Litigation Expense Policies

A litigation expense policy is simply an insurance policy that pays for the costs defending a lawsuit. If a defendant’s only insurance is a litigation expense policy and the insured loses at trial, the litigation expense policy will not pay the plaintiff or indemnify the insured for its losses. It only covers litigation expenses.

In the mid-1990s, with the emergence of the modern captive markets, litigation expense policies resurfaced as a flexible and sophisticated asset protection tool. These instruments now play an important role in advanced asset protection planning.

The primary value of a litigation expense policy is that it pays the legal costs of defending certain claims without making a pot of money available to a plaintiff who is able to obtain a judgment. The issuing insurance company — but not the insured — retains the right to settle the claim within remaining policy limits, meaning that the longer the litigation lasts the less money will be available for settlement, all the way down to nothing. For plaintiffs’ attorneys, this is a tremendous incentive to settle the case early and within the limits of the LEP policy.

But litigation expense policies can cover more than just litigation expenses. Litigation expense policies can be negotiated to cover a broad range of risks, including paying for the lost work time of the insured in responding to discovery requests and travel expenses to and from key depositions and trial.

Litigation expense policies may also be used to strengthen the effectiveness of existing insurance. One way in which they can do this is by providing counsel in addition to the attorney provided by the primary liability insurer in order to ensure that the insured’s interests are well covered, and in order to provide additional assistance in the litigation. Similarly, litigation expense policies also provide “bad faith” coverage to challenge the primary insurance company’s failure to defend a claim or to cover a judgment. A comprehensive litigation expense policy will pay for the cost of hiring an attorney to write demand letters to the primary insurance company insisting that they aggressively defend the case, or settle, if that is in the client’s best interests, and to pay claims to the fullest limits of the policy in the event of a judgment. The presence of a watchdog may keep the primary insurance company from abandoning interests of the client, or at least position the client to bring a bad faith case against the insurance company should it fail to honor the terms of its policy.

Another feature of litigation expense policies is the concept of the “dedicated reserve”, which is a segregated reserve account set aside specifically for the particular policy for which the premium is paid (after the insurance company’s deduction for its fees). The dedicated reserve ensures that regardless of what happens to the insurance company, funds will be available to meet claims.

Litigation expense policies can contain a number of other useful features, limited only by the imaginations of the parties negotiating the policy’s terms. Because litigation expense policies of the type described here are sold exclusively by small offshore insurance companies, their policy provisions can be quite flexible without the risk of interference from the local insurance commissioner.

Although a creditor may challenge the payment of premiums to an insurance company for a litigation expense policy as a fraudulent transfer, that challenge is unlikely to be effective. The transfer of the premium is “for value”, i.e., the insured receives valuable policy benefits in exchange for the premiums paid. Also, if the insurance company is offshore it will be unlikely to refund the premium depending on the terms and services already provided, including, presumably, funding the fraudulent transfer litigation. Thus, litigation expense policies can be useful tools even for a debtor involved in an current lawsuit.

Like any other sophisticated products, litigation expense policies are subject to abuse. In particular, beware of refund policies which are pitched as an asset protection tool but are little more than a dubious tax shelter. Marketed primarily to physicians, these products promise that the insured can pay a premium to the insurance company, take a business deduction for it, and then at the end of the policy term recapture the premium inside a cash-value life insurance product, Roth IRA or some other tax advantaged investment vehicle, allegedly allowing the insured to deduct the substantial premium then to receive the funds back tax-free without recapturing the income tax deduction. These schemes are clearly questionable and aggressive tax shelters. Furthermore, the insurance policies usually do not stand up to scrutiny as insurance policies. For example, coverage limits may be identical to premiums paid, or the policy may require the payment of additional premiums if claims exceed the initial premiums paid. Many such policies require the transfer of money offshore, which of course raises serious concerns about the potential loss of the money to embezzlement and tax or financial transactions reporting requirements that could compromise the supposed tax and asset protection benefits. The IRS is examining at some of the more heavily-marketed arrangements and we would not be surprised to see them soon specifically designated as illegal tax shelters.

Litigation expense policies are really not designed to be tax products, although they have occasionally been used that way. The problem with using them as tax products is that litigation expense policies are meant to be last-ditch products that creates powerful asset protection weapons in the event a determined creditor comes along. Litigation expense policies which are also designed to be tax shelters may compromise the insurance coverage, for if the IRS says that for tax purposes, the policy reserves really belong to the policyholder, the creditor might have an opening to convince a court that the policy reserves really belong to the policyholder for legal purposes as well. A truism of asset protection applies here: that which attempts to accomplish everything often will accomplish nothing.

When considering a litigation expense policy, a U.S. attorney familiar with onshore and offshore property and casualty policies in general as well as with litigation expense policies should always be employed to negotiate the terms of the policy and to investigate the issuing insurance company and the totality of the arrangement.

LEPs are ideal policies to be issued by captive insurance companies.