March 8, 2023
What Is Social Inflation?
We know what economic inflation is, which is bad enough, but social inflation can make claims costs rise even more, often well exceeding general economic inflation.
Social inflation is an indicator of how society is shifting its preferences for determining who is best placed to absorb risk, according to a new white paper by the Insurance Information Institute (I.I.I.), “What is third-party litigation funding and how does it affect insurance pricing and affordability.”
What is the impact of social inflation?
Social inflation drives higher insurer claim payouts and loss ratios, notes I.I.I. Ultimately, policyholders pay more for coverage. A simple way to think about social inflation and its components is to compare the impact of these factors on claims losses over time with growth in an inflation measure like the Consumer Price Index (CPI). The insurance lines that tend to bear the brunt are commercial auto, professional liability, product liability, and directors and officers liability.
Drivers of Social Inflation
Unlike general economic inflation, which insurers can mitigate using pricing models and loss reserves, social inflation can arise from factors that are difficult to foresee, such as rising costs from:
- increases in the number of outsized jury awards
- legal proceedings that take longer than reasonably expected
- rollbacks in tort reform that overturn statutory limits on non-economic damages.
Considered to be a growing cost of doing business in the insurance industry, social inflation is influenced by negative public sentiment about larger corporations, litigation funding, and tort reform rollbacks at the state legislative level, all of which have increased liability costs. Shifting public perceptions and attitudes may lead jurors to sympathize with plaintiffs when awarding damages. Jurors may also believe the business, or the insurance company, has unlimited financial resources, leading to what’s commonly known as “shock” verdicts. These monetary damage awards are much higher than expected based on the evidence presented at trial, often exceeding $10 million.
Emotional appeals to juries by plaintiff’s attorneys are nothing new. Neither are class action lawsuits. But the plaintiff’s bar has gone to a new level with tactics like third-party litigation funding and litigation lending, the report notes. Funding of lawsuits by international hedge funds and other financial third parties – with no stake in the outcome other than a share of the settlement – has become a $17 billion global industry, according to Swiss Re. Law firm Brown Rudnick sees the industry as even larger, estimating it as a $39 billion global industry in 2019, according to Bloomberg.
What is third-party litigation funding and how does it drive social inflation?
The impact of these and other issues in the legal landscape can be intensified by third-party litigation funding.
Third-party litigation funding (TPLF) is a form of financing for legal expenses in which an investor provides money to attorneys or clients in exchange for a financial stake in the settlement or winnings of a lawsuit or arbitration. This money is often described as a non-recourse loan because it does not have to be repaid to the investor if the legal case is lost or never resolved. Also known as legal financing, legal funding, third-party litigation finance, or alternative litigation financing (ALF), this booming global industry is valued at $17 billion dollars and may expand to $30 billion by 2028, according to a Swiss RE report.
Research shows TPLF can contribute to social inflation by enabling more lengthy litigation, ultimately making insurance coverage more expensive. There are several other aspects of TLPF which can create concerns.
What can be done about social inflation?
Some states have implemented rules requiring disclosure of third-party litigation funding in lawsuits, which would give defense attorneys and juries insight into the entities other than the plaintiff who are financing the legal fees of plaintiff’s attorneys. Such efforts predictably meet resistance from third-party litigation funders. In 2020, the 13 largest commercial litigation funders in the world formed the International Legal Finance Association (ILFA) to advocate for litigation funding and oppose blanket disclosure requirements.
More frequent lawsuits and costlier jury verdicts can lead to increased insurance costs as rates are adjusted to reflect the changing risk profile. It can even force insurers to stop writing certain forms of coverage. Higher claim costs tend to be passed along to policyholders in the form of higher premiums. In extreme cases, climbing claim costs can ripple through the entire economy, creating conditions analogous to the 1980s liability crisis, where liability claims were adversely impacting the U.S. insurance industry to the point where some insurers faced insolvency.