What is the meaning of the discount rate and why does it matter?

I posted my first blog on the origins of the Lord Chancellor’s power to fix discount rates at 7 pm two nights ago. Now, nearly 40 hours later, it has already attracted over 500 “views” and a lot of interesting comment on Twitter. This blog is written as an attempt to answer the question posed by Abdul Hafezi:

“What is and why discount rate are relevant?”

I will try and make the answer as simple as possible, although pundits are likely to accuse me of over-simplification.

In this discussion, I am principally concerned with compensation for very serious injuries (or loss of capacity) that has been caused by someone else’s fault: an act or omission that constitutes the breach of a legal duty of care is usually the trigger. The task of a judge, when negligence has been proved or omitted, is to strive to put the claimant back, so far as money can achieve it, in the position in which he/she would have been if the blameworthy act or omission had not taken place.

The judge will be assessing the damages months, if not years, after the injury was originally suffered, and the award of damages will be conventionally divided up into three parts:

“special damages”, for the financial loss already suffered by the time of the date of assessment;

“general damages”, by way of an award of compensation for “pain, suffering and loss of amenity”.

“general damages”, for future financial loss.

Issues relating to the identification of the appropriate discount rate only arise when computing the appropriate figure for future financial loss.

Traditionally, the court set out to find a “multiplicand” – an appropriate sum for future loss in each 12-month period – to which a “multiplier” must then be applied, depending on the number of years over which the future loss is likely to be suffered. Obviously, the award of lifelong damages to an injured child will be much larger than the award to an injured 70-year old.

In the days before the Law Commission’s 1994 report led to the enactment of the Damages Act 1996, the higher courts did their best to give guidance on the way in which trial judges should ascertain the appropriate multiplier and the appropriate multiplicand. Judges distrusted the use of an actuarial approach because they felt that it did not take into account all the different contingencies that might have come the way of the claimant even if the “accident” had not happened, and they knew that it was over-simplistic simply to multiply the multiplicand by the number of years that represented the claimant’s reasonable life expectancy, because the claimant would be receiving all his/her money immediately, which would be immediately available for investment, instead of having to wait to receive it in the year in which a particular slice of future loss would be suffered.

In its 1992 Consultation Paper, the Law Commission illustrated the usual judicial approach by reference to Lord Scarman’s judgment in the 1980 case of Dr Lim Poh Choo, a brilliant young doctor who had been catastrophically injured by an act of clinical negligence which did not affect her life expectancy: in its description of the case the Commission also made comments on the award which show how very complicated the exercise could be.

“Some of the difficulties faced by the judiciary in applying the multiplier approach can be illustrated by reference to Lim v. Camden Health Authority[1]. Lord Scarman, discussing the element of the award in respect of future care, referred to the remarks of the judge[2]:

“Her expectation of life, according to the tables, will be in the order of a further 37 years. In this case I must make a substantial discount because of the accelerated payment, some reduction for the contingency that she will not reach the average age, some reduction to allow for the purely domestic element, and some increase for prospective inflation. Balancing these elements as best I can, I find the appropriate multiplier for the period of future care in England to be 11 .”[3]

Lord Scarman pointed out that adjustment for the ‘domestic element’ is normally made through the multiplicand rather than the multiplier and accordingly made an adjustment. He also confirmed that damages are to be assessed without regard to future inflation, unless exceptional circumstances exist. He made a further adjustment for the fact that under the award “capital as well as the income arising is to be available for meeting the cost of care[4]“, and arrived at a multiplier of 12.

The extent of the reduction for the contingency of not reaching the average age was not discussed in explicit, numerical terms. Indeed, it is difficult to ascertain very clearly what view was taken about survival. In his discussion of loss of future earnings and pension at a later part of the judgment Lord Scarman made the following observations:

“Dr Lim’s expectation of life after her injury is substantially as it was before her injury. Nevertheless.. . the contingency of an earlier death is plainly more likely after than it was before her injury.”

In the event, Lord Scarman upheld the judge’s award of a multiplier of 14 for loss of future earnings. Given that at the date of trial (December 1977) the plaintiff was aged 40 and thus could have expected to work for a further 20 years, the multiplier of 14 falls within the discount bracket of 4 to 5% suggested by Lord Diplock[5].

A heavy discount of pension rights was also upheld by Lord Scarman, suggesting an implicit assumption that Dr Lim faced a high probability of premature death but only once she had reached retirement age. It is not easy to discern why the multiplier for loss of future earnings should, in this particular case, exceed the multiplier for the cost of future care. The other observation which may be made, admittedly with the benefit of hindsight, is that a doctor highly regarded as a senior registrar in psychiatry in 1977 would have had a high expectation of early appointment to a position as consultant. By 1992, at the age of 55, the same doctor was likely to have been earning a great deal more in real terms than the amount assumed by the courts in Dr Lim’s case.”

The Law Commission’s recommendations in 1994 represented a bold attempt, and on the whole a successful one, to place the ascertainment of the multiplier on a more scientific basis. Today, practitioners in the field will have by their sides two essential manuals full of helpful guidance. One is published by the Judicial College (the organisation responsible for judges’ training) which gives a range of possible awards for injuries of different types, depending on their relative severity[6]: this will be used at the second stage of the assessment process.

The other is the current edition of the Ogden Tables[7], which makes use of actuarial evidence in a way that takes proper account of the different contingencies that used to be of concern to the judges, in order to ascertain the appropriate multiplier. And when the appropriate gross sum has been calculated by applying the multiplier to the multiplicand, the courts between 2001 and the present day have been applying a discount rate of 2.5%, even though they know that this will represent far too great a reduction in the damages award at a time when only very low rates of interest are available on capital investment[8].

It is paradoxical that paying parties, such as insurance interests, are now describing the Lord Chancellor’s recent decision as “crazy” when they have taken advantage for so long of successive Lord Chancellors’ failure to give the courts up to date authority to use realistic discount rates when market conditions have been changing so much since 2001 (the year in which the rate was last prescribed).

The ascertainment of a sensible way forward, now that market conditions have changed so much, is an entirely different question. What will be vital is that if claimants, who mostly lack financial sophistication, are to be expected to invest in a prudent bundle of low risk equities instead, they must receive additional compensation for the cost of the independent financial advice they will unquestionably be obliged to obtain in those circumstances.

 

[1] [1980] A.C. 174. For comment see David Kemp Q.C., “The Assessment of Damages for Future Pecuniary Loss in Personal Injury Claims”, (1984) 3 C.J.Q. 120 pp. 126-127.

[2] Lim v. Camden Health Authority [1980] A.C. 174, 195H-196B.

[3] [1979] Q.B. 196, 203.

[4] Lim v. Camden Health Authority [1980] A.C. 174, 196C.

[5] In Cookson v. Knowles [1979] A.C. 566, per Lord Diplock, 571 (in times of stable currency).

[6] Guidelines for the Assessment of General Damages in Personal Injury Cases. The first edition was published in March 1992, shortly after jurisdiction to make many of these awards had been devolved to the county court, whose judges were shown to need help of this kind when undertaking a task that was unfamiliar to many of them.

[7] The seventh edition of the Ogden Tables was published in November 2014.

[8] A tweet from Australia yesterday included this comment: “Interesting to consider in Australia where discount rate can be 5% and is a major contributor to under-compensation for severe injury.”

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