Optimal Litigation Insurance Contracts

We study the problem of a monopolist selling defensive litigation insurance which can cover damages and/or litigation costs, e.g. in the context of patent litigation.  We derive the optimal insurance contract for an entrepreneur whose market activity risks inadvertent patent infringement.  We consider the case where the entrepreneur is uninformed about the strength of the litigation threat it faces, as well as the case where the entrepreneur knows exactly the threat that it faces.  The insurer’s problem features both adverse selection and moral hazard, because the insurance contract changes the agent’s incentive to settle out of court.  We find that optimal insurance is more likely to preclude litigation when entrepreneurs are privately informed about the threats that they face.  We then extend the model to add competition among insurers, and show that the equilibrium  typically features a polling contract which precludes litigation on the equilibrium path.