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The Ogden knock out

Published by Scott Eason on

The Ministry of Justice (MoJ) closed their consultation on 11 May into how the Ogden discount rate should be set in the future. In this blog we will look at some background information about the Ogden rate, the core issues examined in the consultation paper and what could happen next.

Brief Background

  • The Ogden rate is the discount rate which is applied to personal injury claims where a lump sum is paid as compensation. The idea being that the claimant will invest the lump sum and earn interest and therefore should not be under or over-compensated by the insurer.   
  • Originally the rate had been set by assuming that a claimant would be very risk averse and would therefore invest 100% of any lump sum awarded in index linked government securities (ILGS). 
  • The Lord Chancellor was given the power to set the discount rate. He first used his powers in 2001 to set the discount rate at 2.5% above inflation, by reference to ILGS.
  • Following a steady decline in ILGS the MoJ issued a consultation paper in August 2012 on how the rate should be set but the response to the consultation was inconclusive.
  • On 20 March 2017 the Lord Chancellor used the same methodology as before to set the new discount rate at -0.75%.

Examples in the MoJ consultation paper suggest that the lump sum award could be increased by 60%!

Core issues examined in the consultation paper

  • What principles should guide how the rate is set?
  • How often should the rate be set?
  • Who should set the discount rate?

What principles should guide how the rate is set? 

The key overriding principles for the setting of the discount rate under the present law are that the lump sum awarded for future pecuniary loss should: 

  • fully compensate the claimant (neither more nor less);
  • be sufficient to meet all the expected losses in full as they are expected to fall due without shortfall;
  • be exhausted (along with the income assumed to be earned on the capital sum during the period of the award) at the end of the period for which the award is made;
  • be set on the basis that personal injury claimants are to be treated as extremely risk averse and will invest cautiously.

One of the criticisms of using ILGS as a benchmark for setting the discount rate is that claimants are believed in practice not to invest 100% in ILGS.  In fact such a strategy would increase risk due to lack of diversity. The consultation paper confirms that there is very little robust empirical evidence as to how claimants invest their awards.

The consultation paper discussed other possibilities:

  • The discount rate could be set using the above key principles, taking the risk appetite of the claimant into account. This approach is an attempt at striking a balance between not over-burdening the defendant or under compensating the claimant. However, in reality such an approach would be difficult to implement since it isn't easy to gauge someone’s risk appetite accurately and one could argue that a claimant’s risk appetite changes after an accident.
  • Use of more than one discount rate; i.e. different rates could be used for different parts of awards. However this would increase the complexity of awards and could generate additional legal argument, increasing costs and causing delay.
  • Split the rate into two separate rates; the risk free rate and the risk premium rate. The risk premium rate would be fairly static, but the risk free rate would change regularly following movements in the prices of risk free investments.

How often should the rate be set?

Several options are discussed in the paper. Some of them are: 

  • The discount rate should be reviewed as often as necessary to reflect material changes in returns from the investments by reference to which the rate is to be set.
  • Currently the law does not state explicitly when rate reviews should be carried out; the law could be changed so that rate review dates are known in advance.
  • Linking reviews to movements in indices of yields of whichever investments are chosen as a benchmark rate
  • Carry out reviews at the end of a set period e.g. once every one, three, five or ten years.
  • A fixed pattern of review could be combined with a review triggered by a particular percentage change in the yields of the investments by reference to which the rate is set.

Who should set the discount rate?

At the moment the rate is set by the Lord Chancellor who before changing the rate is obliged to consult the Treasury and the Government Actuary. Scottish Ministers are obliged to consult the Government Actuary. The Lord Chancellor and her counterparts are required to set the rate using the same approach as the courts would have done had they continued to set the rate. 

The paper sets out several options for who could set the rate; this includes the following:

  • A panel of experts could be appointed to set the rate in accordance with relevant principles and methodology. The panel would need professional and technical expertise. It could be made up of actuaries, financial experts, investment experts and economists. Five members including an independent chair could be an appropriate number.
  • Rate set by a panel but subject to the agreement of another person who could have the right to veto the panel’s suggestion.
  • Rate set by the Lord Chancellor, but he or she could be required to consult a standing advisory panel before making a decision.
  • If the two rates are set (risk free and risk premium as described earlier) then perhaps the risk premium rate could be set by a Minister and the basic risk free rate could be set by a panel.

PPOs

The consultation paper also has a section on whether sufficient use is being made of Periodic Payment Orders (PPO). It recognises that PPOs are considered to be a more expensive approach to settling a claim, mainly due to the additional required reserve provisions for the insurers.

What could happen next?

This is the $64m question! It is safe to say that the general consensus is that the current way in which the discount rate is set is not suitable. For example the Association of British Insurers (ABI) has recently revealed that it would prefer a panel of experts to set the discount rate as discussed in the paper. The ABI also believes that linking the discount rate to ILGS is flawed. 

What the industry is looking for is a fair and transparent way in which the discount rate is set. Here is our bucket list of what we would like to see:

  • The methodology kept simple! Having two (or more) components for the rate or trying to gauge a claimant’s risk appetite will add an element of unnecessary uncertainty for insurers. One idea might be to have 'an average claimant' portfolio which consists of a portfolio of investments; similar to the default lifestyle funds which many pension funds use.    
  • Discount rate set by a panel of experts, as suggested in the consultation paper.
  • A clear trigger which would cause a review of the rate; for example a particular percentage change in the yields of the investments by reference to which the rate is set. Hopefully this would give insurers some forewarning before the discount rate changes, as well as creating a more transparent rate setting process.

One thing which we all have to accept is that any change is going to take a fair amount of time to be made. So for the moment we will all have to sit back and wait to hear what the MoJ’s consultation results are…

About the author

  • Scott Eason

    Scott is Head of Insurance Consulting, responsible for managing the life and non-life consulting teams which offer high quality, great value advice and support to insurance companies in our core areas of actuarial, risk management and investment advice.

    View Biography

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