Long-tail liability refers to types of insurance claims or liabilities that can be settled over a long period of time. These liabilities arise from harm or injury where the full extent of damage is not known immediately and may take years to fully manifest or settle. This term is most commonly used in the insurance industry.
For example, in a workers’ compensation policy, an employee may get injured on the job and require ongoing medical treatment and rehabilitation. The insurance company may have to make payments for these costs for several years. Similarly, in the case of liability insurance, if a company produces a product that causes harm or damage, claims may come in years after the product was sold.
Long-tail liabilities present particular challenges for insurance companies as they must estimate the potential costs of these liabilities and ensure that they have set aside (or “reserved”) enough funds to cover them. Predicting these costs can be difficult due to uncertainties regarding the duration and cost of claims, changes in medical costs, and potential changes in legal or regulatory requirements.
Outside the insurance context, long-tail liability can refer to any type of liability where the extent of the obligation is not known for a significant period of time after the event that triggered the liability.
Example of a Long-Tail Liability
Let’s look at an example in the context of an insurance company dealing with a long-tail liability:
Imagine InsureCo, an insurance company, sells product liability insurance to a company called MedEquip Corp, which manufactures medical devices. One of their devices is an innovative heart valve that is implanted in patients.
Several years after the heart valves have been sold and implanted, it is discovered that they start to malfunction after five years, leading to health complications. Patients start filing lawsuits against MedEquip Corp. As MedEquip Corp has product liability insurance, these claims are directed to InsureCo.
Even though the insurance policy was written years ago, InsureCo now faces claims resulting from this policy, and these claims could continue for many years into the future as more and more of the heart valves malfunction over time. Furthermore, the total cost of these claims is uncertain and depends on factors such as medical costs, legal costs, and the number of patients affected.
This scenario is an example of a long-tail liability. The liability arises long after the policy was sold, the claims are settled over an extended period of time, and the total cost is uncertain and potentially very large. As such, InsureCo must ensure that it has adequately reserved for these liabilities and that it has accurately priced the risk when it initially sold the policy.