Modeling potential liability costs in large class-action cases with incomplete information

Business Economics, April, 1995 by Robert D. Shriner, Philip B. Cook

Large class-action product liability cases pose special analytical problems for defendant firms. The firm needs to assess realistically the likely costs of resolving claims presented by class participants plus suits and other claims filed separately by "opt-outs," often at an early stage at which the number of claimants and the nature of their claims are still uncertain. The firm's chief financial officer may need to allow for potential claims payments in the firm's cash flow planning and, in major liability situations, also determine whether the probable costs are great enough to exceed the firm's insurance coverage or to be financially "material" to the firm and thus subject to mandatory disclosure under SEC regulations. The firm's legal counsel must have the best available simulations of the effects of various possible settlement strategies, offers, and counteroffers in order to negotiate advantageously and effectively.

In this article, we summarize techniques we have used to develop simulation and forecasting models to estimate the probable extent of liabilities and the likely costs of settling claims arising from major product liability situations. These liability estimation models often combine claims data, marketing and product use data, medical and epidemiological data, medical care cost data, actuarial data, and other information, including expert opinions, that may be relevant to the situation.

Economists often shy away from using noneconomic (i.e., scientific, technical, legal, medical, sociological, etc.) data in their analyses. We explain why it is important to make effective use of such data when they exist and how to assess and avoid potential problems in their use. We also identify common problems that arise with such data. And, finally, we discuss the use and adaptation of the results for changing needs in claims and negotiation management, litigation strategic planning, corporate financial planning and reporting, and other management and legal uses.

The estimation of aggregate product liability costs, particularly in large class-action cases such as those that have become increasingly common in the United States, has rarely been discussed in the economic literature. Several factors discourage such discussion: reluctance of practitioners to discuss secrets of their craft, constraints on the disclosure of confidential business and legal information, bias against discussions of applications rather than theoretical or macroeconomic issues in much of the economic literature, and the special nature of particular class-action cases. In spite of these obstacles, we hope to provide a brief nontechnical overview of the major analytical issues and processes involved in the practice of modeling and estimating product liability costs, based on our own experience, while avoiding the more problematic discussion of specific cases, models, and mathematical methods.

PHASE 1: PRELIMINARY ESTIMATION OF LIABILITY COSTS

"You know it's going to be a bad day when...."

Reporters from major state and local newsrooms are calling to confirm reports that hundreds (perhaps thousands) of people are reporting injuries or illnesses caused by products made or sold by your firm. The legal department, after consulting with the firm's insurance carrier, has hired a claims adjustment organization to handle claims and settle as many as possible quickly, and the claims are pouring in. The CEO has his staff preparing a "heads-up" for the Board, who'll want to know "how big is the problem," as well as "how did it happen," and "what's being done to fix it." The CFO is getting calls from Wall Street analysts with similar questions. Your phone rings...

The first task is trying to estimate how many customers are affected and the likely impact on them. How many claims have been filed? How many were settled. (if any) and at what cost? Are the problems attributable to a single batch, model, or configuration, or to several? How many units were produced? What kinds of problems are being reported? Does it appear that there is a single injury/illness mode, or several? What is the relative frequency among different modes if there appear to be several? What medical measures, hospital days, lost time, or other impacts appear to be prompted by each injury mode? Are the consequences different for different individuals, depending on their behavior or personal characteristics (age, sex, genetics, environment, etc.)?

If there are settled claims, use that as the starting point because the substance of the claims will have been checked by adjusters. Determine the average settlement amount and the ratio between settlement amount and medical costs or other losses cited by claimants. If there are multiple injury modes, or levels of severity, determine the average settlement amounts and ratios for each, along with their relative frequency. Because initial settlements are likely to be those that are easiest to achieve, these averages, ratios, and frequency distributions provide the foundation for estimating the low end of the likely cost range. They can be multiplied by actual losses reported in filed but unsettled claims to make a tentative estimate of the minimum likely cost of settling those pending claims. If there is enough time-series information on claims, it may be possible to assess whether there is a measurable pattern of change over time in either claims or settlements. However, this is rarely determinable in the early stages of a case.