Risk as a Discount Rate Determinant in Wrongful Death and Injury Cases

By Jennings, William P.; Phillips, G. Michael | Journal of Risk and Insurance, March 1989 | Go to article overview

Risk as a Discount Rate Determinant in Wrongful Death and Injury Cases


Jennings, William P., Phillips, G. Michael, Journal of Risk and Insurance


Risk as a Discount Rate Determinant in Wrongful Death and Injury Cases

Abstract

Calculations of lost earnings capacity in wrongful death and personal injury cases

are typically based on the discounted present value of lost future wages. The paper

argues that these calculations have generally overstated damages by using discount rates

that fail to take proper account of risk associated with future wage income. An

examination of the theoretical and empirical bases for such calculations will show that

the practice of discounting with essentially risk-free rates is inconsistent with

fundamental notions of common law and economic theory.

Introduction

While existing literature devoted to proper discount rate selection in wrongful death and injury cases has addressed a variety of important issues (for example, see Harris[8], Jones[12], and Vernon[19]), consideration of risk associated with deviations of actual future earnings from expected future earnings has been largely ignored. Thus, the stream of expected labor earnings has been treated implicitly as risk free. This risk-free treatment of expected labor earnings is quite different from legal or market evaluation of other productive assets which implicitly discount future expected earnings of productive assets by risk-adjusted rates.(1)

The literature illustrates that experts employed by plaintiffs and defendants use low-risk discount rates based on conservative debt instruments: including 13-week United States Treasury Bills; intermediate term, high-grade government or corporate securities; and long-term government or corporate bonds (for example, see Edwards[6] and Hickman[9]). To simplify the present value calculation of damages, nominal interest rates may be reduced by the expected inflation component to produce real discount rates commonly below, and often far below, 5 percent (for example, see Franz[7] and Laber [13]).

The Case for Low Discount Rates

The literature reveals two rationales for low discount rate selection. Edwards[6] maintains a low rate is necessary to ensure receipt of the same expected income the injured party would have received "but for" his or her injury. Additionally, some practitioners view labor as an inherently low-risk asset and, accordingly, believe future expected earnings should be discounted by a low rate.(2)

The first idea of an injured party's receiving a lump-sum amount that is sufficient, when invested safely, to replace lost earnings follows the federal court precedents of calculating present value with a discount rate "at which an ordinary person can invest safely and without any special skills" (Dobbs,[5, ).(3) Upon initial reflection, selection of a low discount rate may seem in keeping with the common law idea that "the general purpose of compensation is to give a sum of money to the wronged person which, as nearly as possible, will restore him or her to the position he or she would be in if the wrong had not been committed" (McCormick[16]). If the damage award is based on expected lost wages that are discounted by a non-risk-free discount rate, the injured party could not safely earn sufficient income from his or her award to replace expected lost earnings with certainty.

Implicitly however, the legal or economic basis for low discount rate selection rests on the premise that the stream of expected earnings the injured party would otherwise have received was reasonably certain. To the extent actual labor earnings may deviate from expected earnings, the court should treat future labor earnings in the same manner it treats earnings from physical and financial assets (see Jennings and Mercurio[11]). In a risk-averse world, recognition of the actual uncertainty surrounding future labor earnings would call for the stream of expected labor earnings to be discounted by a higher, risk-adjusted rate. …

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