By Russ Banham
Carrier Management magazine
Having already paid out billions of dollars in claims related to the Eaton fire, more than 100 insurers have filed lawsuits against Southern California Edison to recoup these costs, alleging the utility’s electrical equipment is the ignition source. Other insurers have made a choice not to sue and have instead sold their subrogation rights.
Home insurer Hippo is among them. Rick McCathron, Hippo’s CEO and President, said the sale of its subrogation rights in March to an unnamed party was financially beneficial, reducing the insurer’s $42 million in estimated pre-tax losses from the Eaton and Palisades fires by approximately $15 million on a gross basis and $11 million on a net basis. The decision to sell rather than sue, he said, was based on “significant economic damage calculations,” including the time value of money and the utility’s bankruptcy risk, among other factors.
The proceeds from the sale of Hippo’s subrogation claims “compare favorably” with what the insurer would have received by pursuing these claims on its own through the legal system, he said. Cash in hand offers financial certitude, whereas long, drawn out court battles are wearisome and costly, the clock ticking on attorney billable hours. Still, if Hippo’s lawyers decided to go for the jugular in court and Southern California Edison was found at fault for the Eaton fire, the insurer may have collected more cash, money offsetting a greater cost of claims to potentially decrease premiums for policyholders.
That’s the lesson from the Camp fire litigation against Pacific Gas & Electric (PG&E), whose electrical transmission lines ignited the 2018 wildfire and forced the utility into Chapter 11 bankruptcy. At least a dozen insurers, including CSAA Insurance Group, Nationwide, Farmers Insurance, AMCO and 21st Century sold their subrogation rights to Baupost Group, a hedge fund, according to documents addressing PG&E’s bankruptcy. Some insurers sold for pennies on the dollar. CSAA, for instance, reportedly sold $1 billion in subrogation claims to Baupost for 35 cents or less. “The insurers that held onto their subrogation claims did much better than those that didn’t,” said Dave Jones, California’s Insurance Commissioner from 2011 to 2018.
While Jones acknowledges that the bankruptcy court could have extinguished the claims from policyholders whose homes were damaged or lost by the Camp fire, the insurers that held onto their subrogation rights and the investors that bought them from other carriers recovered 87 percent of the total insurance payments made to policyholders. Baupost’s total $6.8 billion investment in subrogation claims against PG&E for a series of wildfires in 2017 and 2018 generated a whopping $3 billion profit, Bloomberg reported. Carrier decisions to sell their rights to sue resulted in a missed opportunity. “Hindsight is always 20/20, but the insurers that held onto the subrogation rights did much better than those that sold them,” Jones said.
Nevertheless, the former state regulator said that Hippo’s sale of its subrogation rights in the Eaton fire may be a smart move. “Hippo is not a major insurer. Given how small they are, with a much smaller number of claims from the Eaton fire than other insurers, it may make a lot of sense for them to sell quickly, due to the cost of litigation versus the potential return,” he said. “Other insurers are still working through their claims and may not know for some time their final cost of claims, or even near final.”
A Number’s Game
The economic calculus for determining whether to retain or sell subrogation rights begins with a strong likelihood of an at-fault party. Although the cause of the Eaton fire remains under investigation, video and witness reports of sparking near Southern California Edison’s transmission lines suggest the utility may be responsible for igniting the blaze. “It’s very clear to us that the probable cause of the Eaton fire was Southern California Edison’s faulty electric utility equipment, whereas liability for the Palisades fire is not as clear,” said McCathron. Hippo did not sell its subrogation rights for claims received from the Palisades fire.
After reaching the decision to sell its subrogation claims from the Eaton fire, a series of calculations ensued to arrive at a proper sales price. “We start with a number we think we would get if we sued the utility outright,” said McCathron. “Hypothetically, let’s say that’s 90 cents on the dollar, meaning if our gross event is $50 million, we’d collect about $45 million. From that figure, we subtract our expected attorney fees, which are generally high since these cases can drag out forever. Let’s say that’s $10 million, bringing us down to $35 million. We then estimate how long it would take to collect this time value of money, say five years at a 20 percent discount rate per year. That brings us down another $10 million to $25 million.”
The last calculation is Hippo’s reinsurance costs, which is difficult since the reinsurance contract may include two catastrophic events residing in different parts of a reinsurance tower, among other complications. He estimated this cost for the Eaton fire at $5 million. “That $20 million number represents the floor in our negotiations,” he said. “Investors then come to us through brokers and give us their numbers. If they’re above our floor, we are apt to take the offer. If it’s below our floor, we negotiate to get it closer.”
Rates and Risks
Certainly, an insurer determined to sell its subrogation rights—a practice rooted in common law since Roman times and formally established by the Magna Carta in 1215—treats the decision with utmost seriousness. Nevertheless, interviews with several insurance industry experts and onlookers unearthed significant concerns about what appears to be a growing trend.
Chief among them is how the income from the sale of an insurer’s subrogation rights is treated in requests to regulators for a rate increase. In the 16 states where insurance rates are regulated (other states and territories file and implement rates as they see fit without a regulatory review), insurers are required to file information about the revenues they receive from exercising subrogation claims or from the sale of these rights.
“The way it works is when an insurer gets a subrogation payment, it is reported to the Department of Insurance as part of the next rate filing and gets included in the analysis of how well the carrier is doing financially for the purpose of deciding how much additional rate it will receive,” said Jones. “That revenue would be considered in setting the rate going forward, effectively offsetting some portion of the loss the insurer uses to justify an increased rate going forward.”
However, economist Robert Hartwig, Associate Professor of Finance at the University of South Carolina, said regulators should “seriously question and potentially deny a rate increase to an insurer that simply sells it off to a hedge fund as a matter of course. While the existence of a market for insurers to sell their subrogation rights is beneficial to the carrier and ratepayers alike, [sales] should only occur if recovery from a negligent party is doubtful, uncertain, costly or of indeterminate length.”
Hartwig, who also leads the university’s Risk and Uncertainty Management Center, provided the example of an insurance company that theoretically could recover 85 percent from an at fault party in five years but decides to recover 35 percent from a hedge fund shortly after the loss event.
“It is in the insurer’s interest to maximize the return they receive on their subrogation rights, making it inappropriate in my view to not wait the full five years to recover the 85 percent,” he said. “From a ratemaking standpoint, the insurer should build into their rate an expectation that there will be subrogation and include in that the historic proportion of their recoveries. If they instead opt to sell their subrogation rights on a regular basis, the historic proportion of those sales should be built into the rate, a percentage figure typically much lower.”
Lower recoveries on a historic basis from the sale of subrogation rights would weaken insurer requests for a rate increase, whereas higher recoveries on a historic basis from the retention of these rights would strengthen this possibility, he explained.
A related concern is the price that an insurer arrives at to sell their subrogation rights. Jones said that regulators should review insurers’ pricing rationale, but the former insurance commissioner doubts many regulators conduct the examinations. “The usual practice is to view these as arm’s length transactions between two sophisticated parties,” he said. “Insurers are motivated to get the best possible deal, so there is little or no oversight.”
Hartwig offered a similar perspective. “Insurers engage in calculations every day when it comes to making decisions about whether to settle a case or take it to trial [making it] unlikely that a regulator would need or want to engage in a review of the process used,” he explained. “Regulators do, of course, have the right to review every component of a rate filing, and that would include how the insurer accounts for the value of its subrogation rights.”
If more carriers continue to pursue subrogation sales after a devastating wildfire, two different claims treatment strategies may ensue, with both positive and negative consequences for policyholders, said Douglas Heller, Director of Insurance at the Consumer Federation of America.
“A carrier that sells its subrogation rights may be compelled to pay claims more quickly, a good thing, but there are also potential policyholder downsides,” he said. “The cash in hand insurers receive could encourage them to become reliant on financing more of their claims. The quick money may compel them to tighten the belt on the other claims they don’t subrogate or sell off, taking more time to pay these claims to the detriment of policyholders.”
Litigation Finance
Some but not all interviewees likened the sale of subrogation rights by carriers to the insurance industry’s longstanding criticism of Third Party Ligation Funding (TPLF) firms providing financial support to a plaintiff. Carriers reproach TPLF for driving up the cost of legal verdicts and settlements, forcing them to increase insurance rates. The sale of subrogation rights to a hedge fund, whose attorneys are highly skilled at securing large judgments in litigation to reap a profit for investors, may correspondingly drive up the cost of verdicts and settlements.
“What’s surprising and fascinating is that the insurance industry has demoted TPLF for causing what it calls `social inflation’ and yet it turns around and does the same thing, selling its subrogation rights to a hedge fund that will extract maximum financial gain from a defendant company,” said Tyler Leverty, Associate Professor of Risk and Insurance at the University of Wisconsin School of Business.
Jerry Theodorou, director of the finance, insurance and trade program at R Street Institute, a U.S.-based center-right think tank, said that insurers are “smart enough to know that TPLF doesn’t fuel frivolous lawsuits—they invest in meritorious claims likely to go to court and settle for large numbers. TPLF is all about the ‘Benjamins,’ the big money, whereas subrogation is about responsibility.”
The sale of subrogation rights to a hedge fund that will go the distance in a case is a legitimate way of forcing a responsible party to pay for the damages they caused, Theodorou said. “I imagine that some insurers give up their subrogation rights when the probability of recovering is pretty low. Hedge funds potentially have more aggressive legal tactics. Baupost, for instance, probably has a higher chance of getting a significant recovery [than an insurance company].”
Leverty agreed. “Hedge funds have deep pockets and a time horizon longer than an insurance company that’s looking at protracted litigation over many years. There’s also a capital efficiency argument where an insurer needs funds now to pay losses,” he said.
This “win-win” possibility was echoed by David Perla, Vice Chair at publicly traded Burford Capital, a global provider of legal finance solutions. Perla said the sale of an insurer’s subrogation rights to an investment firm like a hedge fund makes complete sense. “The fundamental difference between an insurance company and a hedge fund is that the insurance company is bound by capital adequacy regulations, possibly impelling it to settle earlier or cheaper than it would prefer. A hedge fund, which is not regulated in terms of capital adequacy, has more latitude in terms of timing and the amount of settlement,” Perla explained.
John Koch, Deputy General Counsel and a member of the Insurance Counseling and Recovery Group at law firm Flaster Greenberg, affirmed the reasons why insurance carriers sell their wildfire subrogation rights. “It’s a question of whether to invest all this time and money into litigation to potentially get a recovery years later, or to have cash in hand now to offset losses,” he said. “In making this decision, a huge actuarial analysis is undertaken to project the likely recovery and other factors. It’s all numbers.”
Nevertheless, Koch, who often writes about subrogation for legal publications, does not share the opinion that hedge funds have more aggressive legal tactics to secure a bigger windfall from defendants. “It’s not an accurate description,” he said. “Any insurance company worth its salt is perfectly capable of hiring the best of the best [law firms] for a whopping claim. I know some of the insurer subrogation firms and they’re very good. From a technical or legal standpoint, a hedge fund is in no better position to litigate for the recovery than the insurer.”
Subrogation Ups and Downs
Two other subjects were discussed with the interviewees: a recent court-imposed limitation of insurers’ subrogation rights, and a legislative resolution urging carriers to exercise their subrogation rights against fossil fuel companies for climate change-induced wildfires. Both topics stem from the 2023 Maui wildfires in Hawaii, caused by utility Hawaiian Electric equipment.
In February, Hawaii’s Supreme Court ruled that insurers cannot pursue their respective lawsuits against the utility and other responsible parties, requiring them to seek reimbursement from a $4 billion settlement fund. The decision restricting insurers’ subrogation rights in wildfire-related lawsuits establishes a significant legal precedent possibly compelling other states to impose similar constraints. While Hartwig supports the creation of a settlement fund ensuring the continuing viability of a utility and full compensation for insurers, he is concerned over a legal precedent impeding insurers’ right to subrogate.
“The right to subrogate is enshrined in law and no government has the ability to abrogate that right,” he said. “If an insurer is unable to subrogate, it may suffer a [ratings] downgrade and, in a worst case scenario, may become impaired at some point.”
Heller from the Consumer Federation of America is equally worried about the implications of the decision. “The subrogation rights of an insurance company are drafted in a contract guided by law. Carriers’ [legal] claims against a responsible party should not be limited in any way,” he said.
In a separate development, Hawaii’s legislature passed a resolution in May urging insurers to exercise their subrogation rights against the fossil fuel industry. The state’s Attorney General also filed a lawsuit the same month against several oil and gas companies and their trade association, alleging deceptive practices in not warning the public about their products’ climate risks.
“More states, including California, are calling on insurers to exercise their subrogation rights against oil and gas majors for their emissions contribution to climate-driven catastrophic events,” said Jones, Director of the Climate Risk Initiative at UC Berkeley’s Center for Law, Energy and the Environment. “Assuming they do, it could help offset the challenges we now see in insurance pricing and availability. No insurer has stepped up, however. There’s no excuse for not doing it.”
Would it benefit insurers to sell their subrogation rights to a hedge fund that takes the offensive against the fossil fuel industry? “I suspect that insurers have not explored in any way the third-party market for their subrogation rights against oil and gas companies,” Jones said. “That’s a reasonable question to ask of the insurers.”