Why Litigation Financing Should Be Driving the Industry Toward E&S Coverage to Buffer the Blows of Social Inflation
Litigation or legal financing, on a fundamental level, is the process of obtaining funds to pay for legal expenses. However, for lawsuits involving potentially larger insurance settlements, a third party may provide financing for legal costs by investing in a case. Then, after a decision is rendered, that investor is paid out of the proceeds of the final judgment.
Litigation financing has become a factor in the rise of social inflation, nuclear verdicts and higher claim costs. According to the Insurance Information Institute, by 2028, up to $30 billion will be invested in litigation financing by third-party groups. In 2021, the average dollar value for funding transactions was $6.5 million; for single-matter deals, the average was $3.5 million.
Social inflation refers to the rising costs of insurance claims due to socioeconomic, legal and behavioral trends that change over time to drive “bigger” lawsuits. Most experts agree that third-party litigation financing is the most significant contributing factor to social inflation.
When adversarial legal procedures are combined with a litigious culture, the result is lawsuits with high jury awards or settlements, otherwise known as nuclear verdicts, which typically award over $10 million. Due to these higher damage amounts, insurance coverage affordability — especially for general liability, medical professional liability and commercial auto products — has come under threat following increases in litigation and claim costs.
How Does Litigation Financing Impact Insurance?
Third-party litigation funding can cause larger claim amounts and defense costs leading to higher risks for insurance companies and potentially higher premiums for insureds. This will push these types of claims away from traditional insurance to excess and surplus lines (E&S). The underlying drivers behind social inflation continue to grow at a rate higher than current inflation levels, resulting in higher customer premiums, increased demand for insurance coverage and a growing E&S market.
Social inflation impacts underwriting by limiting the types of risks underwriters choose to write, which could affect the availability of coverage limits for certain industries. Social inflation can compound over time, severely impacting longer-tail lawsuits. Complex liability claims tend to take longer to settle, and E&S coverage tends to attract more complex claims.
Types of Litigation Financing
The litigation financing sector has become a massive industry where participants invest billions of dollars. Third-party funders include private equity companies, hedge funds, elite university endowment funds, some trusts, and other investors that can afford to take the risk to invest in lawsuits. Legal funding can be done directly with a law firm, broker or company that specializes in this type of arrangement.
Litigation financing can be distributed to individual people or corporations at any stage in a case. The invested money can cover personal or medical expenses, attorney or court fees, and be used to pay for expert witnesses or jury consultants.
The different types of litigation financing include the following:
- Loans: There are two types of loans — personal and commercial. A personal loan allows the client to borrow money for personal expenses. A commercial loan goes to the lawyer to pay for legal expenses.
- Investments: An investor provides funding to cover the legal expenses in exchange for a portion of the settlement.
- Contingency Arrangements: A lawyer agrees to work on a case in exchange for a percentage of the judgment award. If the case is not won, the lawyer does not get paid.
Advantages and Disadvantages of Litigation Financing
The potential for increased damage awards is the ultimate win for plaintiffs. However, there are many downsides to investor legal funding as well:
- Litigation finance is only available to those with a reasonable chance of winning a settlement worthy of the funder’s investment — a case expected to be resolved within a certain amount of time. Investors want to settle cases quickly rather than waiting on judgments for years.
- Some investors require that the damage awarded is valued at up to ten times the amount the third party invests in the case.
- There is also a fear that litigation finance could prolong litigation because an investor’s portion makes reasonable settlement offers less attractive to plaintiffs. They would want higher awards in order to cover third-party investments.
- For commercial litigation funding, legal firms typically get paid no matter how the case is resolved, while the client or funding investors do not see any money. However, legal investors could require a law firm to cap their billing rate to mitigate the risk of a capital loss.
- Litigation finance is often expensive. The litigants only receive a fraction of the award; the rest goes to the investors, leaving the plaintiffs in a worse financial situation.
There may also be a concern of litigation financing judgment bias due to corporate investors having a vested interest in the outcome of the case, which could ultimately compromise the integrity of the legal process. Also, corporations could use legal financing to pursue specific lawsuits that protect their interests.
Future of Litigation Financing and Insurance
Insurers and producers must work together to ensure that insureds are properly covered for the higher exposure that social inflation will bring. Carriers should look at offering E&S policies, and producers need to help insureds understand the importance of these types of coverage.
While the effects of social inflation and the cost of nuclear verdicts can be a challenge for insurers, it is crucial to understand the impact of these judgments and their potential risks.
Transparency is vital in large lawsuits, and legal financing agreements must be disclosed to all parties. This can go a long way toward fairness, cost mitigation and value for the plaintiff and defendant.
Regulation on the litigation financing market can also be helpful in fair judgments and lowering social inflation. Financial innovations tend to outpace legislation and regulation, but history tells us that reining in problematic practices can be good — in the long run — for all stakeholders in the system. &