Policyholders and the Right to a Defense: Don't Be Left Holding the Bag
For the middle-market businessperson, there are few things more exasperating than responding to threatened lawsuits or defending against lawsuits, not to mention the related expense. Good business practices, consistent internal controls and prudent loss-control protocols can help reduce the risk that your business will be sued. But in the real world, it is impossible to eliminate accidents, mistakes, misunderstandings or any of the other uncontrollable events that often result in lawsuits. No matter how meritless or trivial a lawsuit might be, you have to spend money to defend against it. That's where having the necessary insurance coverage—and understanding your right to a defense—can make all the difference.
One of the most important components of commercial liability insurance is the coverage provided for the defense of claims (including lawsuits) against the insured. A key element of liability insurance policies (which cover liabilities owed to third parties), defense coverage typically provides either an actual defense (whether "supplemental" or eroding policy limits) or reimbursement for the cost of defense. For the policyholder, defense coverage is an important cost-containment vehicle across the full spectrum of claims, from minor to catastrophic. Indeed, under a policy that provides for a defense that does not erode the policy's limits (i.e., a traditional commercial general liability policy), the dollar value of the defense component of coverage may outstrip the value of an insurance policy's limit of liability. The following hypothetical scenario, with a nod to Dr. Seuss, illustrates the potential monetary value of the supplemental ("non-eroding") duty to defend:
LoraxCo, a manufacturer of children's novelty straws, has a general liability insurance policy that covers liabilities owed to third parties for bodily injuries suffered while using its products. The policy has an aggregate liability limit of $1 million for bodily injury (meaning that for all bodily injury claims covered by the policy, the insurer will pay a combined total of up to $1 million in judgments or settlements). The policy also contains a duty to defend that does not erode the limit of liability. Once the limit of liability has been paid out in settlements or judgments, however, the duty to defend comes to an end.
Someone posts a comment on an Internet discussion forum suggesting that Lorax novelty straws are toxic and a choking hazard. The posting spreads like wildfire, and within weeks, Lorax is facing several hundred lawsuits claiming bodily injuries. Fortunately, the manufacturer's insurer agrees to defend the lawsuits. After protracted litigation, Lorax is completely vindicated. The cost of the defense ultimately totals more than $2 million. Although Lorax never incurred any liability and the insurance company never had to make any indemnification payments that could be applied against the limits of liability, the insurance company provided a defense that was worth two times the stated limit of liability.
This may appear to be an extreme example, but it is not. The Lorax scenario underscores the significant value of insurance policies containing a supplemental duty to defend. This type of coverage is most frequently found in comprehensive general liability insurance policies, which cover liabilities to third parties for bodily injury, property damage and some categories of advertising and/or personal injury. Management liability (e.g., D&O, fiduciary and EPLI) insurance policies most often contain a duty to reimburse defense costs. Under those types of policies, defense costs typically do erode the limit of liability. For example, if the defense of a covered claim costs $750,000 and the limits of liability are $2.5 million, $1.75 million in limits remain to satisfy a settlement or judgment. The non-eroding duty to defend was once a nearly universal component of general liability policies. Increasingly, however, general liability insurance policies also contain terms intended to limit or place qualifications on the scope of the duty to defend. Policyholders should be on the lookout for such defense-limiting terms (such as a duty to defend that applies against coverage limits) so that they understand the coverage they are buying.
Given the significant potential exposure that an insurer faces from the duty to defend, it should not be a surprise that defense-related issues (e.g., the selection of counsel, the control of defense and the acceptance of settlement proposals) are among the most frequent sources of disagreement between insurers and policyholders. For any business that has found itself in a dispute with its insurance company over the control of a defense, that fight can be as frustrating as being sued in the first place.
The types of disputes that arise between insurers and policyholders concerning the duty to defend are virtually limitless, and it would be futile to attempt a comprehensive overview of the judicial rulings that have defined the outlines of these recurring disputes. The following scenarios, however, are derived from real-life situations (with another nod to Dr. Seuss) and illustrate some of the common pressure points concerning the duty to defend.
I'm Entitled to a Defense: But Who Calls the Shots?
We return to Lorax and its hundreds of meritless bodily injury lawsuits. This time, however, OnceLer Insurance Company decides early on that defending the lawsuits—even though it agrees that Lorax likely will not be found liable—will cost far more than it would to offer its policy limits in settlement and walk away free of any further duty to defend. When OnceLer informs Lorax of its intention, Lorax objects vociferously because it knows that throwing the policy limits into the pot will only encourage more lawsuits. What rights does Lorax have in this situation? Does it make a difference if defense costs are applied against the limits of liability? What if the tables are turned and Lorax believes that the claims can be settled for the $1 million limit of the insurance policy, but OnceLer would rather continue to litigate? Although the answers to these basic questions will have dramatic economic consequences for Lorax, they will vary depending on the particular terms of the relevant insurance policy and the state law under which that insurance policy is interpreted.
Who Represents Whom?
The Sneetch family files a lawsuit bringing bodily injury and unfair trade practice claims against McBean Belly Star Painting Company. McBean promptly tenders the lawsuit to its general liability insurer, ZaxCo, and demands that it undertake the defense of the lawsuit. Zax believes that the unfair trade practice claim is clearly subject to a number of exclusions and that the bodily injury claim may be excluded as well because of an intentional assault exclusion. Nonetheless, Zax decides to defend McBean subject to a reservation of rights. In its initial coverage determination letter to McBean, Zax informs McBean that it is appointing Horton & Yertle to conduct the defense, but only related to the bodily injury claims. Is this permissible? Would it make a difference if, instead of containing a duty to defend, the policy only provided for the reimbursement of defense costs? Given the reservation of rights, does McBean have a right to select its own counsel? Would it have made a difference if Zax had reserved its rights because McBean's notice was untimely, rather than because of the possible applicability of a substantive exclusion? Can Zax require that McBean select so-called independent counsel from a list of pre-approved lawyers? What if Zax objects to the counsel selected by McBean?
Ultimately, the Sneetch litigation does not settle and the jury returns a verdict for the plaintiffs, finding that McBean intentionally injured the Sneetches and knowingly misrepresented the quality of its belly paint. The jury also awards punitive damages to the Sneetches. Zax informs McBean that, given the jury's verdict, the Sneetch litigation was not covered and requests that McBean repay the costs of defense. Under what circumstances is Zax entitled to the repayment of defense costs? Once again, this scenario addresses a series of common areas of disagreement. But the answers to our questions, may have widely divergent consequences for McBean's rights depending on the particular policy terms and the applicable state law.
Who Said Anything About Being Reasonable?
Thing One and Thing Two are injured while being jostled around in Mr. Cat's big red box. The Things sue Cat, whose general liability insurer, Prudent Fish Insurance Company, is concerned that Cat and the Things may be in collusion but agrees to defend him subject to a reservation of rights. Fish informs Cat that he is entitled to select independent counsel. In the reservation of rights letter, Fish states that it will pay for reasonable costs of defense provided in accord with its guidelines for retained-counsel litigation and subject to prevailing local billing rates. Cat retains Grinch & Oobleck, which is well known for leaving no stone unturned when defending its clients. Five months after the first defense bill is forwarded to Fish, Cat receives a letter informing him that Grinch & Oobleck's hourly billing rate of $550 an hour is inconsistent with the prevailing local standards of $175 an hour, that the retention of private investigators was unnecessary and that the litigation guidelines do not permit spending more than five hours preparing a motion to dismiss without obtaining the insurance company's prior approval. Out of a total defense invoice of $25,000, Fish approves just $7,500. Assuming that the insurance policy does not contain the same conditions set forth in the reservation of rights letter, can Fish impose these conditions? Should Cat have objected to Fish's reservation of rights letter? Does it make a difference if the insurance policy states that independent counsel is expected to comply with Fish's litigation guidelines in a conflict situation? Does Fish's delay in reviewing the bills have any effect on its right to reduce the billings?
The fact patterns provided in these scenarios may seem to be exceedingly simple, and the questions raised in the scenarios occur quite frequently. But the answers to these common questions vary depending on the applicable state law and the terms of the relevant insurance policies—factors that are too often taken for granted by policyholders. It is a simple lesson, but one that cannot be over-emphasized: the right to a defense under a general liability insurance policy cannot be taken for granted and policyholders must be diligent in safeguarding and asserting their rights.