In recent years, with the aid of technology, every industry has undergone a transformation. Medicine is embracing telemedicine. Insurtech is providing operating efficiencies. Yet a different development has occurred in the legal community, which has not received the same attention, or perhaps the scrutiny, it deserves: third-party litigation financing, which has been a significant catalyst in the increase of so-called “social inflation.” Though once prohibited, third-party litigation funding allows hedge funds, private equity, and other financiers the ability to invest in lawsuits in exchange for a percentage (usually large) of any settlement or judgment received. Although most are privately owned funds, several publicly traded companies are currently involved in this practice.
The traditional litigation model involving a plaintiff paying a fee for service – when a law firm enters into a “contingency fee arrangement” with the plaintiff who is suing to collect damages for economic or physical injury – is the standard that has been in existence for decades. In the latter case, the law firm collects a percentage of the judgment or settlement, usually in the 33% range plus expenses. However, sometimes cases can be too expensive and too uncertain for law firms to assume the risk. Also, to prove the facts of the case, they may need specialized lawyers who may not be willing to agree to a contingency arrangement. Traditional lenders such as banks typically do not fund litigation, as they do not accept legal assets as collateral. Sometimes the law firm bylaws also prohibit the indebtedness that would be involved, thus entering an opportunity for third-party litigation funding, which is a contributing factor in “social inflation.”
Social inflation is the term given to describe the very dramatic effect in both the frequency and severity of large verdict awards over the past decade. There are many factors being attributed to this phenomenon:
- Rollback of tort reform in many states
- A perceived change in societal attitudes toward litigation
- Law firm advertising
- The proliferation of class action lawsuits and the plaintiffs bar usage of psychology-based strategies on juries to win large verdicts
For example, one psychology-based strategy employs a “reptile theory,” which evokes anger toward the insurer and creates sympathy for the plaintiff. The objective is to get the jury to decide claims based on their emotional reactions rather than on the facts of the case. Another approach uses an “anchoring effect,” where lawyers demand a very large compensation early in the litigation process and then slowly drop the demand, causing jurors who do not know what the appropriate range for compensation is to mentally “settle in” to the belief they are reducing demand to a more reasonable amount. The end result of third-party litigation funding is that plaintiff attorneys now have the “deep pockets” to employ specialists who go up against corporate defense teams backed by the insurance companies.
Litigation investment is being employed in almost every insurance segment served by independent agents, which impacts premium costs directly and indirectly when passed on to consumers in the form of increasing the price of goods and services. Mass tort (product liability, securities fraud, data breach, etc.) comprises the largest segment, followed closely by commercial suits (contract disputes, trademark infringements, anti-trust, etc.) and lastly, personal injury (auto accidents, medical malpractice, and general liability slip and falls).
Independent agents need to communicate to their clients how this environment has substantially increased the possibility of “nuclear” plaintiff action and awards. This risk translates into a need for higher liability coverage limits – if the client can afford it. The Wall Street Journal reported that a 2019 review by VerdictSearch showed an increase of over 300% from 2001 to 2010 in the frequency of verdicts exceeding $20 million. A similar study by the Swiss Re Institute looked at large awards (>$1 million) in both the general liability and auto lines of business from 2010 through 2019. The analysis indicates the verdict population saw a nearly 8-point increase in the percentage of claims settled in excess of $5 million, with the median claim rising from the $6 million to $8 million range to closer to $8 million $10 million.
As mentioned, there is a lack of transparency. In tort litigation, the defendant and insurer are easily identified. However, there are very few state judicial systems that require any such disclosure requirements related to the third party that is providing financing for the plaintiff. There is an effort currently in Congress named the Litigation Funding Transparency Act (LFTA) that would require some level of transparency. Absent this, the jury may view the lawsuit as involving an injured party going up against a large company (“David versus Goliath”), not realizing that the case was selected by a private equity fund using artificial intelligence that scopes out prospects in a targeted industry. The funds lend the money to these prospects, hoping for investment returns ranging from 25% to 35%.
As a result of these higher verdict awards, claim costs and premiums go up, and the availability of coverage goes down. For these reasons, agents need to partner with a wholesaler that has industry-specific knowledge and can navigate the issues that higher limits bring, such as greater utilization of excess and specialty (E&S) insurance.
