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Study: Tort costs go down, employment goes up

By Michael P. Tremoglie | Oct 31, 2011

WASHINGTON (Legal Newsline) - The costs associated with the United States tort system are excessive compared to other countries

Recognizing this, the U.S. Chamber Institute for Legal Reform commissioned a study that examines the economic consequences in all 50 states because of the legal milieu. The study was conducted by NERA Economic Consulting of New York City.

The report "uses a first-of-its-kind econometric model to estimate the economic savings each state can realize by improving its legal environment." NERA is a global firm of experts that solves complex business and legal problems through the application of economic, finance and quantitative principles.

The study, authored by Paul J. Hinton and David L. McKnight, was released Wednesday at the 12th Annual Legal Reform Summit. The ILR puts on the summit and owns Legal Newsline.

The report is comprised of state liability cost data and from that derived an econometric model that provides a graphic illustration of how liability costs vary by state and how significant the potential cost savings could be from incremental improvements in the legal environment in individual states.

There are perceived inequities among the states in terms of the fairness and reasonableness of their tort systems. Some have much higher levels of tort filings in relation to their size. This consistently produces a greater proportion of the most extreme verdict awards. Based on the analysis contained in the study, this resulted in higher tort costs overall.

The study also shows that by simply changing the legal standards in states with the costliest tort environments as well as achieving savings that some states have already been able to achieve, a 26 percent reduction in tort costs could be realized.

Two separate measures of the legal environment were used. One was the perception of in-house counsel reported in the Harris State Liability Systems Ranking Study, which was commissioned by the U.S. Chamber of Commerce. The other was a tort activity index NERA developed for each state.

The state index values were based on the estimated annual number of tort claims filed, frequency of top verdict awards and concentration of lawyers practicing in the state.

Benchmarks were provided by the states perceived to be the fairest and most reasonable in terms of the legal environment, as well as, the state with the lowest tort activity. This "Legal Environment Benchmark" was used to measure the effect of the legal environment on tort costs.

The possible cost savings were projected by formulating how much higher the costs attributed to the legal environment were in each state compared to the LEB. The savings estimates of businesses' tort costs could also be realized in medical malpractice and personal liability costs for each state.
The authors posit that the economic benefits of tort reform will result in an economic stimulus without a concurrent loss in tax receipts, that this is easy to achieve, and that it does not require spending increases. An improvement in the legal environment is essentially a cut in the "tort tax."

While the authors of the study concede that they do not provide a guide for the specific legal reforms that would lessen the costs of the more expensive state, they do measure how much costlier the tort environment is in each state compared to the benchmark. Empirical economic data is furnished to support the proposition that improving a state's legal environment provides the equivalent of tax relief and a concurrent economic stimulus.

The authors state, "Using the response of business to tax savings measured in prior studies, we estimate that the stimulus resulting from improvements in an individual state with the costliest legal environment could increase employment by as much as 1.0% or even 2.8%. In a large state such as New York or California, this could add hundreds of thousands of jobs."

The monograph refers to an annual study of U.S. tort costs which is performed by the actuarial firm of Towers Watson. This study by Towers Watson produces estimates which are routinely cited as a yardstick in public policy discussions. TW relies on liability insurance premiums and loss ratios published by the independent and nonaligned auditor of insurance companies A.M. Best and SNL Financial.

Multiplying premiums by loss ratios provides an estimate of the amounts paid out by insurers in 2009. TW supplements these data with its own estimates of the proportion of costs that are self-insured or uninsured.

According to the ILR report, TW's estimate of the cost of the U.S. tort system in 2009 is $248.1 billion. This is 1.74 percent of the U.S. gross national product and represents a total of $808 per person. Commercial liability costs of businesses - excluding medical malpractice - comprise $122.7 billion of this.

Liability insurance costs have long been used to estimate the effect on costs of different tort system features by comparing before and after tort reform costs in different states. But these studies are not useful in estimating the cost of the entire system. Other studies of the effects of tort reforms have measured resulting changes in the number of lawsuits filed and the value of damage awards.

According to a 2009 survey of Fortune 200 companies, litigation costs continue to increase and consume more and more revenue. The survey found that there was an average of $140 million in outside litigation costs in 2008. This was an increase of 112% from $66 million in 2000. Average annual litigation costs as a percentage of revenues increased 78% for the 14 companies that provided data.

High transaction costs are not limited to large corporations. Claims across several types of liability insurance coverage are held by companies of all sizes. Professors Joni Hersch and Kip Viscusi of Vanderbilt University School of Law conducted a study of closed commercial claims in Texas from 1988-2004 in which $10,000 or more was paid by an insurance company to a plaintiff for a personal injury claim. For every $1 that was received by the claimant, "an average of $0.75 was paid in legal and administrative costs over all claims and $0.83 in legal and administrative costs when the plaintiff had retained an attorney and filed suit."

The 2008 tort liability expense for U.S small businesses - those with less than $10 million in revenue - was $105.4 billion. This includes both dollars paid for legal costs as well as money paid to plaintiffs. Small businesses bore "81 percent of business tort liability costs but took in only 22 percent of revenue. A large portion of these costs ($35.6 billion) was paid out of pocket as opposed to through insurance."

According to the report, the study of tort liability costs relative to products and services have been the target of academicians and researchers for two decades. The challenge to such research has been the development of metrics to accurately gauge liability costs. The authors pointed out two recent surveys of small businesses. One was conducted by Public Opinion Strategies and Douglas Schoen (the "POS/Schoen poll"), and the other by the independent polling firm Harris Interactive (the "Harris Small Business poll"). Both were conducted on behalf of the U.S. Chamber Institute for Legal Reform.

The POS/Schoen poll was done in August 2010. It revealed that frivolous lawsuits are considered an extremely serious problem by small business owners (with 65 percent calling the problem "very serious," 29 percent "somewhat serious," 6 percent "not so serious," and 1 percent "not at all serious").

Seventy-three percent said that a lawsuit could affect a small business's ability to get credit, and 71 percent said a lawsuit could increase the cost of doing business, leading them to delay or curtail hiring new employees.

The Harris Small Business poll was done from November 2006 through February 2007. It found that the threat of frivolous or unfair lawsuits had caused almost two-thirds of those concerned business owners or managers interviewed (62 percent) to make business decisions specifically for the purpose of avoiding such suits.

These avoidance decisions were reported to have had detrimental effects for customers and employees. They made:

The ILR study concludes that reform of the tort system could lower commercial tort costs by up to 26 percent - with medical malpractice costs and personal liability costs lowered by similar amounts. The study also illustrates the job creation benefits that tort reform could have in individual states.

The reports states that in those "states with the most costly legal environments, improving the legal environment could stimulate private sector employment by 1.0 percent to 2.8 percent. In New York, for example, improvements to the legal environment could create between 74,000 and 202,000 jobs."

However, this report is not a primer on how to assess the ability of tort reforms to improve the legal environment. It does not claim to say what causes the level of tort activity in a particular state. It does attempt to quantify the full extent of excess costs in the U.S. tort system.

The report estimates the savings if a given state would improve its tort environment to match that in the state perceived to be the most fair and reasonable-and the state with the lowest level of tort activity.

The report can be found here.

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