New coverage for potentially huge financial risk

New coverage for potentially huge financial risk | Corporate Risk & Insurance

New coverage for potentially huge financial risk
By Martin G Durkin

Class action litigation creates a material financial risk for defendants.  The need to mitigate or eliminate this risk is a leading reason defendants seek to settle class actions.  Where a defendant faces significant liability, the structure of the settlement can have a material effect on the ultimate financial impact.  In these situations, counsel needs to be creative and flexible to craft a settlement that is both fair to the class members, and affordable or within the defendant’s risk tolerance.

One valuable tool for limiting liability in class settlements is class action settlement insurance or “CASI”.  CASI is a post-settlement insurance product used to manage settlement risk, cap exposure, and give a client certainty as to its actual liability in a class settlement.

Class action settlements involving the distribution of payments to class members are generally resolved on a common-fund or claims-made basis.  In a common fund settlement, a defendant negotiates to pay a fixed total amount for the settlement into a settlement fund.  That amount is then apportioned among class members who file claims as part of the administration process.   In a claims-made settlement the defendant agrees to pay a fixed amount to each class member who submits a valid claim, but the total amount of defendant’s liability will vary depending on the number of valid claims filed. Importantly, the claims-made settlement, although it only pays the claims of class members who file them, releases the claims of the entire class.”

CASI, which is only available in a claims-made settlement, is an insurance policy used to protect against the risk of an abnormally high claim rate. In a claims-made settlement, the defendant is obligated to pay valid claims submitted by class members. In most class actions the actual number of class members submitting a claim is far less than the total number of potential claims.  The claim rate can vary materially based on the settlement amount, class demographics, claims process, and other factors.

Under a claims-made settlement, the maximum class benefit is determined by multiplying the claim benefit by the number of class members, but the ultimate cost of the settlement to the defendant is based on the number of class members who submit valid claims.  The defendant is not required to fully fund the maximum benefit.   The insurance is built around the insurer’s forecast of the actual number of claims expected to be submitted and paid.  For example, if a class consists of 1,000 members, and the settlement provides for a benefit of $100 for each member, the total potential exposure to the defendant is $100,000.  An insurer may agree to underwrite the settlement for a fixed premium of $40,000 based on its projection that less than 40% of class members will submit a valid claim.

While CASI is a “post-settlement” insurance product in that it is purchased and placed after the terms of the settlement have been finalized, it is important to incorporate CASI issues into the structure of the settlement, and to consider the underwriting factors, as these will have a material impact on the availability and cost of the insurance.

CASI is used most effectively when a defendant simply wants to quantity the total cost of settlement and to remove the contingent liability from its books.  By purchasing a CASI policy, underwritten by a highly rated insurer, the defendant is able to remove the uncertainty of the final settlement cost and to book a fixed amount sooner.  This can be valuable when a class action lawsuit, a potentially material contingent liability, is interfering with the sale of a business, the refinancing of a credit facility, or other material transaction.

Before making a final decision to purchase a CASI policy a defendant should review the operation of the policy and the role of the insurer stepping into the settlement.  Because CASI is first and foremost insurance, it is important to review the policy in detail prior to placing coverage.  The language of the policy will govern coverage.  Defendants must understand the precise terms of coverage, and how seemingly minor changes in the claims process or the interpretation of the settlement agreement can have a material impact on coverage or the premium.  CASI policies should be reviewed by experienced insurance counsel to assure that the risk is adequately addressed and covered.  Additionally, the insured needs to understand the new role of the insurer in the administration of the settlement.  Although the insured will remain the named defendant, it will no longer be in control of decisions regarding day to day issues of the settlement and how those issues are resolved.  The insurer, who is now responsible for payment, will be controlling those issues. 

CASI, and the factors reviewed by underwriters in setting a premium, is valuable even if the defendant elects not to purchase the insurance.  The defendant negotiating the terms of the settlements and the claims process, should consider these same underwriting factors in evaluating the settlement.  Factors that are material to claims rates include the individual benefit award, the class demographic, the claims process, claim validation and correction review, and the claim period.  Minor changes in the award and process, can have a material effect on the total settlement amount.  Working with an experienced claims underwriter, defense counsel can provide the client will a better analysis and understanding of the risks and potential claim rate for various settlement structures.  With this additional information the client will be in a stronger position to meaningfully evaluate its options and forecast its likely total liability.  

CASI is an insurance product used to protect against a known, but undefined risk. As insurance, the premium to purchase CASI may be deductible as a business expense.  Under the Internal Revenue Code, insurance premiums can qualify as ordinary and necessary business expenses.  Whether CASI qualifies in a particular matter, must be determined on a case by case basis by a tax professional.

Martin G Durkin is a partner at Holland & Knight LLP and a member of the firm’s litigation section.

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