Professional liability insurance policies each contain limits of liability that set the upper threshold that the insurer will fund. However, a policy’s stated limit does not necessarily correlate to the amount that will be available to resolve a claim. Instead, many policies provide that the costs of defense are included within the coverage limit—every dollar spent on defense correspondingly erodes the amount available to resolve the claim. These so-called eroding limits, or defense-within-limits policies become particularly important in heavily litigated cases, where high defense costs can approach, and sometimes surpass, the total limit of liability.
Increasingly, policyholders have been filing bad-faith claims against insurers when their policies do not distinguish the costs of defense from the coverage limits. Policyholders have argued that insurers are acting in bad faith by failing to adequately control the costs of defense, both in the rates charged and the activities performed by counsel, resulting in a depletion of the policy limits.
Take for example Pueblo Country Club v. AXA Corporate Solutions Ins. Co., (D. Colo. May 31, 2007), in which the insured was sued by a former employee and tendered the defense to its insurance carrier. The policy had a $1 million limit that included the costs of defense. The case proceeded to trial and a judgment was entered against the employer for over $1.5 million, which the parties agreed to resolve via a settlement. By the time the case settled, however, the insurer had advanced over $300,000 in legal fees, leaving less than $700,000 to pay towards the settlement. As a result, the employer was left on the hook for over $800,000.
The employer subsequently filed a bad faith claim against the insurer, which included allegations that the insurer caused additional defense costs and placed its interests above the insured. The insurer filed a motion for summary judgment, but the court denied the motion, stating that there was a factual dispute as to whether the carrier’s conduct was reasonable. The court further observed that there was evidence “[the insurer] was aware that attorneys’ fees and costs were reducing the available policy limits, and that [the insured] was exposed to a judgment in excess of the available limits.”
All professionals must be cognizant of the consequences of eroding limits. Notably, attorneys representing professionals should take note when the policy has eroding limits and factor that into the overall defense strategy. Often, the efficiency of an attorney’s representation and the effectiveness of that representation go hand-in-hand. Failure to maintain that balance could lead to additional claims when superfluous strategies deplete the client’s settlement resources.