US litigation funding impacting costs of liability claims

US litigation funding impacting costs of liability claims | Insurance Business America

US litigation funding impacting costs of liability claims

The United States is the dominant player in the world’s third-party litigation finance (TPLF) industry, whereby fund managers finance legal action against companies by accepting legal assets as collateral in return for a cut of the resulting payout.

More than half of the US$17 billion investment into litigation funding globally was deployed in the US in 2020, and despite the widespread court closures and disruption to legal cases during the COVID-19 pandemic, TPLF investment jumped by 16% year-over-year in 2021.

This multi-billion-dollar global industry is growing fast, according to a new publication from the Swiss Re Institute, entitled ‘US litigation funding and social inflation: The rising costs of legal liability’. Swiss Re projects that TPLF could be a US$30+ billion industry by 2028, with the US market driving that growth.

This could have a significant impact on the liability insurance market because TPLF encourages prolonged litigation and larger monetary awards that ultimately benefit the funders. As such, Swiss Re defines TPLF as a growing contributor to social inflation in the US because of its tendency to drive higher, sometimes nuclear, claims costs.

“We see that TPLF has been growing strongly […] and the funds are [often] invested in cases that are tied to certain areas of insurance, like commercial auto, trucking, general liability, and medical professional liability – and we do see higher incidence of very large jury verdicts in these areas,” said Thomas Holzheu (pictured), chief economist for the Americas at Swiss Re Institute.

“We know that the nature of these investment is to better prepare cases so that they result in higher awards. Piecing all of the evidence we have together – [bearing in mind that] a lot of these trials are not public, and the existence of funding is not disclosed - we conclude that TPLF is an important factor that contributes to social inflation and the increase in […] the number of very large claims.”

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The Swiss Re report details how TPLF investments have produced internal rates of return (IRR) from 25% upward in recent years, outperforming even risky asset classes such as venture capital and other private equity plays. This is a very attractive IRR proposition for investors. TPLF typically diverts a greater share of the legal awards to the funder rather than the plaintiff, resulting in what Swiss Re describes as “an opaque, bottom-up wealth transfer from consumers to sophisticated investors and law firms.”

The problem, explained matter-of-factly by Holzheu, is: “Someone has to pay the ultimate bill. I think that’s where awareness is lacking. If the insurance industry has to pay higher claims for trucking, then this has consequences. First, the underwriting results of insurers in these certain lines of business, such as commercial liability and commercial auto, have been negative for multiple years now. We see premium rates increase, but they’re only just catching up with the claims costs, so these are still not profitable lines of business.

“At the same time – as always in insurance when profitability becomes an issue – premiums need to be raised, certain risks need to be underwritten in different ways, and the capacity for high-risk industries becomes smaller. So, trucking businesses face high bills for insurance, and they find it harder to gain cover. As the claims become bigger, the costs fall on the shoulders of the businesses, their customers, and the other insurance clients in related lines of business.

“That is the issue here. Nuclear verdicts get spread out through the insurance system – that’s how it’s supposed to work – but the risk needs to be borne by or paid for by the industry and the clients of these industries where the risks reside. And that’s a side of this matter that’s not necessarily seen or discussed. There’s not a lot of advocacy for the businesses and for the clients of these businesses.”

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Social inflation has had a noticeable impact on liability insurance results in recent years. According to Swiss Re, the average 2020 combined ratio for general liability was estimated at 105.7% and for medical malpractice at 117.5%, the seventh consecutive year of underwriting losses for both lines.

“A lot of these trends are far removed from the direct actions of industry, and the exposures are hard to control,” Holzheu told Insurance Business. “But the insurance industry is really in between, and that’s another reason why we wrote this report. When assuming liability risks, insurers need to be aware of this trend, and need to be mindful of this potential for these nuclear verdicts.

“When underwriting certain industries and determining the amount of limit to put out there – all of this can be adapted and adjusted, and that really requires insurers to monitor this space much more carefully and to look at the drivers and trends. I think that’s an important takeaway. While it may be difficult in the short term to change the underlying trend, the underwriting of these trends is more flexible, and it’s quite important for the insurance industry to take action.”