Compensation is an essential part of the insurance system – if an individual is injured and can no longer work or needs care then a compensation payment can quite rightly support them for the rest of their life.
Yet changes to compensation rates in England and Wales unveiled by Lord Chancellor Liz Truss in February – which changes have been adopted by Scottish Ministers for Scotland in March – have the potential to turn the whole system on its head – and force up the cost of cover for policyholders.
When a claimant is receiving compensation to cover future loss of earnings or lifelong care, they receive a lump sum, which is discounted to factor in the investment income that the compensation payment will generate so that the claimant isn’t overcompensated.
Truss decided to change the “discount rate” that is applied to compensation payments.
Back in 1998, the House of Lords decided that index-linked government securities – better known as government bonds or gilts – should be used as the benchmark for the discount rate. This was based on an assumption that claimants would want their investment to carry as little risk as possible.
A lot has changed since 1998. The 2008 global banking crisis and ensuing recession triggered a rush of quantitative easing by central banks to prop up the financial system by buying bonds. This has taken its toll on gilts and their “yields” – the amount that an investor will receive in interest for buying the bonds – which in turn has distorted the market.
Despite this, the Lord Chancellor decided that an investment portfolio consisting of just gilts was still the best benchmark for the discount rate – even though independent financial advisors say a properly advised claimant would never use such an investment strategy.
As a result, the discount rate has dropped from 2.5 per cent to minus 0.75 per cent. This means that the lump sum is not discounted. Instead it is actually increased to reflect an assumption that the claimant will lose money when he or she invests it.
The Association of British Insurers (ABI), the insurance industry’s trade body, has said that the decision is “crazy”. The ABI warned that the cost of up to 36 million individual and business motor insurance policies may have to rise “in order to over-compensate a few thousand claimants a year”.
A switch of 3.25 percentage points may not sound like a large figure, but the movement is amplified over time. If a young person is injured and can no longer work then a negative discount rate can have a huge effect over their lifetime.
For example, let us consider a 17-year-old man who has a care regime that costs £150,000 a year – not an unusually high sum by any means.
The compensation to cover this care is nearly £5m at the 2.5 per cent discount rate, but at the -0.75 per cent level the figure leaps to just over £14m.
This not only raises issues of a claimant being over compensated, it also creates significant risks for businesses, many of which have claims limits on their insurance policies of £5m or £10m. These businesses are now at risk of needing to meet any shortfall between what a claimant is entitled to receive and what their policy covers. This could be millions of pounds.
The impact of the change in Scotland may be greater than down south, as the Scottish courts can only make lump sum payments whereas in England and Wales, courts can make orders spreading the payments over the lifetime of the injured person.
Whilst those most seriously injured are entitled to be fully and properly compensated, if the negative discount rate remains in place then claimants could be over compensated. This will be at the expense of the wider public, who will be faced with picking up that bill through higher insurance premiums, and businesses, which will be at risk where their insurance cover has a financial limit on it that could be exceeded by the increase in the value of the most serious claims.
Rachel Rough is a partner with BLM, Glasgow