Litigation Risk Insurance: A Tool That Should Be In Every Lawyer’s Toolkit

By: Stephen Davidson & Stephen Kyriacou

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Given the uncertainty inherent in all litigation and the difficulty of predicting case outcomes, counsel can never guarantee how a client’s case will turn out no matter how strong that case may appear. This is true even if a client’s defense case looks like a slam dunk, either because it is highly unlikely that liability will be found if the case goes all the way to trial or because it is clear that the plaintiff is overreaching on damages. And it is true even if a judgment that a client has won at trial, on summary judgment, or in arbitration appears certain to survive post-trial motion, appellate, or other challenges, or if it seems impossible for the damages that the client won to be reduced past a given point once such challenges have run their course.

This uncertainty is, of course, the reason why every state’s rules of ethics and professional responsibility prohibit statements that are likely to create an expectation about the results that a lawyer can achieve on behalf of his or her client. But while an attorney can never guarantee his or her client that they will prevail on the merits of a given litigation, there is a tool – albeit one with which many litigators are not familiar – that, for in-scope cases, can allow counsel to provide certain assurances to his or her client that an adverse litigation outcome will not impact the client monetarily, or will only impact them to a certain pre-defined extent. This tool is called litigation risk insurance, and it most commonly takes two forms: defense-side adverse judgment insurance and plaintiff-side judgment preservation insurance.

 

"While an attorney can never guarantee his or her client that they will prevail on the merits of a given litigation, there is a tool – albeit one with which many litigators are not familiar – that, for in-scope cases, can allow counsel to provide certain assurances to his or her client that an adverse litigation outcome will not impact the client monetarily, or will only impact them to a certain pre-defined extent..."

 

Adverse Judgment Insurance

Adverse judgment insurance protects defendants in pending litigation, or parties that may become defendants in future litigation, against the risk of a potentially significant or catastrophic adverse judgment.

For example, a company being sued for $100 million in damages can buy $90 million in “limits” (i.e., the amount of insurance coverage the company purchases) attaching above a $10 million “retention” (i.e., the policy’s deductible) and, if the company ultimately finds itself on the losing end of a $100 million judgment, the insurers on the policy will pay out $90 million, leaving the company responsible only for the $10 million retention. And if the plaintiff obtains a final judgment against the company for an amount less than $100 million, the policy will pay out everything over the retention such that a $50 million damage award would result in a $40 million payout under the policy, with the company still being responsible only for the $10 million retention. Accordingly, so long as the company purchases enough limits to cover the worst-case scenario damage award, adverse judgment insurance can offer assurance that the company will not be out of pocket for any amount above the retention on the policy.

Adverse judgment insurance placements often arise in the context of M&A transactions. The typical example involves a Target that is a defendant in a significant litigation. Buyer wishes to buy Target, but does not want to take on the potential litigation exposure, and so it requests that Seller escrow an amount equivalent to the damages being sought from Target to cover any indemnity obligations. By contrast, Seller may believe that the litigation is without merit, or that the damages being sought in the litigation are grossly inflated, and so may only be willing to indemnify Buyer for an amount significantly below the worst-case damage scenario in the litigation.

But Seller’s views on the merits of the litigation and/or the likely or realistic damage award if liability is found may not provide sufficient comfort to Buyer, since Buyer could see a significant percentage of the deal value evaporate in the event of a catastrophic result in the litigation, however unlikely that may be. In such a situation, the litigation may very well prevent what would otherwise be a mutually beneficial transaction from closing. But with adverse judgment insurance, Buyer and Seller can transfer the litigation risk to the insurance markets, price the premium payment for the insurance policy into the transaction, and close a deal with a dramatically reduced escrow or indemnity obligation equivalent to the retention on the policy.

 

"With adverse judgment insurance, Buyer and Seller can transfer the litigation risk to the insurance markets, price the premium payment for the insurance policy into the transaction, and close a deal with a dramatically reduced escrow or indemnity obligation equivalent to the retention on the policy..."

 

While the situation described above is commonplace, we have seen many situations where adverse judgment insurance can provide a significant benefit to a company outside of M&A transactions. In just the past few months, we have seen clients looking to obtain adverse judgment insurance where a pending litigation is scaring away potential investors; where they are trying to wind-down a private equity fund in which certain portfolio companies are involved in ongoing litigation; where they want to release money from litigation reserves or from escrows held over from consummated M&A transactions; or where the client just needs certainty around a litigation, but the plaintiff is not yet ready to come to the table to talk settlement. All of these different contexts have one thing in common: a party is seeking assurance that a given litigation exposure is capped at a certain dollar amount.

Defendants also are sometimes keen to use adverse judgment insurance to gain leverage in settlement negotiations with overreaching plaintiffs. Imagine that Plaintiff is suing Defendant for $100 million, and Defendant has in place the same adverse judgment policy used as an example above: $90 million in limits attaching above a $10 million retention, with $10 million representing what the insurers on the policy believe to be the likely damages downside if liability is found. If Plaintiff comes to Defendant and offers to settle for, say, $50 million, Defendant can tell Plaintiff, “Thanks for your offer, but we have an insurance policy in place that will pay out the full amount of any judgment up to $100 million, and we would only be on the hook for $10 million of any amount that is awarded to you, so while we are open to talking about a reasonable settlement, any offer above $10 million plus our anticipated legal costs is a non-starter for us.” In this way, adverse judgment insurance can be a powerful tool in calling a Plaintiff’s bluff as to whether it is willing to actually take a case all the way through to trial (which few overreaching plaintiffs are willing to do), and can be extremely useful in effectuating settlements within a policy’s retention.

Judgment Preservation Insurance

Judgment preservation insurance, on the other hand, protects plaintiffs that have won significant lower court judgments against the risk of reversal or damage award reduction in post-trial motion practice or on appeal. It can also be used to insure arbitration awards against the risk of vacatur, post-confirmation appellate challenges, or other collateral attacks.

For example, if a company protects a $100 million judgment with a judgment preservation insurance policy providing $90 million in limits with a $10 million retention and then, after further proceedings, a final, non-appealable order is entered that erases the full damage award, the insurers on the policy will pay out $90 million. If, instead of being reversed, the damage award is remitted, the insurers will pay out the amount of the remittitur, above the retention. Using the coverage scenario above, a reduction of the $100 million damage award to $50 million would result in a $40 million payout under the policy.

Unlike adverse judgment insurance, companies that seek judgment preservation insurance usually do so not because of some material transaction giving rise to a need for the insurance, but rather simply to mitigate their appellate risk, such that, no matter what happens in appellate or other subsequent proceedings, they will still walk away with a significant portion of their judgment at the end of the day. Some companies also look to use judgment preservation insurance to accelerate the recognition of judgment-related gains in their earnings, since having the coverage in place provides assurances that the company will receive an amount equal to the limits that it purchases, so long as there is no collection risk if the insured prevails on appeal. 

 

"Companies seek judgment preservation insurance to mitigate their appellate risk, such that, no matter what happens in appellate or other subsequent proceedings, they will still walk away with a significant portion of their judgment at the end of the day..."

 

Judgment preservation insurance also can allow a prevailing plaintiff to insure its judgment and then seek financing at an attractive cost of capital because the party lending against the policy does not need to price in appellate risk like other judgment monetization counterparties must do in the absence of insurance. This type of judgment preservation insurance-backed financing is optimized when the appealing defendant has posted an appeal bond or where there is otherwise minimal collection risk associated with the judgment because, while a lender will be comfortable that it will be repaid if the insured borrower loses on appeal, it will also need to be comfortable that it will be repaid if the insured borrower wins on appeal and is left to collect on the judgment.

Even absent the financing component, in situations where prevailing plaintiffs do not have an immediate need to monetize their judgment, judgment preservation insurance is a compelling option, as the one-time upfront premium payment offers assurances that the plaintiff will receive an amount equivalent to at least the full limits that it purchases no matter what twists and turns the case may take on appeal or remand.

How Litigation Risk Insurance Coverage Works

Every litigation risk insurance policy is bespoke and customized for the insured and its coverage goals, as well as for the specific litigation to be insured and its unique characteristics. Accordingly, there is a significant amount of flexibility in structuring precise coverage terms. But one near-constant is that both adverse judgment insurance and judgment preservation insurance provide what is called “judgments only” coverage, meaning that the policies typically pay out only when the loss-triggering judgment or order against the insured has become final and is no longer appealable.

 

"Every litigation risk insurance policy is bespoke and customized for the insured and its coverage goals, as well as for the specific litigation to be insured and its unique characteristics..."

 

For adverse judgment insurance, this means that if the insured defendant loses at trial, it must challenge that loss on appeal and exhaust its appellate options (within reason) before the insurance pays out, even if that means retrying the case following remand. And in the judgment preservation context, “judgments only” coverage means that an appellate ruling remanding the case does not trigger a loss under the policy, and instead requires the insured to retry the case, with the coverage paying out only if the insured then loses the new trial and any subsequent appeals – i.e., when the case has culminated in a final, non-appealable judgment against the insured.

Unlike other types of insurance, most litigation risk insurance policies do not permit insurers to take over or control the litigation, meaning that the insured retains decision-making power and continues to litigate the insured case with its chosen counsel. It is also important to note what these policies typically do not cover: defense costs and settlement amounts. As to defense costs, where litigation is already pending or expected to ensue, insuring defense costs does not make sense for either party to the insurance policy, since they would just be trading premium dollars for legal fee dollars. Notably, however, where a company is seeking to insure itself against the possibility that certain facts and circumstances might give rise to a lawsuit sometime in the future, some insurers are willing to cover at least a portion of defense costs in addition to insuring against an ultimate finding of liability, because they believe that such costs (i) are unlikely to arise because no lawsuit will ever be filed, or (ii) if they do arise, will be minimal because any case that gets filed will likely go away on a motion to dismiss or via an early settlement.

The Underwriting Process

One of the things that makes litigation risk insurance unique is the level of underwriting that it requires, which makes sense given the factual, legal, and procedural complexity of pending litigation, the volume of information that usually needs to be reviewed by insurers, and the eight- and nine-figure policy limits that are common in this particular corner of the insurance marketplace.

Insurers’ underwriting typically focuses on two things. The first, of course, is the insured’s ultimate likelihood of success in the litigation. As to the second, insurers will ask, in the adverse judgment insurance context, “If the insured does, in fact, lose the litigation, what is the likely or realistic damage award that the plaintiff will win?” And in the judgment preservation insurance context, they will ask, “What is the likely or realistic reduction in damages that the insured will suffer if the judgment is not affirmed?” This idea of the “likely or realistic” damage award or damage reduction amount – which should be contrasted with the worst-case or catastrophic damage award or damage reduction amount that the insured is looking to insure against – is important because that dollar figure is typically used to set the retention on the policy, i.e., the amount of risk retained by the insured.

For example, if a company is being sued for $100 million, but underwriting indicates that if the company is found liable, the likely damage award would be only $10 million, then insurers would expect roughly a $10 million retention and provide approximately $90 million in coverage. But if underwriting indicates that the likely damage award would be $25 million, then the retention would be roughly $25 million and the policy would provide approximately $75 million in coverage.

The retention on a litigation risk insurance policy is also important as a means of aligning interests between insurers and the insured and avoiding the moral hazard of an insured altering its litigation strategy as a result of procuring insurance, since the retention requires the insured to keep some meaningful “skin in the game.” There are other ways of aligning interests, as well, like risk-sharing through co insurance, a “hammer clause” (which requires the insured to settle if the plaintiff makes a demand within an agreed upon range), or, in the judgment preservation insurance context, keeping contingency fee counsel’s share of the judgment on risk while the actual party to the case insures its share (or vice versa). But litigation risk insurance policies will always require the insured to litigate as if they did not have an insurance policy in place, meaning that alignment of interests, however such alignment is achieved, is essential.

Of course, not all litigations are insurable. For example, insuring defendants in early-stage litigation can be a challenge if there is a lack of underwritable information about the facts of the case. And insurers strongly prefer commercial cases given that such cases tend to lend themselves to underwriting the quantum of potential damage awards or the extent of potential reductions in damages much more easily than do personal injury, product liability, wrongful death, and other tort cases, where there exists a heightened possibility of runaway jury verdicts and greater uncertainty as to how much large damage awards may be reduced on appeal.

Given the focus in underwriting on setting an appropriate retention, however, adverse judgment insurance can still be viable where a finding of liability is likely and judgment preservation insurance can still be viable where a reduction in damages is likely, so long as the outcome of the case is not binary and there is sufficient information to allow insurers to set an appropriate retention.

Judgment preservation insurance, on the other hand, is more likely to be underwritable because insurers will have the benefit of a fixed and finite appellate record. Indeed, if an appeal has been fully briefed and argued by the time the plaintiff goes to the insurance markets, insurers will be able to see everything that the appellate panel will see in deciding the case.

The Future of Litigation Risk Insurance

Currently, there are more than two-dozen insurers that write litigation risk insurance coverage, and the marketplace has the capacity to provide as much as $1 billion in coverage for in-scope cases. This represents a significant increase, in both market participants and market capacity, from just five years ago, when far fewer opportunities were being brought to market. Today, large litigation risk insurance programs are becoming much more commonplace, with insurers binding multiple policies providing more than $500 million in coverage in the past 24 months. And we anticipate that over the coming months and years, more insurers who have been wary of insuring litigation risks will move into the space, not only increasing the amount of capacity that can be marshaled for any given litigation risk, but also widening the aperture as to the types of litigation risks that insurers are willing to cover.

 

"Currently, there are more than two-dozen insurers that write litigation risk insurance coverage, and the marketplace has the capacity to provide as much as $1 billion in coverage for in-scope cases..."

 

We also expect to see insurers become more open to insuring portfolios of litigation-related risks, whereas the marketplace right now is focused primarily on insuring the outcomes of individual cases. Indeed, as of this writing, we are working with a number of litigation funder clients looking to insure baskets of uncorrelated litigation investments. This type of fund-level insurance can permit funders to offer investment grade opportunities to their investors. The returns will, of course, be lower than they would otherwise be as a result of the cost of coverage, but the insurance can offer assurances that the insured fund will not lose money because, if returns dip below the level prescribed by the policy, the insurance will make investors whole.

Additionally, we envision that law firms will not simply be advising their clients to purchase litigation risk insurance, but that they will become buyers of such coverage themselves with respect to cases that they are taking on contingency. That includes not only insuring single case contingency fee awards that are on appeal with judgment preservation insurance, but also insuring groups or portfolios of contingency fee cases at different points in the litigation lifecycle, just as litigation funders are now looking to do via fund-level policies.

We also anticipate that there will be significant growth in other types of litigation risk insurance, including principal protection insurance (which insures the principal that litigation funders or hedge funds invest in individual plaintiff-side cases), litigation buyout insurance (a solution typically associated with claims-made class actions, where the insurer actually steps into the shoes of the insured and takes responsibility for defending and settling the case and then administering any settlement, in exchange for the payment of a single upfront premium), various types of legal fee insurance (such as “after the event” or “ATE” insurance, which insures a party to litigation against the risk that it will be required to pay for its adversary’s legal costs if it is unsuccessful in the case), and judgment collection and enforcement insurance.

However the litigation risk insurance marketplace may evolve over the coming years, it is clear that adverse judgment insurance and judgment preservation insurance can be important tools in a litigator’s toolkit, as they can provide the sort of assurances that litigation practice otherwise will not. Litigators whose practices involve high-stakes, high-dollar-amount cases, whether on the defense-side or the plaintiff-side, would be well advised to familiarize themselves with the mechanics and applications of these insurance solutions so that they can advise their clients about the risk transfer options that may be available to them when they have won a significant judgment, or where litigation against them is eroding shareholder value, forcing reserve requirements that negatively impact their cash flow, or preventing a merger or acquisition from closing.

 

"Litigators whose practices involve high-stakes, high-dollar-amount cases, whether on the defense-side or the plaintiff-side, would be well advised to familiarize themselves with the mechanics and applications of these insurance solutions..."

 

 

 

 


All descriptions, summaries or highlights of coverage are for general informational purposes only and do not amend, alter or modify the actual terms or conditions of any insurance policy. Coverage is governed only by the terms and conditions of the relevant policy. Please consult with your licensed insurance broker to inquire about the availability of coverage in your jurisdiction.

Aon is not a law firm or accounting firm and does not provide legal, financial or tax advice. Any commentary provided is based solely on Aon’s experience as insurance practitioners. We recommend that you consult with your own legal, financial and/or tax advisors on any commentary provided by Aon. The information contained in this document and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity.


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