Damage Analysis:
The Impact of Assumptions
New York State Bar Journal February, 1998

Every financial report is based upon a set of assumptions that has been selected to estimate the total value of a loss as of a particular point in time. Having an understandable report is crucial to the credibility and effectiveness of the attorney. The use of a financial expert in litigation is becoming more common as attorneys recognize the impact on award size of the proper recognition and valuation of all the contested losses.

Depending on the losses to be valued, a typical report will make numerous assumptions. These might include a salary increase rate, retirement age, periodic inflation rate, etc. A well organized report will have a page devoted to all the assumptions made and the methods used in the valuation. This page should include a description of each category of loss considered, as well as the difference in the treatment of losses already incurred to date and losses anticipated for the future. If not stated explicitly, this information needs to be secured from the financial expert in order to be able to understand the financial results produced by the mathematical model. If an assumption seems incorrect, or unreasonable, it must be explained to the satisfaction of the attorney.

Since the assumptions are the foundation of the calculations, an inappropriate selection will distort all subsequent calculations. For example, if an incorrect current income level were assumed in an employment or disability case, the error would impact the income loss, 401(k) savings plan loss, pension plan loss and any other element derived from current, or future income. We will briefly examine two assumptions present in virtually all financial loss evaluations, interest and mortality, and discuss their selection and impact.

The interest assumption is part of every economic report since it operates as an adjustment factor moving losses from the time actually incurred, or assumed to occur, to the time of payment. This assumed payment date—the determination date at settlement or trial—defines the calculation. The interest assumption selected is typically related to actual past and current economic conditions using standard measures, like government securities or other method receiving judicial notice. Occasionally a deviation might be appropriate where the actual interest rate experience of the plaintiff is documented. For example, if an individual needed to borrow money at 12% interest in order to meet living expenses due to a past loss, it might be reasonable to consider accumulating the loss to the determination date at 12%. The impact of the interest assumption depends upon whether the losses already have occurred, or are assumed to occur in the future.

Accumulated interest calculated on losses that have already incurred increases these losses because the interest is intended to reimburse the plaintiff for the period he was deprived of the use of these funds. A higher interest rate assumption will generate higher losses for the plaintiff, reflecting a higher premium for the time value of money. The determination date value of the actual past losses and associated interest is referred to as the accumulated value.

An interest discount calculated on losses that are assumed to occur in the future decreases these losses because the payment will be made in advance of the anticipated loss. In other words, the sum of the advance payment, and the assumed interest earnings on that payment, will be equivalent to the future loss anticipated. In this instance, a higher interest rate will generate lower losses for the plaintiff since more of each future loss will be covered by the higher assumed investment earnings. The determination date value of the anticipated future losses discounted with interest (and perhaps mortality) is referred to as the present value.

As previously mentioned, the determination date is the assumed payment date and should be close to the date of trial or negotiation as it has an impact on the interest calculations. Using a distant future date as the determination date will increase losses because some future losses get recategorized as past losses. Past losses accumulate interest for a longer time and the interest discount on future losses is for a shorter time. Using a past date as the determination date would have the opposite impact, i.e. losses would decrease. In either event, however, a date off by up to a few months would generally have minimal impact on the calculation.

The mortality assumption serves to reduce future losses, since it recognizes that a loss is incurred only if the individual survives long enough to experience it. The standard table in common use is the United States Life Table as derived from the last census. There are two general methods of incorporating mortality into a loss calculation: the average future lifetime method and the actuarial method.

This method is most typically used by economists or accountants and incorporates general population statistics to estimate an average future lifetime at the individual’s current attained age. The future lifetime then becomes the period over which losses are considered. For example, an individual age 40 might have an average future lifetime of 35 years. In other words, half of the 40 year olds would die before age 75, and half would die after age 75. Therefore, the average future lifetime method would assume that all future losses occur between age 40 and age 75 with 100% certainty of survival and that all deaths occur at age 75.

While in common practice, this method has a significant shortcoming in that it oversimplifies the impact of mortality by assuming all deaths occur at a single age. There is no relationship drawn between the loss at any point in time and the likelihood of survival to experience that loss.

Instead of assuming that all 40 year olds would die at 75, an actuary would construct a table developing the probability of surviving to each point of loss. For example, the loss at age 45, 55 and 65 would have survival factors of .985, .963 and .931, respectively, with the factor decreasing as the future period of anticipated survival increases. The value of each loss would then be reduced by the appropriate factor to reflect the underlying mortality associated with the survival to that age.

There can be a significant difference in the present value of future losses developed under these two methods. This can be illustrated by considering the impact on different categories of loss:

The magnitude of difference between the methods will vary by attained age and the relative sizes of the pre- and post-retirement losses. However, in all cases the Actuarial Method will produce a more theoretically correct loss valuation.

A report that is not clear and meaningful won’t be understood by a jury and will therefore be of little use. Plaintiff attorneys need to be sure that their financial experts produce an understandable report built upon reasonable assumptions. Defense attorneys should depose the plaintiff’s financial expert to determine his or her assumptions—the basis of their calculations—and the reasonableness of the results. For large amounts, the defense might opt to retain their own expert as a consultant to review submitted reports and to aid in negotiation and cross examination. Whether defense or plaintiff, the report of the expert should be a fair assessment of loss and should serve to educate both sides on the types of losses and the means of valuation.