A Review of the Three Arguments used to Justify Including a Risk-Premium in the Discount Factor

Abstract

This article reviews the three arguments found in the literature for using a discount rate that includes a risk premium when calculating the present value of future income in a personal injury situation. Two of the arguments are based upon the fact that future earnings are not certain. As the future earnings are not certain, it is argued that a certain but lesser amount replaces the value of the preinjury expected amount. This reasoning is shown to rely upon utility analysis and that utility analysis is not appropriate in personal injury settings. The third argument for including a risk premium in the discount rate is that, when an individual receives an award he or she has the option of investing the money using an investment vehicle or vehicles with expected returns greater than the returns from a risk-free investment. To use the third argument the economist must first acknowledge that the expected returns may not be realized for two different reasons. One reason is that actual returns may be less than the expected returns used in the calculation of the present value. The second reason is the variance in the return may be such that the award is insufficient even though the expected returns were realized. Finally, if it is assumed that the investments incorporating risk will return the expected amount, an economist relying on the third argument must acknowledge that the money earned by incurring risk is not allocated to the entity earning the money.