Legal blog: Don’t discount the importance of the discount rate

With the current focus of attention on the Jackson reforms, it is easily forgotten that there are still potentially much bigger challenges facing the industry in 2012.

Among these is the cost of catastrophic injury claims which, while few in number, contribute a disproportionate amount to overall claims costs.

The average cost of such claims in the UK has risen by 400% over the past 15 years. This is by far the highest increase of any country in Europe, and significantly in excess of inflation indices such as the consumer price index, retail price index and average earnings over the same period.

Why does the UK stand out in this way? Largely because of costs – care costs and claimant legal costs. 

In the UK there seems to be a mismatch between the measure of loss the courts apply and the “real world”; between the care provision for a disabled individual with a claim and one without. While some difference might be expected due to pressures on the public purse, this now appears extreme.

I could highlight numerous differences between publicly funded and claim-funded care regimes, but want to concentrate here on the “discount rate”. This is the nominal interest rate (currently 2.5%) that is used to calculate lump sum awards to cover lifetime care.

Following intense pressure from the claimant lobby the way this rate is calculated is now subject to consultation by the government. The argument is that the return from a relatively “risk free” investment in long-term, index-linked government securities is falling well short of 2.5% and the discount rate should be reduced accordingly.

Depending on a claimant’s age and disability the implication of such a reduction could be immense, adding millions of pounds to some awards. The resulting total increase in awards could easily far exceed all the cost savings that the full package of Jackson reforms might deliver.

There are two issues here. First, the long-term rate of investment return in the supposedly risky “real world” has consistently exceeded 2.5% despite the recent volatility in the financial markets. Secondly, there is already a fairly “risk free” alternative to lump sum awards in the form of Periodical Payment Orders (PPOs).  

The former probably explains the low take-up of the latter. The courts assume that claimants do not take any risks whatsoever with the investment of their lump sum award, which does not reflect reality in most cases.

Interestingly, a recent report from the International Underwriting Association also suggests that the already low take-up of PPOs is plateauing. Perhaps the claimant side is waiting to assess the significance of any discount rate change before committing to a course of action.

While the financial markets are turbulent, the effect is felt by all of the injured and disabled in society. Should injured claimants continue to receive what amounts to special treatment by way of an even more generous discount rate?

The insurance industry needs to strongly resist any blanket change. Instead it should press for a root-and-branch review of how large loss awards are calculated to restore reality and proportionality.

In tandem, the issue of claimant costs really must be addressed. Claimant costs on large value personal injury claims are now commonly into high six figures and, worryingly, more frequently into seven figures.

Meanwhile, the government’s attention seems to be focused solely on reform of the fixed costs regime, which would leave such cases untouched, missing a great opportunity for real reform.

Don Clarke is President of the Forum of Insurance Lawyers