The precise impact that the flood of funds from investors to law firms large and small is having on social inflation – or increased losses resulting from rising claims settlements and jury verdicts – is impossible to quantify due to the hidden nature of the vast majority of this financing. But the influence is visible in rising losses across multiple lines, from medical malpractice to personal auto and multiple commercial lines.
“The answer for almost anybody who wants to be honest about it is we don’t know,” said Dale Porfilio, chief insurance officer at the Insurance Information Institute. But he said it’s clear that litigation funding is a “material contributor” to social inflation. “I don’t think anybody can break it down and say 25% of the cause or 50% of the cause.”
“We know we feel the impact,” agreed David Perez, CUO, global risk solutions at Liberty Mutual. “But identifying exactly which actions are impacted and which aren’t is tough.”
2022 may shine some light on the actual impact of this funding stream as courts fully reopen and cases that lingered through the pandemic resolve.
What is clear is that there are few tools available to counter its expanding influence.
Industry groups are waging a state-by-state battle for laws that would require increased transparency into which cases have backing from these funders and mandate basic consumer protections, but there’s little guarantee that even successful efforts on this front will produce results that stem the tide of rising litigation costs, soaring settlements and nuclear verdicts.
The growth of litigation funding
US casualty insurers saw underwriting losses linked to outsize legal awards grow dramatically in the past decade.
Most observers consider commercial auto the line where social inflation appeared first and where the impact has been greatest, the Insurance Information Institute said in a recent study.
The portion of commercial auto claims involving attorney representation rose 20% from 2015-2019, while the average total loss rose 20.3%, according to a second study released by the American Property and Casualty Insurance Association (APCIA).
Major and unexpected jury verdicts came down across other lines as well, and the term “social inflation,” which dates to a comment in Warren Buffett’s 1977 shareholder letter, cropped up in more and more discussions.
Those conversations tended to focus on the so-called nuclear verdicts, or outsize awards doled out by juries, and frequently cited theories about anti-corporate sentiment driving up the dollar amounts those juries were awarding.
Swiss Re in a third study found that the median award for verdicts larger than $1mn between 2010 and 2019 rose 26% to $10.3mn for general liability awards, and 29% to $7.9mn for vehicle negligence cases.
More recently, fingers started pointing at third-party financing – where money from unrelated investors backs the costs of litigating a claim – as a hidden influence not only in the problem of ballooning verdicts, but also in pushing legal costs higher by prolonging cases and bringing more cases to trial.
The result for the insurance industry is mounting underwriting losses. Swiss Re cited estimates by insurance asset manager Conning that put the average combined ratio for US general liability in 2020 at 105.7%, and for medical malpractice at 117.5%, the seventh consecutive year of underwriting losses for both lines. Data for general liability was not available, but medmal CR in 2021 rose again, to 113.4.%.
In response, insurers have jacked up rates, compressed limits and in some cases exited certain markets.
Meanwhile, the number of funders and the amount they have to offer is only continuing to grow.
By 2021, there were 47 litigation funders active in the US, up 15% from 41 just two years earlier, according to Westfleet Advisors, a lit finance advisory firm. Lit finance industry assets under management grew even faster, to $12.4bn in 2021 from $9.4bn in 2019, a 32% leap.
Westfleet, in its 2021 Litigation Finance Market Report, said the market is “maturing,” as evidenced by the embrace of such funding by “Big Law,” or law firms ranked among the top 200 firms by American Lawyer. It found a nearly 50% increase in the amount of capital committed to deals involving these firms, which it noted had been slower to adopt such financing than smaller firms. What’s more, the increase was driven by a few massive deals involving investments of $50mn or more.
Smaller deals also grew, Westfleet said, because of several newer entrants to the funding market specializing in smaller transactions. “In fact, despite a significant increase in larger law firm deals, the magnitude of funding activity in smaller deals actually caused the average size of deals industry-wide to decrease by nearly 20% compared with 2020,” the firm found.
Big return potential draws sophisticated investors
While some firms raise money through crowdfunding or pool funds, lit funding’s war chest does not rely on mom-and-pop investors.
There are two publicly traded companies that provide litigation financing, Burford Capital and Omni Bridgeway. Burford, listed on the NYSE, bills itself as the largest investment manager focused on legal finance. It said in its annual report it had assets under management of $2.8bn in 2021, about $1.2bn of which was deployed in the US.
Australian-listed Omni Bridgeway had $2.4bn under management, according to its annual report, and aims to invest $225mn in the US in 2022.
The rest of the billions being deployed by lit funders comes from sophisticated investors looking to balance their portfolios with alternative products that have no correlation to the financial markets, like endowments, private equity and hedge funds. A source who represents “family offices,” which manage finances and investments for families with $100mn or more in investible assets, said these wealthy clients are also chasing the returns produced by litigation finance, though they tend to do so quietly to avoid publicity.
Remarkably, insurance companies also invest in this market, said Eva Shang, co-founder and CEO of Legalist, a financing firm with $650mn invested that specializes in smaller commercial litigation cases, averaging about $1mn.
“We have insurance companies as limited partners,” she said. She declined to name any of the industry investors but noted that each company has multiple goals.
"The asset management division is focused on making a profit so that they can continue to offer insurance,” Shang remarked. “Litigation finance is becoming a much more institutional asset class.”
And the returns are hard to resist. Swiss Re put average investor returns on personal injury cases at 35.3% in 2021, and for commercial cases at 29.9%. Both topped the stellar S&P 500 gain of 27% for 2021.
The argument for litigation financing
Lee Drucker, managing director at $125mn PE fund Lake Whillans Capital Partners, which does significant litigation funding, said his firm backs both plaintiffs and defendants in commercial cases, though the latter are more rare. The typical investment can range from $2mn to $20mn, he said.
His firm looks for cases they judge to have a 60% or greater chance of winning. “We’re only investing in cases where we think we have the much stronger argument,” he said, including “robust” documentary evidence.
While Lake Whillans doesn’t back small cases like those involving individual auto accidents, Drucker said: “Writ large, litigation finance provides access to capital and access to justice.
“If the default, or the way society has been structured to date, is that the wronged party has to settle for pennies on the dollar because they don’t have the resources to properly adjudicate their claim, that’s bad,” he said. “That’s a worse outcome than insurance companies having to pay more.
“And to the extent that society was limiting that access, then this levels the playing field,” he added.
But even in legal circles, there is uncertainty about this financing.
“Litigation finance is our civil justice system’s killer app,” wrote Suneal Bedi, assistant professor of business ethics and law Indiana University and William Marra, a lawyer and investment manager at Validity Finance, in a paper published last year in the Vanderbilt Law Review. “Unheard of yesterday, it is a mainstay today.”
"Whether this is a good thing has been the subject of an infant but vigorous debate,” they wrote. “Some scholars argue that litigation finance furthers the purposes of our legal system by ensuring legal outcomes track the strength of a party’s claim, not the size of its bank account. Others disagree, suggesting that litigation finance will spur frivolous litigation and allow profit-seeking investors to take over our civil justice system.”
Sources said there are signs that that may already be happening, judging by how big verdicts can bring out predatory lawyers backed by lit funding who are looking to reel in clients in hopes of matching those results.
“When there is a verdict in a certain geographic area, a lot of marketing goes in that area for other claims,” one broker observed. “The TVs light up with all the commercials because they think that they can get another verdict.”
Having third-party funding changes the dynamic of a lawsuit, said Richard Henderson, SVP in Trans Re’s medical malpractice claims department. " The focus of the lawsuit becomes less about the claim. The plaintiff is not the focus,” he said. “The funder is involved and they’re looking obviously to maximize their return.”
One notable feature of litigation financing is the high fees or interest rates attached.
Lit funders offer money early in a case as a loan to the plaintiff, typically with the promise that it does not have to be repaid if they lose the suit. If they win, the payback often includes interest or other fees that could amount to 35% or 40% APR – putting the financing in what some critics call “usury” territory and sometimes leaving the plaintiff with less in hand than if they had settled earlier.
Another big concern is how much influence litigation funders have on the progress of a case – whether they play a behind-the-scenes role in convincing plaintiffs to hold out for jury trials rather than settle cases, for instance, or if they encourage clients to delay paying medical bills or seek unneeded medical care to drive up costs.
“The problem is that it’s largely unregulated,” said Richard Montes, a partner at Long Island, NY, appellate law firm Mauro Lilling Naparty. “That leads to a number of potential problems not only for the plaintiffs themselves, but for plaintiffs' counsel.”
Fighting for disclosure
The insurance industry has few means to counter litigation finance’s impact, but one goal is to get more regulation enacted.
In particular, there’s some hope that bills requiring that all parties in a case be made aware when third-party funding is involved will pass state legislatures and get signed into law.
Right now, a handful of states require in at least some cases that such funding be disclosed. Some also police the interest rates charged, require clear explanations to plaintiffs about the contracts they sign, mandate that potential conflicts of interest be revealed or have other consumer protections built in.
“When these types of things are put on the books, particularly the regulatory portion, that was not considered favorable to the lenders,” said Lee Ann Alexander, APCIA vice president for government relations. In fact, she said, there’s some evidence that in some of those locales, the use of litigation funding appeared to decline.
That suggests such laws “would disrupt the model” that litigation funders use, Alexander said.
There is legislation pending in 11 states, and Iowa Sen. Chuck Grassley and Rep. Darrell Issa this month reintroduced federal legislation that would require disclosures.
“There’s a growing sense that there’s a lot we need to do, because the ramifications are ominous if litigation funders are allowed to continue to operate in a hidden fashion,” said Trans Re’s Henderson. "We need to know who’s out there.”
If that doesn’t happen, he added, it’s not only the insurance industry that will pay the price. “As it becomes more costly to defend and settle, the end result is that ends up being passed along to everyone else in some fashion. “
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