Social Inflation and Property/Casualty Insurance

Litigation Funding

The growth of litigation funding and its potential effects on commercial auto insurance

By Diane Injic

It started in Australia, made its way to Europe, and has been growing in the United States. In fact, litigation funding has grown 414 percent in this country from 2013 to 2017, according to a 2017 report by Burford Capital. It’s now a multi-billion-dollar business.

Generally, in litigation funding, third-party investors provide funds to plaintiffs to pursue lawsuits against large companies, oftentimes insurers. It’s become a hot emerging issue and can significantly impact the insurance industry. This is especially prevalent in commercial auto insurance, where the use of litigation funding could be helping to drive up claim severity.¹

With the current state of the commercial auto insurance industry being very challenging, where losses are outpacing premiums as Verisk research has shown, litigation funding could be another obstacle for profitability. Commercial auto carriers have deeper pockets, busier drivers, riskier payloads, and other conditions that make cases attractive to third-party investors willing to support higher payouts to plaintiffs for claims.

The practice of litigation funding is complicated by the fact that disclosure laws requiring plaintiffs to reveal they’re being supported by a third party are rare. In 2018, Wisconsin passed a law that requires litigants to disclose any agreements where third party funders could receive a share of earnings from the lawsuit.² Multiple states have adopted laws regulating some aspects of litigation funding.³ Even so, insurers can be surprised by a claimant with unexpected financial resources during a legal action.

What is litigation funding?

The litigation funding that can concern insurers is generally where a third-party investor provides funding for litigation costs in exchange for part of the eventual payout. The litigation funder provides money to the plaintiff and takes a calculated risk that there will be a payout in the case large enough to return the investment plus a profit.⁴

The percentage of the return to the investor is usually quite large, and to avoid certain penalties and limitations, the investor reportedly will structure the agreement as a non-recourse cash advance—an investment, not a loan.⁵ In these agreements, the plaintiff isn’t charged anything if the case is lost.

The attraction for third party investors

As of October 2017, third-party litigation funders had committed more than $1 billion to plaintiffs for lawsuits.⁶ [Editor’s note: As of this writing, that figure has reached approximately $11.3 billion.⁷] Attorneys are finding this a viable way to pursue lawsuits where plaintiffs have limited resources. The article points out that since the investor is looking to make a profit, it’s an indication that this business-minded third party feels the claim is strong enough to win and earn a worthwhile return, possibly giving the lawsuit greater legitimacy.

Hedge funds have emerged as some of the biggest investors in litigation funding. In an example given by a lawyer experienced in these cases, a third party invests $100,000 in a case.⁸ The agreement specifies that the investor gets back the initial funding plus 100 percent and 15 percent of the rest of the settlement. If the case settles for $1 million, the investor could realize a 220 percent return and 32 percent cut of the settlement. The article does note that such agreements vary from case to case depending on the underlying circumstances.

In addition to the returns, investors benefit in other ways. They can diversify their portfolios with risks not connected to overall financial markets or other investments and spread risk across a larger book. These investments are typically structured as a prepaid forward contract not a loan, because the investor is looking to avoid charges of usury and other potential issues.⁹ Prepaid forward contracts can provide capital gain tax treatment since the reward amount is deferred until litigation is resolved.

There are benefits for the plaintiffs in a litigation funding arrangement, too. The plaintiffs get to mitigate their risk while only giving up a percentage of the proceeds. The willingness of a third party to fund a lawsuit can provide incentive to pursue a case in anticipation of a larger reward, and may even lead to frivolous lawsuits.¹⁰ Litigation funding can also discourage settlement and prolong a case for a potentially larger payout.

Issues with third party litigation funding

Verisk staff research has shown that states and the federal government are looking into the practice of litigation funding, especially the issue of disclosure. Insurers and others are pushing for strong disclosure laws and the right to know when a third-party investor is involved. It’s not a black-and-white issue, however, as there are privacy considerations.

Additional litigation funding methods are under scrutiny because they could create other situations for plaintiffs. Instead of providing money for legal fees, the litigation funder might give advances against the final payout for other expenses, and these advances could have very high interest rates.¹¹ As plaintiffs are often considered vulnerable targets, the Consumer Financial Protection Bureau has shown serious interest in protecting them. There’s a concern that more and longer lawsuits can add cases to an already busy legal system.

Impact on insurers

Litigation funding’s impact on insurers can be huge, starting with the potential for nuclear verdicts. Commercial auto insurers consider anticipated risks and predicted losses as part of the calculation in determining premiums. Unanticipated large claim settlements or verdicts, like those supported by litigation funding, can result in large payouts with a severe negative effect on the bottom line.

Payouts in commercial insurance cases can often be larger than in personal insurance due to the liability limits of the policy, type of plaintiff, and the other financial resources a commercial insurer may be willing to commit. Litigation funders that use the practice on a portfolio level may take on cases just to spread out their risk, lengthening the time and cost of a case for an insurer.

If litigation funding provides the incentive to bring frivolous cases, insurers have to spend time and money fighting them, increasing claims expenses. With the lack of disclosure laws for litigation funding (with the exception of Wisconsin and West Virginia), insurers can be blindsided when a case continues to grow because the plaintiff now has more financial resources.¹² Many insurers may settle a case to avoid ongoing litigation and prevent increasing the size of the reward, expenses, and time spent on the case.

What can insurers do?

Litigation funding is a relatively new practice in the United States and has many unknowns. How does the relationship between attorneys and investors develop, and how does that affect insurers? Other than hedge funds, what’s the general profile of an investor? What are the typical returns on such cases? How many who seek litigation funding get it? What percentage of plaintiffs win these type of cases?

As investors generally take on cases they believe they can win, insurers should consider what makes a case attractive to investors:

Did the insurer do something wrong?
Are there commonalities in cases investors take?
Were the policies inadequate or contain certain loopholes?
Are the inadequacies caused by relying on incorrect policy language or the inefficient use of proprietary or non-standard forms?

Insurers could face systemic liability risks from a number of trends. Are you prepared?

Systemic Liability Events

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First published in two parts on Visualize: See Part 1 and Part 2.

Mark Ruquet, “Commercial Auto: Profitability Issues Remain, But There’s Light at the End of Tunnel,” Carrier Management, July 23, 2018, accessed on May 12, 2021.
Jamie Hwang, ”Wisconsin law requires all litigation funding arrangements to be disclosed,” ABA Journal, April 10, 2018, accessed on May 12, 2021.
Alison Frankel, “CFPB signals regulation of litigation funding industry,” Reuters, February 8, 2017, accessed on May 12, 2021.
Jonathan Friedland, et. al., “Third-Party Litigation Funding,” Law Journal Newsletters, October 2017, accessed on May 12, 2021.
John Divine, “Litigation Finance: How Wall Street Invests in Justice,” U.S. News, January 22, 2018, accessed on May 12, 2021.
“Third-Party Litigation Funding.”
Bob Van Voris, et. al., “Apollo Stole Litigation-Funding Trade Secrets, Suit Claims,” Bloomberg, February 25, 2021, accessed on May 12, 2021.
“Litigation Finance: How Wall Street Invests in Justice.”
“Third-Party Litigation Funding.”
“Litigation Finance: How Wall Street Invests in Justice.”
“Litigation Finance: How Wall Street Invests in Justice.”
James Anderson, “Is Increased Transparency into Litigation Financing on the Horizon?”, National Law Review, January 15, 2020, accessed on May 12, 2021.