Risk as a discount rate determinant in wrongful death and injury cases.
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.
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, Jones, and Vernon), 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 and Hickman). 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 and Laber ).
The Case for Low Discount Rates
The literature reveals two rationales for low discount rate selection. Edwards 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). 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). 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. Thus, damage calculations treating future earnings of labor as risk-free are inconsistent with the fundamental tenet of common law compensation.
The second common justification for low discount rates directly addresses the relevant risk of future earnings and explicitly treats labor as a low-risk asset. Liberman, who has analyzed human capital risk, provides major arguments for the position that labor is a risk-free asset:
Employees are typically the first in line of all creditors to be compensated by the firm.
They would be the least affected by the periodic fluctuations in the fortunes of the
firm, while creditors farther down the line would bear the major burden of the risk
. ... And second ... most salaried workers have multi-period contracts which would
smooth out earnings streams and protect them from periodic fluctuations in the
fortunes of the market and the firm.
While Liberman's two points may correctly indicate a small probability of short-term variation in expected labor earnings, neither point addresses the potential, long-term deviation between actual and expected labor income. Simply knowing that the salary due this month is an almost risk-free claim does little to reduce significant salary variation over the next five, ten, or more years of an individual's work life. Even for a worker employed under a complex contract or longstanding employer commitment, substantial variation in lifetime earnings cannot be avoided easily when economic conditions change. An individual worker's future income can be materially altered by a variety of largely unpredictable events: promotions, demotions, job terminations or transfers, illnesses, death, disabilities, and other changes in supply and demand of labor.
The mistaken belief that labor earnings are low risk is probably attributable to the non-marketability of labor which may have obscured much of the actual risk for labor by redirecting attention from unobservable asset price variation of human capital to observable wage variation. Unlike common stocks, apartment houses, or other assets, the asset value of labor cannot be readily observed. Lack of market information on the asset value of labor coupled with the relative stability of average real wages (across workers), may have prompted some researchers to conclude that the unobservable asset value of labor is also stable.
Yet, the risk for any asset cannot be correctly measured through consideration of short-term rental prices alone. Risk is fundamentally based on expectations of possible future variation in overall return. The non-marketability of labor conceals variation on the asset value of labor but cannot eliminate actual risk associated with labor. Moreover, because labor cannot easily be sold or encumbered and represents a major asset of many people, workers may be constrained in attempts to diversify and may well end up with greater risk than desired for their total portfolio (see Hirshleifer).
The distinction between apparent stability of periodic payments and actual asset risk can easily be shown. Consider Figure 1 which shows the post-World War II variability of annual payments for 13-week United States Treasury Bills and dividend payments for the Standard and Poor's 500.(4) A comparison of their payment streams' variability, without any regard to changes in asset prices, would lead to the mistaken conclusion that a portfolio of short-term Treasury Bills is riskier than a portfolio of common stocks. The inappropriateness of using annual payments alone in predicting relative risk of Treasury Bills and common stocks is obvious. A portfolio of common stocks has more risk than would be indicated by an examination of dividends or earnings alone. Risk associated with Treasury Bills, common stock portfolios, or any other asset involves consideration of possible future changes in asset value and not simply consideration of periodic payments to asset holders.
Similarly with respect to labor, the risk facing workers involves consideration of possible future changes in earnings (and the value of these anticipated earnings) and not simply consideration of expected annual wage payments. Although the lack of an observable asset price for labor makes direct estimation of risk difficult, an absence of market data should not be taken as evidence of an absence of risk.
Labor -- A Non-risk-free Asset
The theoretical work and empirical evidence of mainstream economists indicate that labor is a non-risk-free asset. Becker, Thurow, and Schultz all find investment in human capital subject to considerable risk; likewise, Levhari and Weiss believe human capital is "probably more risky than physical capital."
Given that labor is fundamentally a productive asset, the idea of labor as a non-risk-free asset is hardly surprising. Whether a productive resource is a worker, a building, or a complex machine, its competitive compensation or asset value would be theoretically based on its anticipated marginal value product. Changes in real economic variables by altering marginal value products would produce changes in compensation and asset value. Once the productive nature of labor compensation is recognized, the idea of a worker as a risk-free asset insulated from the "fortunes of the market and firm" makes little, if any, sense.
One indirect measure of risk, and a starting point for proper risk-adjusted discount rate selection, is available from studies on returns to investment in human capital. If labor is a risk-free asset operating in a perfectly competitive and efficient market-place, then estimated real returns from education and training should reflect the low level of risk with real rates of return in the range of zero to three percent. On the other hand, if labor is a non-risk-free asset, investors would require higher expected returns to compensate them sufficiently for the additional risk. By examining rates of return from investment in human capital, an independent (though admittedly imperfect) estimate of risk is obtained.
Blaug found that "calculated rates of returns have fallen within the range of 5 to 15 percent ..." in the vast majority of studies on real returns to education and training. These real rates of return are far in excess of what would be expected if labor were a risk-free asset. Also, they are an indication that appropriate real discount rate selection, properly adjusted for risk, should generally involve rates in excess, and in some cases far in excess, of 5 percent. [Figure 1 Omitted]
(1)Brealey and Meyers , state, "If the [future stream of earnings] is risky, the normal procedure is to discount its forecasted (expected) value at a risk-adjusted discount rate r which is greater than [the risk-free rate]." (2)A notable exception is found in Bell and Taub who state that consideration should be given to the "risk of the lost earnings stream." (3)See also Jones and Laughlin Steel Corporation v. Pfeifer, 678 F.2d 453 [3rd Cir. (Pa.) 1982] and Chesapeake and Ohio Ry. v. Kelly, 241 U.S. 485 (1916), where the Court emphasized safety; and Bealieu v. Elliott, 434 P.2d 665 (Alaska, 1967), where the Court adopted a zero discount rate to help minimize investment risk of the injured party. (4)While Figure 1 is shown in nominal terms, the greater stability of dividends as compared to interest payments also holds in real terms. The coefficients of variation for real dividends and real interest payments are .292 and .301, respectively.
References Becker, Gary S., Human Capital, (New York: Cambridge University Press, 1964). Bell, Edward B. and Allan Taub, "Selecting Income Growth and Discount Rates in Wrongful Death and Injury Cases: Additional Comment," The Journal of Risk and Insurance, Vol. 44, No. 2 (1977), pp. 122-29. Blaug, Mark, "The Empirical Status of Human Capital Theory: A Slightly Jaundiced Survey," Journal of Economic Literature, Vol. 14, No. 3 (1976), 827-55. Brealey, Richard and Stewart Meyers, Principles of Corporate Finance, (New York: McGraw-Hill, 1984). Dobbs, Dan B., Handbook on the Law of Remedies, (St. Paul: West Publishing, 1973). Edwards, N. Fayne, "Selecting the Discount Rate in Personal Injury and Wrongful Death Cases," The Journal of Risk and Insurance, Vol. 42, No. 2 (1975), pp. 342-45. Franz, Wolfgang W., "A Solution to Problems Arising from Inflation When Determining Damages," The Journal of Risk and Insurance, Vol. 45 No. 2 (1978), pp. 323-33. Harris, William G., "Inflation Risk as a Determinant of the Discount Rate of Tort Settlement," The Journal of Risk and Insurance, Vol. 50, No. 2 (1983), pp. 265-80. Hickman, Edgar P., "Selecting Income Growth and Discount Rates in Wrongful Death and Injury Cases: Further Comment," The Journal of Risk and Insurance, Vol. 44, No. 1 (1977), pp. 129-32. Hirshleifer, Jack, Investment, Interest, and Capital, (Englewood Cliffs: Prentice-Hall, 1970). Jennings, William and Penelope Mercurio, "Selection of an Appropriate Discount Rate in Wrongful Death and Personal Injury Cases," Journal of Contemporary Law, Vol. 14, No. 2 (1988), pp. 195-209. Jones, David D., "Inflation Rates Implicit in Discounting Personal Injury Economic Losses," The Journal of Risk and Insurance, Vol. 52, No. 1 (1985), pp. 144-50. Laber, Gene, "The Use of Inflation Factors in Determining Settlements in Personal Injury and Death Suits: Comment," The Journal of Risk and Insurance, Vol. 44, No. 3 (1977), pp. 469-73. Levhari, David and Yoran Weiss, "The Effect of Risk on the Investment in Human Capital," American Economic Review, Vol. 64, No. 4 (December, 1974). Liberman, Joseph, "Human Capital and the Financial Capital Market," Journal of business, Vol. 53, No. 2 (1980), pp. 165-91. McCormick, Charles T., Handbook on the Law of Damages, (Mineola: Foundation Press, 1935). Schultz, Theodore, Investment in Human Capital, (New York: Free Press, 1971). Thurow, Lester C., Investment in Human Capital, (Belmont: Wadsworth, 1970). Vernon, Jack, "Discounting After-Tax Earnings with After-Tax Yields in Tort Settlements," The Journal of Risk and Insurance, Vol. 52, No. 4 (1985), pp. 696-703.
William P. Jennings is Professor of Economics and G. Michael Phillips is Associate Professor of Finance at California State University in Northridge. They wish to thank William Brown, Penelope Mercurio, James Gikas, Susan Leslie, and anonymous referees for their assistance.
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|Title Annotation:||calculating lost earnings capacity|
|Author:||Jennings, William P.; Phillips, G. Michael|
|Publication:||Journal of Risk and Insurance|
|Date:||Mar 1, 1989|
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