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Insurance Law – Eroding Limits Policies

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An eroding limits policy is a policy where defense costs are considered part of the loss, and therefore reduce or exhaust, the available limits of the policy to pay damages or settlement costs. Effectively, every dollar spent in the defense of an action under an eroding limits policy is a dollar less that will be available to settle or satisfy a judgment. This can cause conflicts between the insured, the insurer, and counsel hired to defend the action. The types of policies where an eroding limits clause may be included range from commercial lines policies to Professional Liability, Directors & Officers Liability, and Employment Practices Liabilities.

Eroding limits policies have become increasingly common in recent years. They have been held to unambiguously terminate an insurer’s contractual duties once defense costs exceed the stated limits. The issue in most cases is whether the policies actually include the requisite language to enact an eroding limit. In most states, where an ambiguity exists, it is enforced as against the insurer. Therefore, to effectively create an eroding limits clause, explicit language is required.

For defense counsel, the presence of an eroding limits clause places a premium on early resolution, accurate budgeting, advance discussions with the insured and the insurer regarding litigation decisions that will affect the costs of defense and accurate disclosure of the remaining limits as the case continues.

Eroding limits policies have the potential to create bad faith litigation by the insured against the insurer, based on the insured’s failure to adequately control the cost of defense. Bad faith claims often arise out of attorney costs. These disputes usually center on an insurer’s ability to insist on market standard hourly rates, or to limit litigation to necessary activities. It is generally understood that such policies necessitate handling matters differently.  For example, if the value of a claim approaches or might exceed the policy limit, certain investigative costs (observation, site inspections, expert analysis) may not ultimately be in the best interest of the policyholder, as such expenses directly undercut the available policy limit. This creates a strain between the insured, the insurer and the attorney. An attorney, concerned that an investigation may ultimately not reveal any new information, may be hesitant to explore options that could lead to a stronger defense, as the expenses will be viewed as a bad faith activity by the insurer.

To minimize these issues, the insurer and defense counsel must regularly update the insured on all steps taken in the defense of the case. To protect against prospective bad faith suits, the attorney may even seek approval directly from them. Further, the insurer should endeavor to make an early assessment of the case, and take steps to make good faith efforts to achieve a settlement within limits. Settlement becomes a very important function in a defense within limits policy. Evaluating the reasonableness of a potential settlement is fact-sensitive. Early mediation, after some factual groundwork has been established, is an effective tactic in preventing excessive defense costs.

 Dan Morrison

Partner, Jones Morrison, LLP
 
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