Insurance Can Reduce Litigation-Related Uncertainty

Litigation has a tendency to interfere with companies’ operational plans, often forcing parties to settle winnable cases so that they can put the litigation behind them and get on with business. Settlement on suboptimal terms may once have been the only option for lawyers and clients when they could not get a case dismissed or otherwise prevail within a reasonable time frame, but, now, insurance can provide a more effective way to neutralize these litigation-related risks.

The last year has seen a significant uptick in the fast-developing but still under-the-radar litigation risk insurance marketplace, driven by increasing use of litigation risk insurance by both litigators and transactional counsel.

While many litigation-related risks are potentially insurable, most of the activity in this burgeoning market centers around two types of coverage: adverse judgment insurance, typically purchased by defendants before their case has gone to judgment; and judgment preservation insurance, typically purchased by plaintiffs after they have won a lower court judgment that will be subject to appeal.

Adverse Judgment Insurance

Adverse judgment insurance protects defendants or parties that may become defendants in future litigation against the risk of potentially catastrophic outcomes. It began as a tool for transactional lawyers to facilitate M&A deals by ring-fencing litigation risk associated with acquisition targets. By transferring this risk to the insurance markets, deals can close without onerous escrow or indemnity requirements that can either torpedo the transaction or force the seller to tie up a significant portion of its sale proceeds for an indeterminate time period.

While this still is the most common rationale for seeking coverage, adverse judgment insurance has moved beyond the M&A context. Now lawyers are advising their clients to consider using it to allay shareholder or potential investor concerns about the threat posed by a given litigation, or to help restore a company’s stock price that has been depressed by concerns about litigation, and to gain leverage in settlement negotiations with overreaching plaintiffs.

In short, situations where a company can demonstrate that it has a strong defense case (though it may take months or years for the litigation to conclude on the merits) and a genuine business motivation for insulating itself from a potentially significant damage award, can be good candidates for adverse judgment insurance.

Judgment Preservation Insurance

Judgment preservation insurance—which protects prevailing plaintiffs against the risk of judgment reversal or damage award reduction on appeal—can be used by parties that win significant judgments or arbitration awards to “lock in” their damages pending appeal, allowing them to reap immediate benefits from judgments that might take years to become final and are at risk of being overturned.

For example, the insurance can enhance a company’s balance sheet by allowing it to recognize earnings from an uncertain judgment, since it sets a floor for what will be recovered even if the judgment is fully reversed. Of course, not every judgment is insurable–insurers will only stand behind judgments that they view as either highly unlikely to be reversed on appeal or highly unlikely to see a damage award reduction beyond wherever the policy deductible is set.

But from insurers’ perspective, the benefit of judgment preservation insurance is that they are underwriting a fixed and finite appellate record, as compared to insuring defense-side cases that have not yet gone to trial, and where the record is not fixed, meaning that there can be less predictability.

Insurance-Backed Judgment Monetization

One of the most exciting recent developments in litigation risk insurance is insurance-backed judgment monetization. Previously, when clients wanted to monetize large judgments, their lawyers would point them in the direction of litigation funders, hedge funds, and other third parties that, because of the risk that those judgments would be overturned on appeal, would charge a multiple-of-invested-capital-based premium to buy out some or all of the client’s interest in the judgment.

With insurance-backed judgment monetization, a company can monetize the judgment at a lower cost of capital because the entity lending against the judgment is insulated from appellate risk, some or all of which has been transferred to insurers. This means that, depending on the structure of the loan, the lender may only face durational risk–i.e., when will the case end, allowing the plaintiff to collect from either the defendant (if the case is affirmed on appeal) or insurers (if the case is reversed), then repay the loan.

Of course, the judgment holder needs to pay the additional cost of the insurance premium, which typically comes in at around 7-15% of the amount of coverage or “limits” being purchased. But once the premium is paid, either out of the judgment holder’s pocket or with the monetization proceeds, the judgment holder will extract greater value from an insured judgment than from an uninsured judgment to the extent that the cost of the insurance premium is less than the upside paid to a traditional judgment monetization counterparty.

Law Firms Insuring Their Own Litigation Risks

Law firms also are increasingly turning to litigation risk insurance to address their own litigation-related risks. On the defense side, for example, insurers can provide a law firm with excess coverage for a specific pending malpractice suit that could result in a damage award that would go beyond the firm’s legal malpractice insurance limits.

Firms also are seeking to insure, or use insurance to monetize, their contingent fees from judgments that they have won for their clients and even wrap their entire contingent fee book with insurance to protect against the risk that the fees they ultimately receive on those cases will be less than the cost to the firm of litigating them. They can use insurance to provide greater certainty in defense-side alternative billing arrangements.

Lawyers should familiarize themselves with the mechanics and applications of these insurance solutions. Then 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.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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Stephen Davidson leads Aon’s Litigation Risk Group and Claims Advocacy for Aon’s M&A and Transaction Solutions practice. He practiced law at DLA Piper as a partner in the firm’s litigation practice.

Stephen Kyriacou is a senior vice president and senior lawyer in Aon’s Litigation Risk Group. He joined Aon after practicing law for eight years as a complex commercial litigator at Boies, Schiller & Flexner.