Dramatic reduction to discount rate will push up claim costs for insurers, says expert

The rate, which is designed to account for the investment return an individual would receive over their lifetime if they invested the lump sum payment in the lowest risk investments, will fall from 2.5% to minus 0.75% from 20 March. This is the first change to the discount rate since 2001, and will effectively increase compensation awards in order to reflect assumed loss of value.

Elizabeth Truss, the lord chancellor, said that the new rate was "the only legally acceptable rate" that could be set. The government would publish a consultation before Easter on whether there is a "better or fairer" alternative to the current rules, and will bring forward any necessary legislation as quickly as possible, she said.

Insurance law expert Alexis Roberts of Pinsent Masons, the law firm behind Out-Law.com, said that the change had been prompted by the fact that investment returns had been significantly lower in recent years.

"The change in the rate announced by the government will mean that awards are discounted by materially less, so the awards will be higher," he said.

"This affects insurers because it means a significant increase in the cost of claims. It also means that they will have to set aside more money to cover future claims. This will probably mean an increase in motor and liability premiums for millions of drivers and businesses across the UK," he said.

The Association of British Insurers (ABI), which had previously attempted to challenge the government's review of the rate in the courts, said that increased premiums were "inevitable".

"We estimate that up to 36 million individual and business motor insurance policies could be affected in order to over-compensate a few thousand claimants a year," said Huw Evans, director general of the ABI.

Compensation awards for life-changing injuries are calculated in such a way as to put the injured party in the same financial position as if they had not been injured, including loss of future earnings and care costs. The discount rate, once applied by the courts, ensures that the actual amount received reflects the interest the individual can expect to earn by investing a lump sum payment.

The 1996 Damages Act requires that those receiving lump sum compensation awards are treated as risk averse investors, reflecting the fact that they will be financially dependent on the lump sum for perhaps the remainder of their life. The discount rate is therefore linked to returns on the lowest-risk investments, typically index-linked gilts.

In a statement to parliament, Truss said that when the rate was set at 2.5% in 2001, it was based on "a three year average of real yields on index-linked gilts". Following consultation, she adopted the same methodology in order to reach a minus 0.75% rate, she said.

Truss said that the new rate would have "significant implications across the public and private sector", particularly for NHS clinical negligence claims.

"The government has committed to ensuring that the NHS Litigation Authority has appropriate funding to cover changes to hospitals' clinical negligence costs," she said. "The Department of Health will also work closely with GPs and medical defence organisations to ensure that appropriate funding is available to meet additional costs to GPs, recognising the crucial role they play in the delivery of NHS care."

Chancellor Philip Hammond will meet with insurance industry representatives to discuss the impact of the change on their businesses, she said.