Know whether your client’s defense costs are inside or outside policy limits

The Court Decisions column is one of the most popular features of Rough Notes magazine. One reason is that the courtroom is where the promises made in an insurance contract often become real. All insurance professionals can develop “what if” scenarios, but until those scenarios are tested with an actual loss and a court decision, they remain mere mental exercises. In this column, the editors of PF&M Analysis, a publication of The Rough Notes Company, will dig a little deeper into one of those court decisions to identify a coverage problem and then provide possible solutions.

This case involved a 16-vehicle accident that occurred after the driver of a semitrailer was unable to stop in time when approaching congested traffic. The driver swerved into another lane, striking a logging truck. Both trucks then struck several other vehicles. With multiple instances of vehicular damage and occupant injury, the driver’s insurance was insufficient to handle the mega-claim.

The insurer, faced with the potential for a huge defense obligation spread among many claims, chose a strategy to end its obligation. It selected a single claimant and paid out the policy’s limits. Per policy language, the exhaustion of limits ended the insurer’s obligation to provide its insured a legal defense.

The duty to defend is at the heart of liability insurance. The provision’s wording is usually along these lines:

• The insurer states that it has a duty (obligation) to another party, in this case the insured.
• The insurer has the right to provide a defense against any lawsuit for damage or injury to others that is covered under the policy.
• Lawsuits against the insured may be investigated and settled if appropriate.
• The insurer will pay interest levied during litigation, taxes, or loss of income suffered by the insured.
• Specific situations may terminate the obligation to defend; these could include a determination that a claim is not covered, payments have been made, or limits have been exhausted.

The insurer’s duty to defend is the first layer of coverage for damages alleged against an insured. When allegations are investigated or disputed, the costs can become substantial.

In personal liability insurance, the cost of defending the insured is outside policy limits. In commercial liability coverage for premises and vehicles, defense costs also typically are outside limits. In specialty or professional liability policies, defense costs are more likely to be inside limits.

It makes sense for agents to educate their personal lines clients about the value of having defense costs paid outside their liability policy limits. With regard to commercial lines clients, it would be prudent to make them aware of the value of their policies’ coverage for defense costs and to guide them in making coverage decisions that take the protection into consideration, regardless of whether it is provided within or outside policy limits.

When coverage is provided outside of limits, insurers frequently consider such limits and the premium they have collected versus what is being expended in handling suits. It may make sense to recommend that your client increase limits. When defense is provided within limits, careful consideration of selected limits is critical. When defense costs reduce available limits, limit adequacy must be an immediate concern. Increased limits and excess coverage may be the path to pursue.

The author

Bruce D. Hicks, CPCU, CLU, is senior editor for Technical and Educational Products at The Rough Notes Company. He has more than 30 years of property/casualty insurance experience, including personal and small business underwriting as well as compliance duties for several national and regional insurers. Active in the CPCU Society, Bruce served as a Governor of the organization from 2007 through 2010 and currently serves on its International Interest Group Committee.