LIMITING DEFENSE WITHIN LIMITS

Some states revisiting “burning limits” in claims-made liability policies

 Defense-within-limits provisions appear

most often in claims-made coverage for

economic losses not necessarily

tied to physical damage or injury.

By Joseph S. Harrington, CPCU

“What happens in Vegas stays in Vegas,” according to Sin City’s signature tourism slogan. Liability insurers are hoping that what recently happened in Carson City, Nevada’s capital, will be squelched in Carson City and seen nowhere else.

In April 2023, Nevada became the first state to enact an outright ban on “defense-within-limits” provisions in liability insurance policies. The act takes effect on October 1 for policies commencing or renewing on or after that date.

Defense within limits, otherwise know as “burning limits” or “eroding limits,” refers to the practice of charging the costs of providing a legal defense against a single liability limit, thus depleting the amount available to indemnify claimants. This approach contrasts with “defense outside limits,” under which a policy covers the costs for defending a claim separately from the applicable limit of insurance; the amount available for indemnity is thus unaffected by the costs for defense.

Generally speaking, covering defense costs outside policy limits is the norm for bodily injury and property damage claims covered by auto, homeowners, and commercial general liability policies. The rationale is that injured third parties should not have their primary, perhaps only, source of compensation diminished by legal costs.

Defense-within-limits provisions appear most often in claims-made coverage for economic losses not necessarily tied to physical damage or injury. This includes policies covering directors and officers (D&O) liability, professional errors and omissions (E&O), employment practices liability (EPLI), and cyber liability, among others. In these lines, defense within limits provides incentives for both claimants and defendants to limit legal expenses and reach a settlement.

Medical professional liability (MPL, or “malpractice”) policies occupy a middle ground in this spectrum. Since MPL coverage applies to insureds who are very knowledgeable about the risks of their work, some states permit defense coverage within the policy limits. Other states require that MPL policies provide defense coverage outside limits to ensure that injured patients have access to the full amount of coverage.

Awkward surprise

The Nevada bill apparently flew under the radar and caught the state’s insurance department by surprise, leading the insurance commissioner to issue an emergency order seeking clarification of the law’s application to various lines of coverage. In a letter to the governor, Commissioner Scott Kipper expressed his “grave concerns regarding carriers leaving the Nevada market altogether due to the impact of this new legislation.”

Two other states have statutory prohibitions on defense-within-limits provisions, but their laws are much more limited in application to Nevada’s.

In New Mexico, coverage for D&O, E&O, EPLI, and some other lines are exempt from the prohibition (if the policy limit exceeds $500,000), as are any policies with limits greater than $5 million (except for auto and MPL). A Louisiana law restricting use of defense within limits allows the insurance commissioner to exempt cyber, management, and professional liability coverages, with the exception of MPL.

The Louisiana measure was passed in 2021, and was followed a little more than a year later by a notice from the Connecticut Insurance Department reminding insurers that defense-within-limits is permitted only for coverages specifically designated by the department.

Although the Connecticut notice was addressed to carriers, it is important for agents and brokers to be aware of its call for insurers to provide “conspicuous disclosures” in applications and dec pages explaining how defense-within-limits provisions can deplete the amount left for covering damages, and to inform insureds of any option to add or enhance their additional defense cost coverage.

The Nevada insurance commissioner was awkwardly surprised by the act banning defense within limits. Don’t let your clients be surprised by the effects of its application. 

The author

Joseph S. Harrington, CPCU, is an independent business writer specializing in property and casualty insurance coverages and operations. For 21 years, Joe was the communications director for the American Association of Insurance Services (AAIS), a P-C advisory organization. Prior to that, Joe worked in journalism and as a reporter and editor in financial services.