Coverage Concerns In Burning Limits PoliciesNovember 2, 2010 | |
Policies that include the cost of defending a particular claim or action in the policy’s limit of liability are commonly referred to as “Burning Limits” or “Defense Within Limits” policies. Such policies raise a number of significant coverage issues for the insurer, the insured, and the third-party claimant. This article examines how courts around the nation have analyzed and resolved various concerns raised by Defense Within Limits policies.
Drafting the Defense Within Limits Provision.
The first and most obvious concern is the interpretation of policy provisions that attempt to include “defense costs” in the applicable limits of liability.
Illinois Union Insurance Co. v. North County Ob-Gyn Medical Group, S.D. California, 2010 WL 2011522, May 19, 2010, illustrates the need to carefully draft policies with burning limits provisions. Illinois Union’s (“IU”) Policy provided that “Costs, Charges and Expenses reduce the Limit of Liability. If such Limits of Liability are exhausted by payment of Loss, the obligation of the Insurer under this Coverage Section are completely fulfilled and extinguished.” “Loss” was defined as “the damages, judgments, settlements…awarded by a court, and Costs, Charges, and Expenses incurred by any of the Insureds.”
IU argued that the phrase “incurred by the insured” meant the amounts the insured might be liable to pay even though the insurer pays them directly. The Court, however, found that the insured could not be expected to have understood the term to mean that its policy limits would be eroded by costs incurred in defending the action. Even if “incurred by” meant “legally obligated to pay,” the insurer may well have believed only IU was legally obligated to pay defense costs. As the Court stated, “IU really needs ‘incurred by the insureds’ to mean ‘for the benefit of the insureds’…Frankly, the Court’s impression is that the policy simply wasn’t drafted carefully.”
Some examples of provisions that various courts have upheld:
Loss means damages, settlements, judgments, and defense expenses. California Dairies, Inc. v. RSUI Indemnity Co., 2010 WL 2598376, E.D. California, June 25, 2010. The policy should further define the term expenses or “defense expenses” as including the attorney’s fees, legal costs, and expenses spent to defend the underlying suit to make clear that the policy is in fact a burning limits policy. See Weber v. Indemnity Insurance Co. of North America, 345 F. Supp. 2d 1139, United States District Court, District of Hawaii, Nov. 17, 2004.
Loss includes “damages, judgments, settlements and costs, charges and expenses incurred in the defense of actions, suits or proceedings and appeals therefrom.” Continental Ins. Co. v. Bangerter, 37 Cal.App.4th 69, Court of Appeals, Second District, Division 3, July 27, 1995.
“When payment not exceeding the Limit of Liability has to be made to dispose of a claim, costs, charges, expenses and settlements shall be payable up to the Limit of Liability”. The Court commented favorably on the following notices: “Costs, Charges, and Expenses and Defense Included in Limit of Liability”; “The Limit of Liability Available to Pay Judgments Shall Be Reduced by Amounts Incurred for Legal Defense.” Helfand v. National Union Fire Ins. Co. of Pittsburgh, P.A., 10 Cal.App. 4th 869, Feb. 11. 1993.
Essentially, the courts are concerned with whether or not the policy provision provides the insured with sufficient notice of precisely what the defense within limits provision seeks to include within the policy’s limits of liability. Given the longstanding principle that ambiguous provisions will be construed in favor of the insured, detail and clarity are essential.
The Scope of the Defense Within Limits Provision.
Provided the Defense Within Limits provision has been drafted to give the insured adequate notice that certain defense expenses will be included within the limits of liability, how broad can the definition of “defense expense” be? In other words, are there particular “expenses” that may not be included within the limits of liability even if specifically referenced in the provision? Can the insured place self-serving limitations on the costs and expenses associated with a particular claim?
In Essex Ins. Co. v. Doe, 511 F.3d 198 (C.A.D.C. 2008), the liability insurer brought a declaratory judgment action against its insured, who operated a children’s residential facility, and the resident of the facility who was sexually assaulted by other residents, to determine the scope of its policy’s “defense within limits” provision. The provision provided: “The sublimit of liability shown in this endorsement is the most we will pay for all damages including investigation and defense because of injury arising out of any one claim for sexual abuse and/or misconduct…[the] aggregate limit stated in this endorsement is the most we will pay for all claims, including investigation and defense, arising out of sexual abuse and/or misconduct.”
The resident argued that the “investigation and defense costs” referenced in the provision were his investigation and defense costs, and not the insurer’s investigation and defense costs. The Court disagreed and reasoned that the resident, who was suing for sexual abuse, could never have “defense” costs. Accordingly, the Court allowed the insurer to reduce its coverage by the amount it spent in investigating and defending the resident’s action against its insured.
In Edwards v. Daugherty, 883 So.2d 932 (La. 2004), a pedestrian’s mother and his former spouse sued the driver, sheriff and risk management program’s excess liability carrier to recover for the pedestrian’s injuries. The District Court entered judgment against the carrier allowing deductions for attorney’s fees, including fees incurred by the carrier to defend itself as a named defendant, but denied deductions for interest.
Plaintiffs argued on appeal that the carrier should not be allowed to deduct attorney’s fees incurred to defend itself from the policy limits. The Court agreed and noted that the policy made no mention of including the defense of claims for penalties brought directly against the insurer, and arising out of the insurer’s conduct, within the policy limits. To the contrary, the policy provided the limits of liability included payment of Defense Costs and Expenses which was defined as “payments allocated to a specific claim for its investigation, settlement or defense, including attorney fees and all other litigation expenses.” Claim was defined as “a written demand…received by an insured for money damages.” The Insuring Agreement provided that the carrier agrees to pay “those sums in excess of the Underlying Insurance…that the insured becomes legally obligated to pay as damages because of bodily injury, personal injury or property damage…which is caused by any person whilst acting within the course and scope of their employment by the insured.” Based on these policy definitions and provisions, the Court found that “defense costs and expenses incurred directly by the insurer are neither sums that the insured is liable to pay nor that it should pay.”
The carrier also argued that it should be allowed to include prejudgment interest payments in its limit of liability pursuant to the policy’s definition of “Defense Costs and Expenses” which included “interest on the full amount of any judgment that accrues before or after entry of the judgment.” The Court held that such a provision was void against public policy, since it obliterated the carrier’s statutory obligation to pay legal interest on the limits of its policy.
Defense with Limits Provisions: Against Public Policy?
Depending on the factual circumstances of the underlying claim, the Defense Within Limits provision may be void as against public policy. In Gibson v. Northfield Ins. Co., 631 S.E.2d 598 (W.Va. 2005), the estate of a motorcycle passenger who was killed when a city-owned ambulance passed a red light brought an action against the city’s carrier after the city assigned its rights to pursue a declaratory judgment action against the carrier. The estate sought to hold the policy’s “Defense Within Limits” provision void as against public policy and state law.
W.Va.Code 33-6-31(a) requires that a motor vehicle insurance policy contain a provision insuring the named insured, and any other person responsible for the use of or using the motor vehicle, against liability for another’s death, bodily injury, property damage or loss sustained as a result of negligence in the operation or use of a vehicle. Since the code is silent regarding the inclusion of additional types of coverage, the Court inferred that the Legislature intended to prohibit insurance companies from reducing the required types of coverage by including other forms of coverage. Accordingly, the Court held that any additional provision in a motor vehicle insurance policy which tends to limit, reduce or nullify this statutorily-mandated liability coverage is void and ineffective as against public policy.
The Court did note, however, that if the policy was “custom-designed” such that the city deliberately chose to purchase a policy with automobile liability coverage that was contrary to the requirements of the statute, then the defense within limits provision might be enforceable. In order to be “custom-designed”, the offending provision must be the result of some choice, judgment, volition, wish or inclination as a result of investigation or reasoning by the government entity. Here, the record demonstrated no conscious consideration of the defense within limits provision by city employees. Rather, the provision was included in the policy on a take-it-or-leave-it basis. Consequently, the Court held the provision void as against state law. The Court further noted:
[O]n a more general note, we believe that the inclusion of a defense within limits provision in a governmental entity’s insurance policy offends traditional notions of fairness. Governmental entities purchase liability insurance to protect their employees and to protect [public funds]. The quiet inclusion of a defense within limits provision into a governmental entity’s liability policy subverts that intent by using the liability coverage to pay the insurance company’s litigation expenses and attorney fees, rather than protecting the governmental entity and its employees and making injured third parties whole against their losses.
Various other States have enacted statutes limiting or banning Defense Within Limits provisions:
60A.08, subdivision 13: Reduction of limits by costs of defense prohibited.
(a) No insurer shall issue or renew a policy of liability insurance in this state that reduces the limits of liability stated in the policy by the costs of legal defense.
(b) This subdivision does not apply to:
(1) professional liability insurance with annual aggregate limits of liability of at least $100,000, including directors’ and officers’ and errors and omissions liability insurance;
(2) environmental impairment liability insurance;
(3) insurance policies issued to large commercial risks; or
(4) coverages that the commissioner determines to be appropriate which will be published in the manner prescribed for surplus lines insurance in section 60A.201, subdivision 4.
(c) For purposes of this subdivision, “large commercial risks” means an insured whose gross annual revenues in the fiscal year preceding issuance of the policy were at least $10,000,000.
11 NYCRR Section 71.2. General prohibition
(a) No liability insurance policy, except as specified in this Part, shall be issued or renewed in this State containing a provision that:
(1) reduces the limits of liability stated in the policy by legal defense costs;
(2) permits legal defense costs to be applied against the deductible, if any; or
(3) otherwise limits the availability of coverage for legal defense costs.
(b) Notwithstanding any other provisions of this Part, no liability insurance policy shall be issued or renewed in this State if it contains the limitations specified in subdivision (a) of this section for:
(1) motor vehicle liability;
(2) medical malpractice liability, except hospital medical malpractice liability as otherwise permitted by this Part; or
(3) any liability risk or coverage subject to section 3425 of the Insurance Law.
(c) No liability insurance policy shall be issued or renewed in this State unless legal defense costs are incident to a claim of legal liability covered under the policy.
Section 71.3. Exceptions to general prohibition
(a) A liability insurance policy which contains a provision that reduces the limits of liability stated in the policy by the costs of legal defense, may be issued or renewed in this State only for the types of risks or coverages, and minimum limits, specified in subdivision (d) of this section. Unless the policy provides the insured with control of the defense, as specified in subdivision (c) of this section, legal defense costs charged against the stated limits of liability shall not exceed 50 percent of such limits and, except for the offset against the deductible authorized by subdivision (b) of this section, the insurer shall assume any legal defense costs over the amount or percentage specified in the policy.
(b) A liability insurance policy which contains a provision permitting legal defense costs to be applied against the deductible may be issued or renewed in this State only for the types of risks or coverages, and minimum limits, specified in subdivision (d) of this section. Unless the policy provides the insured with control of the defense, as specified in subdivision (c) of this section, the legal defense costs assumed by or charged to the insured shall not exceed 50 percent of such deductible and, except for the offset against the policy limits authorized by subdivision (a) of this section, the insurer shall assume any legal defense costs over the amount or percentage specified in the policy in regard to such deductible.
(c) The percentage limitation specified in subdivisions (a) and (b) of this section may be omitted if the policy provides that the insured shall have the option to:
(1) select the defense attorney or to consent to the insurer’s choice of defense attorney, which consent shall not be unreasonably withheld;
(2) participate in, and assist in the direction of, the defense of any claim; and
(3) consent to a settlement, which consent shall not be unreasonably withheld.
(d) A legal defense cost offset provision as specified in subdivision (a) or (b) of this section may be included in a liability policy only for the following types of risks or coverages, and only where the per occurrence liability limits for all liability risks and coverages under the policy are at least:
(i) employee benefit liability;
(ii) fiduciary liability; and
(iii) employment practices liability.
(i) environmental impairment and pollution liability;
(ii) directors and officers liability;
(iii) media, publishing and advertising liability;
(iv) architects and engineers;
(v) errors and omissions liability; and
(vi) professional liability, other than medical malpractice liability.
(3) $1 million: hospital medical malpractice liability, for renewals only, if the expiring policy contained approved legal defense cost offset provisions.
(e)(1) A liability insurance policy containing a provision that reduces the limits of liability stated in the policy by the costs of legal defense, or permits offsets against the deductible by the costs of legal defense, and which meets the requirements of paragraph (2) of this subdivision, may be issued or renewed in this State if the policy:
(i) insures a large commercial insured;
(ii) provides primary coverage of at least $5,000,000 per occurrence;
(iii) provides umbrella or excess coverage of at least $1,000,000 per occurrence, where the underlying limits are at least $2,000,000 per occurrence; or
(iv) is written with a deductible, or over a self-insured retention, of at least $100,000 per occurrence.
(2) Any policy issued or renewed pursuant to this subdivision must comply with all the provisions of this Part except:
(i) subdivisions (a), (b), (c) and (d) of this section; and
(ii) subdivisions (b)(1)–(3), (c) and (d) of section 71.5 of this Part.
(f) Legal services insurance that is a part of a policy of liability insurance that contains a provision reducing the limits of liability by the costs of legal defense, in accordance with the provisions of this Part, may reduce the per claim or aggregate liability limits of the liability policy if the policy limits are not reduced by greater than 25 percent.
Section 71.5. Required notification
(a) Any policy issued or renewed in this State permitted pursuant to this Part must print a conspicuous notice of its defense cost offset provisions on the face of the application for insurance and on the face of the policy.
(b)(1) Except as provided in paragraph (4) of this subdivision, any policy containing legal defense cost offset provisions specified in section 71.3(a) of this Part must contain a statement signed by the insured acknowledging that the insured is aware that the limits of liability contained in the policy shall be reduced up to the amount or percentage stated in the policy by legal defense costs and, in such event, the insurer shall be liable for legal defense costs (except those due to any offset against the deductible) exceeding that amount or percentage.
(2) Any policy containing the legal defense cost offset provisions specified in section 71.3(a) of this Part where the percentage limitation may be omitted pursuant to section 71.3(c) must contain a statement signed by the insured acknowledging that the insured is aware that the limits of liability contained in the policy shall be reduced, and may be completely exhausted, by legal defense costs and, to the extent that policy limits are thereby exceeded, the insurer shall not be liable for legal defense costs or for the amount of any judgment or settlement.
(3) Any policy containing the legal defense cost offset provisions specified in section 71.3(b) of this Part must contain a statement signed by the insured acknowledging that the insured is aware that legal defense costs that are incurred shall be applied against the deductible up to the amount or percentage stated in the policy and, in such event, that the insurer shall be liable for legal defense costs (except for those due to any offset against liability limits) exceeding that amount or percentage.
(4) Any policy containing the separate defense limit provisions specified in section 71.4 of this Part shall contain a statement signed by the insured, describing the separate defense limit, and acknowledging that the insured is aware that the amounts available for the payment of legal defense costs are limited and may be exhausted and, in that event or in the event that the separate liability limits are exhausted, the insurer shall not be liable for any further legal defense costs.
(5) Any policy issued pursuant to section 71.3(e)(1)(ii) through (iv) of this Part shall contain a statement signed by the insured, acknowledging that the insured is aware of the extent to which legal defense costs that are incurred shall be offset against the limits of liability or the deductible and, if such limits can be completely exhausted by the payment of legal defense costs, that the insurer in the event of such exhaustion shall not be liable for further legal defense costs or for the amount of any judgment or settlement.
(c) The signed statement required by subdivision (b) of this section shall be attached to, and made a part of, the policy.
(d) In lieu of the signed disclosure statements required by subdivision (b) of this section, an insurer may include the following in the notice required by subdivision (a) of this section:
(1) The notice shall specify the amount or percentage by which legal defense cost will reduce the limits of liability or deductible. If the limits of liability may be completely exhausted by legal defense costs, the notice must state that the insurer shall not be liable for legal defense costs or for the amount of any judgment or settlement after exhaustion of the liability limit.
(2) If the notice applies to a policy containing separate defense limits as specified in section 71.4 of this Part, the notice shall describe the separate defense limit and shall specify that in the event that either the separate defense limit or the liability limit is exhausted, the insurer shall not be liable for any further legal defense costs.
Ark.Code Ann. § 23-79-307(5)(A):
Policies containing provisions that would reduce the limit of liability available for judgments or settlements by the amount of payment made for defense cost or claim expenses shall not be approved by the Insurance Commissioner unless a separate limit for defense costs equal to one hundred percent (100%) of the annual aggregate limit of liability stated in the policy for judgments or settlements is offered for defense costs or claims expenses to the insured. However, no policy covering automobile liability insurance may contain the defense within the limits concept.
Mont.Code Ann. §§ 33-1-502:
Mandates that the Montana Insurance Commissioner disapprove policies which incorporate “inconsistent, ambiguous or misleading clauses,” including provisions in casualty insurance forms that permit defense costs within limits.
Or.Rev.Stat. §§ 742.063:
A liability policy that includes defense costs within policy limits may not be delivered or issued for delivery unless approved by the director. Mandates the inclusion of a statement disclosing that costs of defending claims are included in policy limits.
Defense Within Limits Provisions and Reservation of Rights.
Does the insurer have an obligation to raise the Defense Within Limits provision in its Reservation of Rights letter? What are the consequences if it fails to timely raise the provision?
The United States District Court, Western District of Washington, answered these questions in Lexington Ins. Co. v. Swanson, 2007 WL 1585099 (2007). Swanson, an injured party, brought counterclaims against the carrier after purchasing the insured’s rights against the carrier at a sheriff’s sale of the insured’s assets. Swanson moved to dismiss certain of the insurer’s contract defenses to coverage, in part, on the basis that the insurer’s control of the defense of a claim subject to its policy’s spend-down provision without a timely reservation of rights created a conflict of interest. Swanson argued that the conflict arises because although the insured may wish to settle to avoid any excess liability, the insurer has an interest in defending the suit to avoid liability entirely. In the event the insurer should lose, it has the same liability as if it had paid a policy limits settlement offer.
The Court agreed and held that the insurer’s control of the litigation defense for nearly two years before issuing a reservation of rights raised a presumption that its insured was prejudiced. The insurer was precluded from asserting contract defenses to coverage. The Court did note, however, that an insurer need not issue a reservation of rights letter to its insured in order to limit its risk to the policy limit:
By providing its insured with policy limit information, an insurer is attempting to protect itself against a bad faith claim rather than protecting its right to deny that the policy applies to the claim.
Consequently, although the insurer was now barred from litigating its defenses to coverage, it could still rely on the policy’s spend-down provision to dispute the applicable policy limit without a timely reservation of rights.
The practical effect of Policies with Defense Within Limits Provisions: Settlement.
Courts are more likely to grant motions to approve/enforce settlement agreements in cases involving burning limits policies. In Stratton v. Glacier Ins. Administrators, Inc., 2007 WL 274423, E.D. California, Jan. 29, 2007, the trustee in bankruptcy of an insolvent benefits plan filed a motion for approval of a settlement agreement. In granting the motion, the Court specifically noted that the insurance policy for the trustee defendants was a burning limits policy and that pursuing litigation would likely exhaust all insurance proceeds otherwise available to satisfy judgment.
In upholding the Depositors Economic Protection Corporation Act against an equal protection challenge, the Rhode Island Supreme Court noted that encouraging payment of insurance proceeds to depositors of failed credit unions insured by “defense within limits” policies is a legitimate legislative objective, given that the alternative is allowing the policies to deplete by payment of attorney’s fees and litigation expenses. Rhode Island Depositors Economic Protection Corp. v. Brown, 659 A.2d 95, Supreme Court of Rhode Island, May 19, 1995.
In approving the settlement in a fraud class action, the Court took into account that the insurance policy was “self-consuming” and, therefore, defense costs and expenses would reduce the amount of coverage available to satisfy any judgment. Scholes v. Stone, McGuire & Benjamin, 839 F. Supp. 1314 (N.D. Ill. 1993). See also DeBruycker v. PM Beef Holdings, LLC, 2005 WL 681298 (D. Minn. 2005).
This article was co-written with Krishna Shah.
Reprint with permission from DRI. All rights reserved.