based on those returns may result in overcompensation. Instead, the evidence was that claimants tend to invest in a "mixed portfolio" of assets.
With that in mind, and as part of the impact assessment accompanying the consultation response, the MoJ commissioned the Government Actuary's Department (GAD) to construct a representative low risk portfolio. Analysis of that portfolio suggested that a claimant would be expected to achieve a real rate of return of just above 1% per annum (before tax and investment charges). On an initial high level assessment, the GAD suggested an annual deduction of around 0.5% for both tax and management expenses was likely to be reasonable.
The draft legislation therefore requires the Lord Chancellor to make certain assumptions and take into account certain factors. The assumptions include:
that the claimant invests the relevant damages in a diversified portfolio of investments; and
that the relevant damages are invested using an approach that involves more risk than a very low level of risk, but less risk than would ordinarily be accepted by a prudent and properly advised individual investor who has different financial aims.
The factors include requirements to:
have regard to the actual returns that are available to investors, and the actual investments made by investors of relevant damages; and
make appropriate allowances for taxation, inflation and investment management costs.
The provision in the current law enabling the Lord Chancellor to set more than one discount rate will be retained. Interestingly, both the response to the consultation and the explanatory notes to the draft legislation explicitly mention the possibility that "different rates might … be prescribed for different durations of loss" potentially leaving the door open in the future for the dual rate/Ontario type model consulted on.
When should the rate be reviewed?
The Lord Chancellor will be required to review the rate at least every three years. It was widely accepted that a period of 16 years was too long to wait for a review, especially one that resulted in such a dramatic change. The consultation responses produced a range of opinion on the appropriate review period and three years was seen as a suitable compromise. The key considerations for the Government in coming to this decision appear to have been the need to try and avoid dramatic movement in the rate and to minimise the potential for parties to seek to delay settlement if they anticipate an advantageous review. To further mitigate against those risks, the Lord Chancellor will retain the discretion to trigger an earlier review if necessary, although there will be no set criteria in place to "trigger" such a review.
The first review will start within 90 days of the new legislation coming into force and on this occasion the Lord Chancellor will consult with the Government Actuary alone. Subsequent reviews will be started within three years of the previous review and the Lord Chancellor will be required to consult an expert panel. Both the Government Actuary (in the first review), and the panel (in subsequent reviews), must respond within 90 days of the commencement of the relevant review and reviews must be completed within 180 days of their commencement.
Who should set the rate?
The main area of discussion in relation to this question was whether the Lord Chancellor should continue to make the decision, with the assistance of an independent expert panel or whether the panel itself should make the decision. Ultimately, given the importance of providing clear political accountability for such an important financial decision, it was decided the Lord Chancellor will retain responsibility for setting the rate, but in consultation with an expert panel and HM Treasury. The panel will be made up of appropriate experts, consisting of the Government Actuary, who will chair the panel, and four other members appointed with these specific areas of experience: as an actuary, in managing investments, as an economist, and of consumer matters relating to investments.
As mentioned above, there will be no panel for the first review and the Lord Chancellor will only consult with the Government Actuary and HM Treasury.
A number of questions in the consultation related to the current availability and use of PPOs, and whether a change in the law relating to PPOs is needed. The overwhelming majority of responses agreed that there was no need for reform in this area, save for addressing the anomaly in Scotland where the courts currently do not have the power to order PPOs if the parties do not agree. The Scottish Government is currently consulting on proposals to bring the law into line with that in England and Wales.
The impact assessment also reminds stakeholders that a higher discount rate resulting from the new method of calculation will make PPOs relatively more attractive to claimants who are unwilling to invest in higher risk portfolios.
Legislation and timings - the draft legislation is in the form of a clause which inserts a new Section A1 and a new Schedule A1 into the Damages Act 1996. We do not yet know how this clause will be enacted. There had been speculation before the General Election that any change could be incorporated into the Prisons and Courts Bill which fell by the wayside when parliament was dissolved. Logically, the clause could be included within the Civil Liability Bill announced in the Queen's Speech, but this Bill has not yet been presented to parliament and the Government may wish to find a quicker means of enacting the amendments.
In the meantime, the MoJ has invited comments on the draft legislation, but without giving a timescale. The Lord Chancellor has however invited the views of the Justice Select Committee and has asked for their review to be completed by the end of November. To that end, the Justice Committee has launched an inquiry seeking written submissions by Friday 13 October 2017.
As we have mentioned, there is a maximum period of 270 days (approx. 9 months) from the clause being enacted for the review to be completed. Insurers will be hoping that the issue remains high on the Lord Chancellor's agenda and that as work has already been carried out by the GAD, it would be disappointing indeed if he requires the full period to come to a decision when conducting the first review.
Application of any new rate: no retrospective effect – any change in the rate will not affect awards of damages already made i.e. those using the current minus 0.75% rate. Any change will apply to all outstanding claims from the date of the change as of course has been the position when change took place previously.
Territorial extent - the draft clause only relates to England and Wales whereas the Damages Act 1996 relates to the whole of the United Kingdom. The current Schedule in the Act will be amended to refer to "Schedule 1" which relates only to the law of Northern Ireland. Because of the absence of an executive in Northern Ireland since the change in the rate to minus 0.75% in England, Wales and Scotland, the discount rate applicable in Northern Ireland remains at 2.5%. Even if an executive is restored following an agreement between the parties involved, it now seems likely that there may be a policy of “wait and see” adopted until the developments taking place in and Wales have reached a conclusion.
As we already know, the Scottish Government proposes to introduce a Damages Bill including provisions on the discount rate, presumably (although not yet confirmed) along the same lines.
Litigation strategy – at this stage, the reality is that these proposals are unlikely to change current strategies. If there is to be a trial within the time frame anticipated for the legislation to pass and therefore before the rate can be expected to change, the minus 0.75% rate will continue to apply.
In any other case settlements can continue to be explored on the basis on which many are currently being achieved, namely a recognition on all sides of the likelihood of the discount rate going back into positive territory and therefore settling using appropriate multipliers calculated on that basis.
Estimating approaches should continue as currently until we have certainty as to the new rate and when it will take effect from.
Insurers have welcomed the Government's response to the consultation and although claimant representatives have been less welcoming, there is not a sense of outright opposition to the proposals. Of course, much will depend on the outcome of the review although we sense an attempt by the Lord Chancellor to manage expectations on all sides by suggesting that a review today could produce a figure in the region of 0% to 1%, based in turn no doubt on the GAD's representative low risk portfolio.
It seems to us that the Government has carefully considered the consultation responses and is genuinely trying to balance the interests of claimants, defendants and wider society to come up with a fairer process that should, in time, also result in increased certainty. It would have been difficult to justify maintaining the status quo when "virtually all respondents" agreed that claimants are not advised to invest all of their lump sum on one asset class and particularly in ILGS. Whilst a higher assumed risk profile is likely to result in a higher discount rate and therefore lower multipliers leading to reduced lump sum payments, the Government is clear that the assumption is that insurance companies will pass on any savings through lower insurance premiums.
The Government is acutely aware of the uncertainty in current cases pending the legislation being passed and the first review taking place. David Lidington highlighted this in his letter to the Justice Committee saying "I am keen to make progress with the proposals because of the significant financial impact of the unrealistic assumptions reflected in the current rate and to minimise the length of the period of uncertainty as to what the law will be." Insurers will therefore be hoping that the findings of the Committee are uncontroversial and that the clause can be promptly introduced to parliament paving the way to the first review.
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.