A federal appellate court decision underscores a notable risk of purchasing a defense-within-limits insurance policy. The U.S. Court of Appeals for the Fifth Circuit held that defense costs paid in underlying litigation did, in fact, erode the policy limits.
The insurance policy at issue in this coverage dispute contained provisions stating that the insurance company would pay—on behalf of the insureds—“Loss for which the Insureds become legally obligated” on account of a qualifying claim. The policy also contained specific language indicating that policy limits would be reduced—and might be exhausted—by defense costs.
The insured had the option to purchase separate defense costs coverage, but declined to do so. The insurance company defended the underlying lawsuits on behalf of the insureds under a reservation of rights. In the reservation of rights letter, the insurance company specifically stated that according to the policy, defense costs deplete the policy limits.
The district court found that under the Moeller rule, defense costs should not be deducted from policy limits. The Moeller rule in Mississippi says that when an insurer provides defense under a reservation of rights such that a conflict exists, the insurer must also pay for the insured’s separate counsel. Many, but not all, states have rules similar to the Moeller rule.
The appellate court reversed. The court explained that Moeller simply reflects “the commonly accepted rule that where a conflict of interest exists, the insurer must pay for the insured’s separate counsel.” Moeller does not create an “absolute right to reimbursement of all defense costs.”
The appellate court emphasized that the underlying policy stated in multiple places that defense costs erode policy limits and that the insured had “specifically declined to purchase separate coverage” for the defense costs. Other courts considering this issue would also likely take into account the availability of non-eroding coverage for an additional premium, says Anna D. Torres, West Palm Beach, FL, vice-chair of the ABA Section of Litigation’s Insurance Coverage Litigation Committee.
The appellate court’s decision was not surprising because “whether defense costs erode limits is based entirely on the language in the policy,” according to Ernest Martin Jr., Dallas, TX, vice-chair of the Section of Litigation’s Insurance Coverage Litigation Committee. There is, however, an important takeaway for legal practitioners. “We better advise our clients to know what they’re buying,” Martin says. Though Martin exclusively represents corporate policyholders and Torres’s practice focuses on representation of insurers, Torres agrees. She notes that when purchasing insurance, the insured must make a “deliberate business decision on the type of risk and the amount of risk they are willing to take.” Torres likens the decision to purchasing an additional warranty on a home appliance where the purchaser must weigh the cost against the risk that the appliance will break. Similarly, a business must make a deliberate decision regarding the level of risk it is willing to take and how much it is willing to pay.
Another key takeaway is “to advise our clients to take a very careful and close look at any reservation of rights letter they get from insurance carriers,” Martin says. Sometimes clients get such a letter and simply place it in the file drawer without carefully reviewing it or consulting anyone. Martin states that it is a “fundamental point, but a very important one”: We must advise our clients that these are important documents that affect their rights, and they need to fully understand them.
When it comes to litigation, this decision “really forces the stakeholders—the insured, the carrier, and the lawyers—to early on in the case do an evaluation of potential exposure and try to come up with an accurate projection of the costs of defense,” Torres advises. Those factors must then be balanced with non-monetary considerations of the insured, she adds, which could include anything from trade secret issues to reputation of the business. In addition, this decision means that the insured business truly has skin in the game, Torres explains, as they must ensure they are purchasing good value for their money when selecting independent counsel. The decision places the onus upon the insured to be “deliberate in the litigation decisions that they make because those decisions are going to affect ultimately how much is going to be left in the policy limits to try to get the case resolved,” she says. In short, the insured must be both “an engaged participant in the defense of the case,” as well as a “sophisticated consumer of legal services when they hire independent counsel.”
