Swiss Re has outlined the impact of third-party litigation finance (TPLF) in contributing to social inflation, with the reinsurer in a new report advocating for several changes to combat this such as mandatory disclosure of funding arrangements and greater transparency of funding terms.
According to a new report on US litigation funding and social inflation from the Swiss Re Institute, TPLF investment rose by 16 percent to $17bn in 2020 compared to the previous year, despite Covid-19 disrupting legal proceedings. The US accounted for more than half of the investment for litigation funding globally.
Swiss Re projects that TPLF could be a $30bn-plus industry by 2028.
Speaking to The Insurer, Thomas Holzheu, chief economist Americas at Swiss Re, said the motivation for the report was to try to better understand the TPLF industry because it is “very opaque and very hidden”.
“We are trying to shed light on an industry that is by design not highly visible. A lot of the funding is not disclosed and it doesn’t lend itself very easily to be analysed and quantified,” he said.
Holzheu added: “It has been growing very strongly over the last decade or so and will continue to grow in our estimation. All the factors are lined up for more use on behalf of law firms and corporations. It pays very well for investors, so the money will keep flowing.”
The TPLF industry is fuelled by investors such as hedge funds and family offices that finance legal action against companies.
“We see TPLF as a contributing factor to the trend of social inflation in the US,” Swiss Re said in the report. “US general liability and commercial auto lawsuit data show a strong rise in the frequency of multimillion-dollar claims over the past decade.”
Litigation funding companies (LFCs) back claims in many of these areas, such as trucking accidents, bodily injury, product liability mass tort and medical liability claims.
“We find TPLF contributes to social inflation by incentivising litigants to initiate and prolong lawsuits,” the report said. “Higher claims costs drive up insurance premiums, can reduce the availability of liability cover, and lead to higher uninsured legal liability risks for US businesses.”
Third-party funding alters the distribution of legal costs in commercial liability cases, the report argued. In addition, legal verdicts are becoming more skewed towards large awards as TPLF is used more.
The report found that TPLF contributes to higher awards, longer cases and greater legal expenses. In addition, TPLF also diverts a greater share of legal awards to the funder rather than plaintiff.
Swiss Re estimates that up to 57 percent of legal costs and compensation in US TPLF cases go to lawyers, funders and others. This compares with an average of 45 percent in typical tort liability cases.
The report pushes back on litigation funding advocates’ argument that TPLF increases access to justice by backing ’David vs Goliath’ legal action by individuals.
Swiss Re said data show that large corporations and law firms are the biggest users, while the industry is poorly regulated and the consumer segment in particular would benefit from greater transparency.
Holzheu said that TPLF is not well targeted towards those that would benefit most, and is also inefficient.
“The proponents of litigation funding see this as an important way of creating access to justice but, if you look at the numbers, that argument doesn’t come through very strongly,” he said. “A lot of the money doesn’t flow towards the small cases and the plaintiffs that are in need.”
Rather, commercial litigation and mass tort represent 75 percent of new TPLF investments.
The report stated that the largest share of new investments went into mass tort litigation, representing 38 percent of investments, followed by commercial litigation (37 percent) and personal injury (25 percent).
Calling for change
The report makes a number of suggestions about how the situation can be addressed.
“We advocate for an efficient, stable legal system and fair access to justice,” Swiss Re said in the report. “TPLF has a role to play in holding defendants to account, but its strong profit motive and potential for creating conflicts of interest creates risk of economic and ethical harm.”
Swiss Re recommends enhancing the regulation of TPLF through: mandatory disclosure of funding arrangements to all involved parties; greater transparency and consumer protection in funding terms; legal aid for consumer protection claims; and legal expense insurance.
Speaking to this publication, Holzheu highlighted the ethical issues related to TPLF. Adding LFCs to the attorney-client relationship creates agency problems, including conflicts of interest, the need to protect attorney-client privilege, LFCs’ financial incentives to influence case management, and questions around shifting of funding costs.
“It can be problematic if nobody knows who is involved or is funding a litigation,” Holzheu said. “We are asking for full transparency, so every party is aware of who is driving a litigation.”
He added: “Both sides should know if there is litigation funding involved and who that is to avoid potential conflicts of interest and have a level playing field.”
This will help make it easier to estimate likely outcomes and hopefully lead to faster and better settlements rather than extended, protracted litigation, he added.
On the issue of disclosure of funding arrangements, the report noted that some US states are already introducing greater protection.
For example, district courts in California and New Jersey are among those that require the disclosure of litigation funding contracts in a case, while state courts in Colorado and North Carolina have concluded that litigation funding can violate usury laws.
But Swiss Re stated that the best way to achieve uniform rules is through the legislature. “In the absence of legislation, TPLF disclosure requirements in the US today differ by jurisdiction, with courts diverging in their conclusions,” the report said.
US lawmakers in March this year reintroduced the Litigation Funding Transparency Act, which would require plaintiffs to disclose third-party funding. “Although it applies only to class actions and MDL, it is a step in the right direction,” the report said.
On the issue of greater transparency and consumer protection, the report noted that the high costs of TPLF affect plaintiffs’ net awards from cases.
“There is an asymmetry between sophisticated lenders with experience in assessing, underwriting and structuring funding agreements, and borrowers who are typically inexperienced in matters of TPLF and often in a situation of duress. Financiers could be required to disclose case-value estimates to plaintiffs who have obtained non-recourse advances,” the report said.
Discussing legal aid, the report noted there is a precedent globally for wider use, such as seen in Germany and Ireland for personal injury cases.
Lastly, Swiss Re noted legal expense insurance is a policy that protects insured parties from costs associated with litigation, with both commercial and personal lines cover available. Countries with widespread market penetration for this type of insurance include Germany, Japan and Sweden.
The cost of social inflation for insurers
Swiss Re noted in the report that, as a result of social inflation, US casualty insurers have incurred many years of underwriting losses linked to outsized legal awards and are being forced to raise premium rates.
The reinsurer stated that TPLF encourages prolonged litigation and larger monetary awards that ultimately benefit the funders. This is a growing contributor to social inflation in the US through higher claims costs, it said.
The social inflation-driven surge in large legal awards is leading to rapid increases in insurance claim losses.
For example, US verdicts of $5mn or over are a rising share of large awards – ie, $1mn and higher – in liability cases. Between 2010 and 2019, the median size of large awards rose by 26 percent for general liability cases and by 32 percent for vehicle negligence cases.
Swiss Re noted the damaging impact that social inflation has had on insurers’ results.
The average 2020 combined ratio for general liability was estimated by Conning at 105.7 percent while for medical malpractice it was 117.5 percent, the seventh consecutive year of underwriting losses for both lines.
For commercial auto, the 2020 combined ratio was 104.1 percent, the tenth year of underwriting losses.
Insurers have responded to rising concerns about adverse development and social inflation by pushing up pricing in all liability lines.
Commercial auto prices rose by 10.0 percent in 2019 and 10.7 percent 2020, with double-digit price increases continuing until the second quarter of 2021, the report noted.
In 2020, D&O and umbrella rates rose by 15.8 percent and 22.6 percent, respectively, while general liability and medical professional liability increased by 7.3 percent and 8.8 percent.
Umbrella covers are particularly exposed to the increase in large claims. Insurance carriers are reducing capacity, and prices increased a further 20 percent for this business in the first half of 2021.
The report commented that the price increases and reduced capacity make insurance more expensive, make it more difficult to obtain liability insurance and lead to higher uninsured legal liability risks – placing major strain on individuals and businesses.
Holzheu suggested that social inflation will continue to adversely impact the insurance industry and its consumers if action is not taken.
“If there’s no reaction to it then certainly social inflation will continue and will challenge the corporations and the insurance industry,” said Holzheu. “The insurance industry needs to react with underwriting and pricing to keep this insurable. These claims costs are ultimately borne out of the corporate sector. So whether insured or not, it will get paid by the consumers of these products.”
Holzheu noted that costs are already increasing strongly in the trucking industry, for example, and a lot of small businesses are struggling to stay afloat.
“The insurance industry cannot subsidise these industries,” said Holzheu. “It needs to react to this through underwriting and rate changes, and charge a price that’s adequate to the risk. And that means that certain areas become less insurable. That will become an issue.”
He added: “It’s not yet where we were in the 1980s with the liability crisis, but that comes to mind. If industries can’t get covered, then you get a ripple effect.”