Patent Litigation Insurance

Abstract Empirical studies have found that high litigation costs often discourage small firms from investing in R&D, as they fear their patent will be infringed and they will not be able to afford litigation. As a solution, firms have been encouraged to purchase insurance policies that, by covering legal costs in the event of a trial, serve as a commitment to litigate so that settlement terms are more favorable to the insured, and potential infringement is less likely to occur. However, very few firms are purchasing insurance and the market remains poorly developed throughout the world. I show that firms might be discouraged from buying insurance because of information asymmetries, not only with insurance companies but also with their competitors. I study the situation of a patent holder, who perfectly knows the validity and enforceability (“strength”) of her patent, which has been infringed by a competitor with less information on the patent. The patent holder can purchase insurance to have a credible threat to litigate and increase the infringer's settlement offer. But the decision to buy insurance conveys information about the patent strength to the infringer. As a result the patent holder may prefer not to be insured rather than transmitting this information. This signaling effect can yield different equilibriums, in particular, a pooling equilibrium “no insurance” where no patent holder purchases insurance. I study if this situation might be improved by imposing mandatory insurance or by giving the insurer a share of litigation proceeds.