Deflating Social Inflation

For insurers, estimating reserves against claims is an art and a science. But the time-tested methods used in this process have been increasingly challenged by the rising role of social inflation in civil litigation.

Unanticipated claims costs linked to social inflation are estimated to be in the tens of billions of dollars—it’s become a leading risk for the property and casualty industry. Insurers that do not understand the full scope of their key risks, while simultaneously having zero or weak enterprise risk management (ERM), may lack adequate protection against these stresses and shocks.

To limit severe losses, insurers must understand the changing and growing nature of liability risks to effectively manage claims. The value of ERM in this work cannot be overstated. Enterprise risk management allows organizations to identify and quantify their risks, set risk tolerances based on their corporate objectives, and take the necessary actions to manage risk in light of those objectives.

Stress testing is similarly key for companies of all sizes, enabling management teams to view the impacts of severe but plausible scenarios on insurers’ balance sheets and operating results. For example: an outsized jury verdict against an insured commercial entity.

Stress testing is not limited to underwriting; it also considers investment and geopolitics, among other factors, and aids insurers in developing contingency plans. If an event falls outside of expectations, a company should have mechanisms to restore capital to an appropriate level in a timely manner. This work can help management evaluate a firm’s modeling process, assumptions, and data and provide valuable insights into the amount of risk an insurer can assume and how it can manage the assumed risk.

Strong risk management programs will help insurers tackle future uncertainties, which certainly would include social inflation.

Paying the Piper

Social inflation, broadly, is the rise in the cost of insurance claims due to factors such as a growing number of lawsuits and larger awards in those cases.

Insurance actuaries have no formula or empirical evidence to pinpoint how juries comprised of ordinary citizens will consider specific case circumstances in deciding what award is justified when a defendant is found liable for damages. In particular, it is difficult to set reserves for potential pain and suffering payouts because such payments are based less on facts (e.g., medical bills or monetary awards tied to lost time from work, which would be based on actual salary data) than they are on subjective considerations. Those considerations may include how badly jurors feel for the injured party or how negligent they believe the defendant was.

Studies have shown an ongoing decline in sentiment toward major public corporations, including the increasing belief that they sacrifice safety for profits in operating their businesses and producing products sold to the public. Attorneys have capitalized on these attitudes toward big business, often obtaining higher jury awards than one objectively might think the case was worth.

Attorneys in cases involving commercial auto and other commercial lines (and even product liability claims) are also increasingly using radio, television, and print advertising to become more embedded in the public consciousness.

Over time, the proliferation of advertising can affirm the idea that large jury awards are normal and acceptable, no matter the facts of the case. The growing amount of legal advertising is also boosting public expectation and desire for higher settlements and more favorable judgments. Law firms that win big settlements advertise them, continuing the cycle.

Further exacerbating the risk is third-party litigation funding, in which private equity firms or other investor groups provide upfront financing to plaintiff attorneys in personal injury and liability litigation in return for a share of the ultimate jury award or settlement. Litigation funding is now a $17 billion global industry, with just over half spent in the United States.

Unfortunately, the public policy climate continues to erode in various states with efforts to roll back tort reform and eliminate monetary caps on non-economic damages. The shift is reducing the public’s willingness to defend and protect institutions, particularly healthcare professionals, even from meritless lawsuits.

Considering that the average loss severity appears to be increasing with every case that is settled, coupled with an increased level of settlements, total indemnity payouts are soaring into hyperdrive. Jurors may look at these awards as being funded with Monopoly money, but ultimately, they impact the entire universe of policyholders—not just those involved in the lawsuits.

Managing Risks and Reserves

Product liability, auto, and medical malpractice cases accounted for roughly two-thirds of the reported nuclear verdicts, or verdicts of $10 million or more, between 2010 and 2019.

A nuclear verdict does not just affect the claim being considered in a lawsuit, but all other open claims as well, as plaintiffs, guided by their attorneys, seek similar verdicts or settlements, rendering an insurer’s existing reserves inadequate. Plus, as courts have reopened post-COVID-19 pandemic, releasing the case backlog, jury verdicts have been accelerating.

The impact on adverse loss development then flows into pricing, as insurers adjust their view for the affected lines. Using the most recent claim trend information to establish initial reserves for new claims in long-tail liability lines should make those initial reserves more adequate. Effectiveness of these efforts will likely separate the more successful insurers from those whose liability results are unfavorable over the near-to-medium term.

Fortunately, the most impacted casualty lines of business from an industry-wide standpoint currently are adequately reserved, outside of commercial auto liability, which appears to be deficient.

Meanwhile, the industry and allies on Capitol Hill are taking steps to mitigate the threat posed by social inflation.

Among other initiatives, the insurance industry is promoting alternative dispute methods, such as arbitration and mediation, to drive down litigation costs and delays. Companies also have been turning to artificial intelligence-driven software to help identify certain risks. Regularly analyzing claims data can help identify patterns and trends related to social inflation, which then can help insurers identify emerging risks and enable them to adjust mitigation strategies accordingly.

Early claims resolution can identify and resolve cases that could go nuclear—but a pre-litigation settlement isn’t always possible. The industry also can combat plaintiff attorneys’ tactics during pretrial work to defend the case and secure rulings to limit what the plaintiff can say and do.

Developing proactive litigation strategies can be vital to future success (including mock trials to see how different approaches might affect a jury).

In Washington, the Litigation Transparency Act, a draft of which has been introduced into Congress by Rep. Darrell Issa (R-Calif.), would require disclosure of third-party litigation financing agreements in federal and civil lawsuits. This would ensure that opposing parties know who is financing these agreements and whether there is a conflict of interest. Similar legislative efforts have failed, but given the increased attention to the issue, perhaps the new attempt at regulating litigation finance will gain traction.