September 19, 2018

Scotland: Government Actuary’s Department predicts 1% discount rate

Following publication of the Damages (Investment Returns and Periodical Payments) (Scotland) Bill, Government Actuary's Department (GAD) has been consulted on various aspects of the proposed changes.

The report considers the design of the hypothetical 'low risk' portfolio, the interplay with the 'further margin', as well as appropriate expenses and tax allowances.

Taking these considerations into account in the context of a pursuer as a 'low risk investor', the average portfolio was calculated to produce a return of 0.9% above RPI (resulting in a discount rate of 1%).

This is likely to be viewed by the market as an estimate of what the rate may look like under the new legislation, however as GAD identifies, there are a number of caveats and areas for 'flexibility', ensuring much uncertainty still remains for insurers.

Methodology

GAD analysed pursuer outcomes, meeting inflation-linked damages of £10,000 per annum for 30 years, using an assumed award basis and investment strategy to consider under what scenarios the settlement would be sufficient to meet their needs.   

It is not clear why this assumption has been used for the purposes of the Bill and it is disappointing this has not been questioned by GAD. ABI data demonstrates that the average investment period of 46 years is more appropriate, it being the mean duration of future damages.

Accordingly the 30-year period appears too low and overly cautious and will result in over-compensation for pursuers. It is to be hoped that these parameters are addressed as the Bill proceeds through parliament.

Low risk portfolio

GAD constructed a range of 20 sample portfolios with reference to investment funds categorised as ‘low risk’ by investment management company, Morningstar.

Based on the economic scenarios used throughout their analysis, the expected returns on the portfolios considered at December 2017 were in the range of 0.3% - 1.8% pa above RPI (considering the median return), with the baseline portfolio returning 0.9% pa above RPI. This would produce a discount rate of 1% under the new rules (0.9% rounded up to the nearest 0.25% under the terms of the Bill).

Mandating a 'notional investment portfolio' is somewhat artificial and as GAD identifies, are not representative of the way in which pursuers should invest their damages, are advised to do so, or actually invest their damages. Indeed the notional portfolio (or any of the 20 sample funds considered) is overly cautious and should contain a higher proportion of equity investments to ensure the 100% compensation principle is upheld. Further evidence of how pursuers invest their damages or should invest their damages is required to inform the composition of the notional portfolio. 

Interestingly it is noted in the report that an assumed investment strategy of 100% UK equities would produce a discount rate of 2.5%. Whilst this would be considered too risky a strategy for pursuers, the proposed baseline of only 7.5% investment in UK equities is too low and should be revised upwards if the 100% compensation principle is to be upheld. 

Further reduction

GAD considered potential pursuer outcomes under different combinations of award bases and investment strategies. The key results from their analysis are that even though the portfolios considered are low risk, there remains an element of risk involved for the pursuer no matter what the award basis.

This is unsurprising; there is always some risk in any investment and the majority of pursuers accept such a possibility. Pursuers not wishing to take on any risk have the option of Periodic Payment Orders.

GAD also note that larger awards (i.e. lower PI discount rates) will mitigate some of the risk to pursuers, but would lead to a higher expected level of over-compensation. As the discount rate is reduced, the probability of under-compensation reduces, whilst the median level of over-compensation increases.  Identifying the correct balance is therefore critical to the process in order to ensure the 100% compensation principle is adhered to.

GAD concludes that reducing the discount rate (or increasing the margin for prudence, the 'further margin' as described in the Bill) will ultimately improve the likelihood of the pursuer having sufficient funds to meet their damages. The proposed further reduction is currently 0.5% and it will be a decision for Scottish ministers. It must be asked what the cost of this will be to defenders, who will have to foot the bill for increasingly likely overcompensation.

The justification for using the 'further reduction' is far from clear. If the cautious portfolio is the appropriate way to meet the needs of the hypothetical pursuer, then this 0.5% reduction must go beyond their needs and therefore beyond the 100% compensation principle. As noted, the notional portfolio is already too cautious and the "further margin" is likely to erode the 100% compensation principle still further.

Furthermore the need for the "further margin" is undermined by the availability of PPOs. The 0.5% margin is said to be included to avoid the risk of under-compensation. This is simply unnecessary given the investment portfolio approach is overly cautious and pursuers with the lowest risk appetite can utilise a PPO.

Next steps

The Scottish Parliament’s Economy, Jobs and Fair Work Committee has been assigned as the Committee responsible for scrutiny of the Bill. The Committee will begin to review the responses to the call for evidence which ended on 7 September 2018, together with GAD's report and will begin to hear oral evidence shortly.