Impact Blog

Social inflation is a term referring to when re/insurers' claims costs increase above general economic inflation. In the short term, this can occur for purely economic reasons, such as an acceleration in the cost of health care. However, more recently, litigation has emerged as a source of abnormally elevated claims costs for re/insurers; and this has turbocharged social inflation to levels rarely seen before. This growing trend to litigate claims and the associated costs has created critical, financially material risks for the re/insurance industry.

ESG analysis usually does not focus on social inflation because of the lack of direct indicators to gauge it. Likewise, traditional investors tend to neglect this challenge owing to their relatively low interest in assessing litigation risk through time and across securities. Calvert's research approach bridges this gap by building on our expertise in evaluating litigation risk.

Litigious trends on the rise globally

The global corporate environment has become increasingly litigious because of the interplay of two societal trends. The first is the loss of trust in institutions. The second is the sentiment that companies should be held accountable for a variety of issues, such as climate change or social equality.

In the U.S., social inflation is further exacerbated by several idiosyncratic factors. First, juries are increasingly awarding massive punitive damages in tort cases. For example, the share of general liability verdicts above $5 million almost doubled from 7.8% in 2012 to 14% in 2022.¹ Second, ample third-party litigation funding (TPLF) is helping plaintiffs pursue cases for longer. Between 2019 and 2022, the U.S. TPLF market, as measured by assets under management, increased by 44% to $13.5 billion.² As only $3.2 billion was deployed by the end of 2022, it is safe to assume there is enough firepower for this trend to continue. This is especially true in view of challenges posed by novel issues such as PFAS (perfluoroalkyl substances), which are linked to cancer, algorithmic liability (where AI algorithms fail to perform as expected) or addictive software design, intended to keep people "hooked."

Insurance industry at epicenter of risk

Although social inflation poses material issues across multiple sectors, the insurance industry is at the epicentre of the problem from a financial materiality perspective. The more litigious the corporate environment, the more insureds attempt to recoup part of their legal expenses from filing insurance claims - and by litigating with re/insurers when they are not paid. This translates into abnormally high claims costs for re/insurers, with areas with the longest tail lines, or settlement periods - such as occupational diseases, medical malpractice, and cybersecurity - being particularly prone to being disrupted.

Calvert's approach to litigation risk

In our view, litigation risk as a source of social inflation in liability insurance is a negative externality that investors struggle to model. At Calvert, we utilize both a backward and forward-looking approach to evaluate the extent to which re/insurers are exposed to this risk.

• Our analysis includes a qualitative review of the legal cases the companies we cover are involved in. We assess the economic impacts of past legal cases, gathering granular, company-specific insights as to the evolving source, nature and materiality of litigation risk in a given market.
• We complement this qualitative and backward-looking approach with quantitative indicators that are based on the volume of litigations that re/insurers are facing at a given point in time. This data serves as a forward-looking proxy for vulnerability to future legal liabilities because it focuses on all outstanding litigations, only a proportion of which will have adverse economic impacts for the re/insurer.

Bottom line: In the medium term, social inflation will continue to affect the profitability of liability insurance companies with a disproportionate impact on those industries with the longest tail lines. This is a global trend; but U.S. re/insurers appear more exposed to it. Although it is challenging to price in litigation risk as a source of social inflation, our deep research leverages both backward-looking qualitative analyses and forward-looking quantitative indicators to extrapolate risk levels on a company-by-company basis.