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Bill Brandt
Bill Brandt

This document discusses several approaches to discounting future losses, including income losses and life care costs, to present value. It notes that the discount rate should be based on risk-free investments according to Jones & Laughlin v. Pfeifer. However, it argues that using long-term treasury yields to discount losses may violate this principle by exposing plaintiffs to inflation risk not inherent in the losses. Short-term rates that match the inflation risk of losses are preferable. The document also discusses duration matching between plaintiff assets and liabilities.

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Consideration of Inflation Risk and Market Risk in Deriving a Discount Rate for Income Loss and Life Care Claims
Jones & Laughlin v. Pfeifer : Impact on Damages Discounting Guidelines: "The discount rate should be based on the rate of interest that would be earned on 'the best and safest' investments... Once it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-free stream of future income to replace his lost wages; therefore, the discount rate should not reflect the market’s premium for investors who are willing to accept some risk of default." Guidelines on Inflation Risk: "On the one hand, it might be assumed that at the time of the award the worker will invest in a mixture of safe short-term, medium-term, and long-term bonds, with one scheduled to mature each year of his expected worklife… On the other hand, it might be assumed that the worker will invest exclusively in safe short-term notes, reinvesting them at the new market rate whenever they mature... We perceive no intrinsic reason to prefer one assumption over the other.
Laddered Approach: 1) Project Future Value of Year-by-Year Losses • Include Real Growth/Decline • Include Expected Inflation 2) Design Hypothetical Portfolio of Zero Coupon Treasuries Maturing Annually • FV Annual Maturities = FV Expected Losses 3) Calculate Market Price of Hypothetical Portfolio 4) Market Price = Loss Compensation High Degree of Reliance on the Treasury Yield Curve High Degree of Reliance on the Accuracy of Projected Inflation Short-Term Rollover Approach (Gross-Up): 1) Project Future Value of Year-by-Year Losses • Include Real Growth/Decline • Include Expected Inflation 2) Discount Future Values by Expected ST Treasury Yields Over Full Projection Horizon 3) S Discounted Values = Loss Compensation Short-Term Rollover Approach (Net): 1) Project Future Value of Year-by-Year Losses • Include Real Growth/Decline • Exclude Expected Inflation 2) Discount Future Values by Expected Spread Between ST Treasury Yields & Expected Inflation High Degree of Reliance on Expected Spread Between Inflation & Future Short-Term Yields
Yield Curve Usually Slopes Upward (Compensates Treasury Investors for Increased Market Risk) Yield to Maturity Years to Maturity It is important to understand the yield curve if it is to be used to discount future losses.
Why is Treasury Curve "Normally" Upward Sloping? Why Isn't Treasury Curve Always Upward Sloping? Preferred Habitat Hypothesis: • Two Factors Determine Slope of Yield Curve • Expected Future Trend in Interest Rates (or Inflation) • Market Risk • Key Assumption • Different Maturities are Close Substitutes, but NOT Perfect Substitutes • Implications for Yield Curve • Long-Term Bonds Have Higher Market Risk; Generally Higher Rates • Downward-Sloping ("Inverted") YC's Only Occur when Interest Rates are Expected to Decrease SUBSTANTIALLY
Treasury Curve Valuation Paradox Impact of Hypothetical Event that Increase Inflation Uncertainty (Assume Expected Future Value Remains Unchanged, but Probability Distribution widens) Impact of Hypothetical Impact of Hypothetical Event Event on the Probability on the Yield Curve for U.S. Distribution of Future Value Treasury Securities of a Bond Yield Curve 1 Yield Curve 2 Probability Distribution 1 Probability Distribution 2 Treasury Expected Value Curve shifts EV1 = EV2 Probability Curve upward. shifts downward and Yield to Maturity widens. Probability Future Real Value Years to Maturity
Impact of Hypothetical Event on Treasury Bond Transaction: Cash  Treasury Treasury Securities Buyer  Inflation Risk Securities Seller  Inflation Risk Compensation 1) Uncertainty event flattens the future value distribution curve, thereby increasing inflation risk. 2) Treasury Curve shifts upward, enticing the Treasury Buyers to purchase the riskier bond. 3) Amount paid by Treasury Buyer is reduced at a higher discount rate to compensate for the added level of inflation risk. Impact of Hypothetical Event on the Reduction to Judgment in a Loss Claim: (When Treasury Curve is used to value long-term future losses) Cash  Defendant Inflation Risk  Plaintiff  Inflation Risk Compensation 1) Uncertainty event flattens the future value distribution curve, thereby increasing inflation risk. 2) Treasury Curve shifts upward, enticing Treasury Buyers to purchase the riskier bond. 3) Amount paid by Defendant (to the Plaintiff) is reduced at a higher discount rate, based on the Treasury Curve. 4) Inflation risk compensation is effectively paid to the wrong party.
Plaintiff Damage Fund Using Laddered Zero's Investment Assets & Loss Compensation Liabilities Maturity (Years from Present) Assets Liabilities $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year
Savings & Loan Institution Analogy Savings & Loan Business Model: • Primary assets were mortgage loans. • Primary liabilities were customer deposits. (Demand Deposits, Short-Term CD's & Savings Accts) • Mortgage Loan Interest Rates > Deposit Interest Rates • Positive spread generated profits for many years. Roots of S&L Crisis • Inflation/Interest Rates Spiked in the 1970's • Short-Term Bank Deposits Turned Over Quickly • Long-Term Mortgages Turned Over Slowly • Interest Expense 1970's Rates; Interest Income at 1950's/1960's Rates • NEGATIVE SPREAD Between Interest Income & Interest Expense • Problem: Duration Mismatch between Assets & Liabilities (Long-Term Loans versus Short-Term Deposits) Survival Strategy for Financial Institutions: • Goal: Improve Duration Match Between Assets/Liabilities • Lengthen Duration of Assets (if possible) • Shorten Duration of Loans • Sell LT Loans & Retain Servicing • Hedge with Interest Rate Futures/Swaps • Emphasis on Adjustable Rate Mortgages (30-Year Loans with 6-Month "Repricing" Duration) • Emphasis on Other Variable-Rate Loans
Structure of Plaintiff's Damage Fund: • Assets are Hypothetical Zero Coupon Bonds • Liabilities are Expected Future Losses • Fund Will Offset Future Losses IF Actual Losses  Expected Losses Forecasted at Trial Date Plaintiff's Potential Crisis under Laddered Approach: • Inflation Spike (as in the 1970's) • Actual Losses Exceed Projections Made Before Spike in Inflation • Zero Coupon Proceeds Don't Change (Set at Trial Date) • NEGATIVE SPREAD Between Award Receipts & Loss Offset Disbursements Plaintiff's Response to Crisis: • Plaintiff Liquidates Funds Earmarked for Future Losses • Early Liquidation Triggers Capital Losses in Rising Rate Environment • Shortfalls & Capital Losses Compound in Prolonged Rising Rate Environment • Fund is Exhausted Before End of Loss Period
Select Beginning Date  1955 Select Rate 1  Consumer Goods CPI Select Ending Date  2010 Select Rate 2  30-Day Treasury Bills Total Returns Yield Lock-In Date  1965 Select Rate 3  20-Year Treasury Bond Yields 30-Day Treasury Bills Total Returns and 20-Year Treasury Bond Yields Versus Consumer Goods CPI 16% Consumer Goods CPI 30-Day Treasury Bills Total Returns 14% 20-Year Treasury Bond Yields 12% 10% 8% 6% 4% 2% 0% -2% 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 195_ 196_ 197_ 198_ 199_ 200_ 201_ Decade/Year
Assets Liabilities $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year
Assets Liabilities $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year • The Plaintiff's assets are his/her award fund investments; liabilities are his/her future losses. The job of the award fund is to offset those future inflation-sensitive losses. • Zero coupon investments "lock-in" nominal cash flows. Duration of a ZC Bond is equal to the maturity of the bond. • Liabilities for future losses have duration of 0!!!! Expected nominal value of future losses changes dynamically, while the nominal value of assets does not change. • Duration mismatch can result in significant shortfalls or windfalls to the Plaintiff over long periods of time. • Duration mismatch creates significant exposure of inflation risk that didn't exist with the underlying losses which are being compensated!!! • Long-Term Bonds carry fundamental risk characteristics not inherent in the underlying Income Losses.
Q: "Why does this matter?" A: The Long-Term Treasury yield should not be used because Long-Term bonds carry a degree of inflation risk that is not present in the underlying loss being compensated. The risks inherent in the rate are fundamentally different than the risks inherent in the loss. Q: "Isn't the Plaintiff likely to invest in something other than Treasuries anyway? A: Our responsibility is to match the appropriate risk against the loss being valued, regardless of what the Plaintiff ultimately chooses to do with the damage compensation (see "CAL"). Q: "Hasn't the Plaintiff benefitted from the avoidance of other real-life risks that he would have faced if the loss hadn't occurred? Doesn't 'Parity in Risk' suggest that he has eliminated other elements of risk that offset any inflation risk that he would face with Long-Term Bonds?" A: Jones & Laughlin v. Pfeifer seems to imply that risks of uncertainty in future income streams are to be resolved before the discounting step, rather than through the discounting step. Further analysis indicates that Jones & Laughlin v. Pfeifer may have gotten it right.
Short-Term Treasuries Expected Return Long-Term Treasuries Risk Premium Risk-Free Return Risk (Expected Variation of Return)  Low Risk/Low Return High Risk/High Return  Long-term Treasury securities carry more risk that short-term Treasuries when interest rate/inflation risk is taken into consideration . The FE's job is to discount the losses based on the safest investments that carry a similar inflation risk to the underlying loss. Any subsequent decision by the Plaintiff to "move up" on CAL should not influence the FE's calculation.
Does Jones/Laughlin v. Pfeifer Violate "Parity in Risk?" Transfer of Liability under Jones/Laughlin v. Pfeifer Certainty Equivalent of an Income Loss to the Plaintiff & Defendant Assumptions Before Liability Transfer: • Before reduction to Present Value. • Approximately normal distribution curve, with all relevant inputs properly accounted for. • Both Plaintiff and Defendant are risk-averse. • Let Expected Value = EV, Plaintiff Certainty Equivalent = CEp, Defendant Certainty Equivalent = CEd, Transactional approach to the transfer of liability from Defendant to Plaintiff: Certainty Equivalent Value of Economic Loss Distribution EV Probability Distribution Expected Value CE Plaintiff CE Defendant Probability Future Value of Losses
The Defendant and Plaintiff both prefer a certainty equivalent (at a "price" less favorable than Expected Value) to the uncertainty of the distribution curve. The risk premium reflects the economic value of the elimination of uncertainty to each party when the claim is reduced to judgment. Liability Transfer Amount based on Value of Consideration Received/Paid to Both Parties: Cash (EV)  VRp  Defendant Plaintiff  Discharge of Liability (EV)  VRd Both sides benefit from the elimination of risk when the claim is reduced to judgment. Consideration to Plaintiff = EV + RPp , consideration to Defendant = EV + RPd If RPp  RPd, Parity in Risk is not violated under Jones/Laughlin v. Pfeifer . Alternative Valuation Approach: Equilibrium Price of Liability Transfer in a "Perfectly Competitive" Market What would market price be if liability transfers were sold in a free market setting? Liability Transfer Market Assumptions (Imagination is required): 1) "Perfect Competition" Supply 2) Plaintiffs & Defendants can freely enter/exit market. 3) Plaintiffs "supply" liability transfers. CE d (Quantity supplied varies directly with price) 4) Defendants are "purchasers of liability transfer: EV Price (Quantity demanded varies inversely with price) 5) RPp  RPd CE p 6) Plaintiffs' price sensitivity  Defendants' price sensitivity Demand Equilibrium price  EV Parity in Risk is not violated under Jones/Laughlin v. Pfeifer . Quantity
Expected Value of Life Care Plans & "Parity in Risk" Transfer of Liability for Life Care Costs Certainty Equivalent of Life Care Costs to the Plaintiff & Defendant Assumptions Before Liability Transfer: • Before reduction to Present Value. • Approximately normal distribution curve, with all relevant inputs properly accounted for. • Both Plaintiff and Defendant are risk-averse. • Let Expected Value = EV, Plaintiff Certainty Equivalent = CE p , Defendant Certainty Equivalent = CEd , Plaintiff Value of Risk = VR p = EV - CEp , Defendant Value of Risk = VR d = CEd - EV Certainty Equivalent Value of Economic Loss Distribution Probability Distribution Expected Value CE Defendant EV Probability Future Value of Losses The Defendant benefits from the transfer of life care liabilities at expected value AT THE EXPENSE OF THE PLAINTIFF. The Plaintiff is required to assume risky liabilities that did NOT EXIST before the loss at the Expected Value, with no compensation for his/her risk, and no offset of risks that existed before the loss.
TIPS Yield Curve TIPS YIELD CURVE: (Coupon Yields) "Normal" Curve is Upward Sloping. Historical Averages from 2004 - 2011 Evidence of Market Risk. (Risk of Capital Gain/Loss to Holders 2.5% of Securities) Source: FRB Release H-15. Sources of Market Risk: 2.0% 1) Flight to Safety/Reversal 2) U.S. Fiscal Policy. 3) Federal Reserve Monetary Policy. 1.5% 4) Competition from Private Debt. 5) Activity of Other Central Banks: • PBC Trade Surpluses (to Date) • BOJ Earthquake Debt 1.0% • ECB/Bundesbank, SNB, Bank of England, … 6) Fiscal Policy of Foreign Govts. (e.g., 1990's German Reunification 0.5% Merkel Nuclear Plant Decommission, etc.) 7) Other Supply/Demand Issues 0.0% 0-Yr 5-Yr 10-Yr 15-Yr 20-Yr 25-Yr

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Anarisktalk

  • 1. Consideration of Inflation Risk and Market Risk in Deriving a Discount Rate for Income Loss and Life Care Claims
  • 2. Jones & Laughlin v. Pfeifer : Impact on Damages Discounting Guidelines: "The discount rate should be based on the rate of interest that would be earned on 'the best and safest' investments... Once it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-free stream of future income to replace his lost wages; therefore, the discount rate should not reflect the market’s premium for investors who are willing to accept some risk of default." Guidelines on Inflation Risk: "On the one hand, it might be assumed that at the time of the award the worker will invest in a mixture of safe short-term, medium-term, and long-term bonds, with one scheduled to mature each year of his expected worklife… On the other hand, it might be assumed that the worker will invest exclusively in safe short-term notes, reinvesting them at the new market rate whenever they mature... We perceive no intrinsic reason to prefer one assumption over the other.
  • 3. Laddered Approach: 1) Project Future Value of Year-by-Year Losses • Include Real Growth/Decline • Include Expected Inflation 2) Design Hypothetical Portfolio of Zero Coupon Treasuries Maturing Annually • FV Annual Maturities = FV Expected Losses 3) Calculate Market Price of Hypothetical Portfolio 4) Market Price = Loss Compensation High Degree of Reliance on the Treasury Yield Curve High Degree of Reliance on the Accuracy of Projected Inflation Short-Term Rollover Approach (Gross-Up): 1) Project Future Value of Year-by-Year Losses • Include Real Growth/Decline • Include Expected Inflation 2) Discount Future Values by Expected ST Treasury Yields Over Full Projection Horizon 3) S Discounted Values = Loss Compensation Short-Term Rollover Approach (Net): 1) Project Future Value of Year-by-Year Losses • Include Real Growth/Decline • Exclude Expected Inflation 2) Discount Future Values by Expected Spread Between ST Treasury Yields & Expected Inflation High Degree of Reliance on Expected Spread Between Inflation & Future Short-Term Yields
  • 4. Yield Curve Usually Slopes Upward (Compensates Treasury Investors for Increased Market Risk) Yield to Maturity Years to Maturity It is important to understand the yield curve if it is to be used to discount future losses.
  • 5. Why is Treasury Curve "Normally" Upward Sloping? Why Isn't Treasury Curve Always Upward Sloping? Preferred Habitat Hypothesis: • Two Factors Determine Slope of Yield Curve • Expected Future Trend in Interest Rates (or Inflation) • Market Risk • Key Assumption • Different Maturities are Close Substitutes, but NOT Perfect Substitutes • Implications for Yield Curve • Long-Term Bonds Have Higher Market Risk; Generally Higher Rates • Downward-Sloping ("Inverted") YC's Only Occur when Interest Rates are Expected to Decrease SUBSTANTIALLY
  • 6. Treasury Curve Valuation Paradox Impact of Hypothetical Event that Increase Inflation Uncertainty (Assume Expected Future Value Remains Unchanged, but Probability Distribution widens) Impact of Hypothetical Impact of Hypothetical Event Event on the Probability on the Yield Curve for U.S. Distribution of Future Value Treasury Securities of a Bond Yield Curve 1 Yield Curve 2 Probability Distribution 1 Probability Distribution 2 Treasury Expected Value Curve shifts EV1 = EV2 Probability Curve upward. shifts downward and Yield to Maturity widens. Probability Future Real Value Years to Maturity
  • 7. Impact of Hypothetical Event on Treasury Bond Transaction: Cash  Treasury Treasury Securities Buyer  Inflation Risk Securities Seller  Inflation Risk Compensation 1) Uncertainty event flattens the future value distribution curve, thereby increasing inflation risk. 2) Treasury Curve shifts upward, enticing the Treasury Buyers to purchase the riskier bond. 3) Amount paid by Treasury Buyer is reduced at a higher discount rate to compensate for the added level of inflation risk. Impact of Hypothetical Event on the Reduction to Judgment in a Loss Claim: (When Treasury Curve is used to value long-term future losses) Cash  Defendant Inflation Risk  Plaintiff  Inflation Risk Compensation 1) Uncertainty event flattens the future value distribution curve, thereby increasing inflation risk. 2) Treasury Curve shifts upward, enticing Treasury Buyers to purchase the riskier bond. 3) Amount paid by Defendant (to the Plaintiff) is reduced at a higher discount rate, based on the Treasury Curve. 4) Inflation risk compensation is effectively paid to the wrong party.
  • 8. Plaintiff Damage Fund Using Laddered Zero's Investment Assets & Loss Compensation Liabilities Maturity (Years from Present) Assets Liabilities $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year
  • 9. Savings & Loan Institution Analogy Savings & Loan Business Model: • Primary assets were mortgage loans. • Primary liabilities were customer deposits. (Demand Deposits, Short-Term CD's & Savings Accts) • Mortgage Loan Interest Rates > Deposit Interest Rates • Positive spread generated profits for many years. Roots of S&L Crisis • Inflation/Interest Rates Spiked in the 1970's • Short-Term Bank Deposits Turned Over Quickly • Long-Term Mortgages Turned Over Slowly • Interest Expense 1970's Rates; Interest Income at 1950's/1960's Rates • NEGATIVE SPREAD Between Interest Income & Interest Expense • Problem: Duration Mismatch between Assets & Liabilities (Long-Term Loans versus Short-Term Deposits) Survival Strategy for Financial Institutions: • Goal: Improve Duration Match Between Assets/Liabilities • Lengthen Duration of Assets (if possible) • Shorten Duration of Loans • Sell LT Loans & Retain Servicing • Hedge with Interest Rate Futures/Swaps • Emphasis on Adjustable Rate Mortgages (30-Year Loans with 6-Month "Repricing" Duration) • Emphasis on Other Variable-Rate Loans
  • 10. Structure of Plaintiff's Damage Fund: • Assets are Hypothetical Zero Coupon Bonds • Liabilities are Expected Future Losses • Fund Will Offset Future Losses IF Actual Losses ï‚» Expected Losses Forecasted at Trial Date Plaintiff's Potential Crisis under Laddered Approach: • Inflation Spike (as in the 1970's) • Actual Losses Exceed Projections Made Before Spike in Inflation • Zero Coupon Proceeds Don't Change (Set at Trial Date) • NEGATIVE SPREAD Between Award Receipts & Loss Offset Disbursements Plaintiff's Response to Crisis: • Plaintiff Liquidates Funds Earmarked for Future Losses • Early Liquidation Triggers Capital Losses in Rising Rate Environment • Shortfalls & Capital Losses Compound in Prolonged Rising Rate Environment • Fund is Exhausted Before End of Loss Period
  • 11. Select Beginning Date  1955 Select Rate 1  Consumer Goods CPI Select Ending Date  2010 Select Rate 2  30-Day Treasury Bills Total Returns Yield Lock-In Date  1965 Select Rate 3  20-Year Treasury Bond Yields 30-Day Treasury Bills Total Returns and 20-Year Treasury Bond Yields Versus Consumer Goods CPI 16% Consumer Goods CPI 30-Day Treasury Bills Total Returns 14% 20-Year Treasury Bond Yields 12% 10% 8% 6% 4% 2% 0% -2% 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 195_ 196_ 197_ 198_ 199_ 200_ 201_ Decade/Year
  • 12. Assets Liabilities $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year
  • 13. Assets Liabilities $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year • The Plaintiff's assets are his/her award fund investments; liabilities are his/her future losses. The job of the award fund is to offset those future inflation-sensitive losses. • Zero coupon investments "lock-in" nominal cash flows. Duration of a ZC Bond is equal to the maturity of the bond. • Liabilities for future losses have duration of 0!!!! Expected nominal value of future losses changes dynamically, while the nominal value of assets does not change. • Duration mismatch can result in significant shortfalls or windfalls to the Plaintiff over long periods of time. • Duration mismatch creates significant exposure of inflation risk that didn't exist with the underlying losses which are being compensated!!! • Long-Term Bonds carry fundamental risk characteristics not inherent in the underlying Income Losses.
  • 14. Q: "Why does this matter?" A: The Long-Term Treasury yield should not be used because Long-Term bonds carry a degree of inflation risk that is not present in the underlying loss being compensated. The risks inherent in the rate are fundamentally different than the risks inherent in the loss. Q: "Isn't the Plaintiff likely to invest in something other than Treasuries anyway? A: Our responsibility is to match the appropriate risk against the loss being valued, regardless of what the Plaintiff ultimately chooses to do with the damage compensation (see "CAL"). Q: "Hasn't the Plaintiff benefitted from the avoidance of other real-life risks that he would have faced if the loss hadn't occurred? Doesn't 'Parity in Risk' suggest that he has eliminated other elements of risk that offset any inflation risk that he would face with Long-Term Bonds?" A: Jones & Laughlin v. Pfeifer seems to imply that risks of uncertainty in future income streams are to be resolved before the discounting step, rather than through the discounting step. Further analysis indicates that Jones & Laughlin v. Pfeifer may have gotten it right.
  • 15. Short-Term Treasuries Expected Return Long-Term Treasuries Risk Premium Risk-Free Return Risk (Expected Variation of Return)  Low Risk/Low Return High Risk/High Return  Long-term Treasury securities carry more risk that short-term Treasuries when interest rate/inflation risk is taken into consideration . The FE's job is to discount the losses based on the safest investments that carry a similar inflation risk to the underlying loss. Any subsequent decision by the Plaintiff to "move up" on CAL should not influence the FE's calculation.
  • 16. Does Jones/Laughlin v. Pfeifer Violate "Parity in Risk?" Transfer of Liability under Jones/Laughlin v. Pfeifer Certainty Equivalent of an Income Loss to the Plaintiff & Defendant Assumptions Before Liability Transfer: • Before reduction to Present Value. • Approximately normal distribution curve, with all relevant inputs properly accounted for. • Both Plaintiff and Defendant are risk-averse. • Let Expected Value = EV, Plaintiff Certainty Equivalent = CEp, Defendant Certainty Equivalent = CEd, Transactional approach to the transfer of liability from Defendant to Plaintiff: Certainty Equivalent Value of Economic Loss Distribution EV Probability Distribution Expected Value CE Plaintiff CE Defendant Probability Future Value of Losses
  • 17. The Defendant and Plaintiff both prefer a certainty equivalent (at a "price" less favorable than Expected Value) to the uncertainty of the distribution curve. The risk premium reflects the economic value of the elimination of uncertainty to each party when the claim is reduced to judgment. Liability Transfer Amount based on Value of Consideration Received/Paid to Both Parties: Cash (EV)  VRp  Defendant Plaintiff  Discharge of Liability (EV)  VRd Both sides benefit from the elimination of risk when the claim is reduced to judgment. Consideration to Plaintiff = EV + RPp , consideration to Defendant = EV + RPd If RPp ï‚» RPd, Parity in Risk is not violated under Jones/Laughlin v. Pfeifer . Alternative Valuation Approach: Equilibrium Price of Liability Transfer in a "Perfectly Competitive" Market What would market price be if liability transfers were sold in a free market setting? Liability Transfer Market Assumptions (Imagination is required): 1) "Perfect Competition" Supply 2) Plaintiffs & Defendants can freely enter/exit market. 3) Plaintiffs "supply" liability transfers. CE d (Quantity supplied varies directly with price) 4) Defendants are "purchasers of liability transfer: EV Price (Quantity demanded varies inversely with price) 5) RPp ï‚» RPd CE p 6) Plaintiffs' price sensitivity ï‚» Defendants' price sensitivity Demand Equilibrium price ï‚» EV Parity in Risk is not violated under Jones/Laughlin v. Pfeifer . Quantity
  • 18. Expected Value of Life Care Plans & "Parity in Risk" Transfer of Liability for Life Care Costs Certainty Equivalent of Life Care Costs to the Plaintiff & Defendant Assumptions Before Liability Transfer: • Before reduction to Present Value. • Approximately normal distribution curve, with all relevant inputs properly accounted for. • Both Plaintiff and Defendant are risk-averse. • Let Expected Value = EV, Plaintiff Certainty Equivalent = CE p , Defendant Certainty Equivalent = CEd , Plaintiff Value of Risk = VR p = EV - CEp , Defendant Value of Risk = VR d = CEd - EV Certainty Equivalent Value of Economic Loss Distribution Probability Distribution Expected Value CE Defendant EV Probability Future Value of Losses The Defendant benefits from the transfer of life care liabilities at expected value AT THE EXPENSE OF THE PLAINTIFF. The Plaintiff is required to assume risky liabilities that did NOT EXIST before the loss at the Expected Value, with no compensation for his/her risk, and no offset of risks that existed before the loss.
  • 19. TIPS Yield Curve TIPS YIELD CURVE: (Coupon Yields) "Normal" Curve is Upward Sloping. Historical Averages from 2004 - 2011 Evidence of Market Risk. (Risk of Capital Gain/Loss to Holders 2.5% of Securities) Source: FRB Release H-15. Sources of Market Risk: 2.0% 1) Flight to Safety/Reversal 2) U.S. Fiscal Policy. 3) Federal Reserve Monetary Policy. 1.5% 4) Competition from Private Debt. 5) Activity of Other Central Banks: • PBC Trade Surpluses (to Date) • BOJ Earthquake Debt 1.0% • ECB/Bundesbank, SNB, Bank of England, … 6) Fiscal Policy of Foreign Govts. (e.g., 1990's German Reunification 0.5% Merkel Nuclear Plant Decommission, etc.) 7) Other Supply/Demand Issues 0.0% 0-Yr 5-Yr 10-Yr 15-Yr 20-Yr 25-Yr