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

Abstract

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 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 theoretical and empirical bases such calculations will show that 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, 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 present value calculation of damages, nominal interest rates may be reduced by 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 Low Discount Rates The literature reveals two rationales low discount rate selection. Edwards[6] maintains a low rate is necessary to ensure receipt of same expected income 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 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 common law idea that the general purpose of compensation is to give a sum of money to wronged person which, as nearly as possible, will restore him or her to position he or she would be in if wrong had not been committed (McCormick[16]). If damage award is based on expected lost wages that are discounted by a non-risk-free discount rate, injured party could not safely earn sufficient income from his or her award to replace expected lost earnings with certainty. Implicitly however, legal or economic basis low discount rate selection rests on premise that stream of expected earnings injured party would otherwise have received was reasonably certain. To extent actual labor earnings may deviate from expected earnings, court should treat future labor earnings in same manner it treats earnings from physical and financial assets (see Jennings and Mercurio[11]). In a risk-averse world, recognition of actual uncertainty surrounding future labor earnings would call stream of expected labor earnings to be discounted by a higher, risk-adjusted rate. …