Contracting on litigation

Two risk-averse litigants with different subjective beliefs negotiate in the shadow of a pending trial. Through contingent contracts, the litigants can mitigate risk and/or speculate on the trial outcome. The opportunity for contingent contracting decreases the settlement rate and increases the volume and costs of litigation. These contingent contracts mimic the services provided by third-party investors, including litigation funders and insurance companies. The two litigants (weakly) prefer to contract with the external capital market when third-party investors are risk neutral and the capital market is transaction-cost free. However, contracting with third parties further decreases the settlement rate, increases the volume and costs of litigation, and may increase the aggregate cost of risk bearing. In this sense, third-party involvement in litigation can reduce social welfare