Legal and ethical considerations for "defense within limits" policies.

• Author: Baldwin, Shaun McParland

A "wasting" or "defense within limits" policy, known as a DWL policy, is one which includes all defense costs and litigation expenses within the applicable limits of liability. DWL policies have long been utilized for directors and officers and professional liability risks. Many of these policy forms are pure indemnity policies carrying no duty to defend on the part of the insurer, but only a duty to reimburse defense costs as part of the total limits of liability. Under an indemnity policy, the insured usually controls its own defense and selects its own counsel, and many DWL policies contain sizeable self-insured retentions.

In 1985, the Insurance Services Office introduced a commercial general liability policy form that included defense within limits provisions. Under that policy form, the insurer had the duty to defend and the corollary right to select defense counsel and control the defense. All costs of defense, however, were chargeable against the policy limits. There was no supplementary payments provision.

While there was a great deal of insurer support for the ISO policy form, brokers, agents, insurance buyers and regulators voiced strong opposition.(1) Such a policy form was prohibited or restricted in many jurisdictions. Ultimately, ISO withdrew the form, but many insurers continue to use manuscript general liability DWL policies for their larger commercial risks, and many non-admitted insurers utilize DWL policies with even smaller commercial entities.

DWL policies can present practical and ethical dilemmas for both plaintiffs' attorneys and defense counsel because every dollar spent on defense reduces the amount available to satisfy potential judgments. When the insurer attempts to control the defense under a DWL policy, defense counsel also can be placed in a conflict of interest position. On the plaintiff's side, the client's ultimate recovery and the attorney's own fee can be greatly affected by the pretrial handling of the case. The more extensive the pretrial discovery, the less insurance money available for judgment or settlement.

Insurers also can be placed in potential or real conflict situations under a DWL policy when they attempt to control the insured's defense. In fact, at least one commentator has opined that an insurer faces a greater risk of bad faith claims under a DWL policy, stating, "Instead of controlling the cost of defense, the DWL policy may place the insurer in a position of having no limit on its liability for the costs of defense and no limit on its liability for the claim."(2)

Insurance regulators responded to the proposed policy form by placing restrictions on DWL policies in many states. These regulations limit or, in some instances, prohibit the use of DWL policies.

For example, Minnesota by statute provides, "No insurer shall issue or renew a policy of liability insurance in this state that reduces the limits of liability stated in the policy by the costs of the legal defense," but then excepts "large commercial risks," defined as an insured with gross annual revenues of $10 million or more.(3) New York permits defense within limits for (1) a policy issued to a "large commercial insured" with net worth of $15 million, gross assets of $50 million and net worth of $3 million, or generating annual gross revenues over $50 million and a net worth of $3 million, or generating annual with limits of at least $5 million or with a deductible or self-insured retention of at least $100,000.(4)

At least one state--Arkansas--requires by statute a separate limit for defense costs, so that indemnity limits are not depleted. It forbids the approval of any policy in which defense expenditures deplete policy limits, unless a separate limit for defense costs equal to 100 percent of the annual aggregate limit of liability stated in the policy for judgments or settlements is offered for defense costs or claims expenses to the insured.(5)

State insurance commissioners also have expressly retained the right to disapprove policies that include defense costs within limits, as well as policies that do not clearly disclose the effects of the policy.(6)

State regulations generally do not restrict non-admitted insurers. In addition, most restrictions apply only to approval of insurance forms and not to manuscript policies. Manuscript policies, which are written by the insurer and insured to fit a unique risk, often do not face state commissioner scrutiny. Thus, despite restrictions or prohibitions, DWL policies are being issued and their effects are starting to be litigated across the country.

TYPICAL DWL POLICY WORDING

The most common method of including defense costs within the limits of the policy is to expand the policy's definition of "loss" to include defense costs and expenses. An example is Helfand v. National Union Fire Insurance Co., a California Court of Appeal case that involved a D&O policy that defined a "loss" as:

any amount which the insureds are legally obli-

gated to pay for a claim or claims made against

them for wrongful acts, and shall include dam-

ages, judgments, settlements, costs, charges and

expenses (excluding salaries of officers or em-

ployees of the company) incurred in the defense

of actions, suits or proceedings and appeals

therefrom; provided always that such subject or

loss shall not include fines or penalties imposed

by law or other matters which may be deemed

uninsurable under the law pursuant to which this

policy shall be construed.(7)

When confronted with a challenge by the insured as to whether defense costs are within the limits or payable in addition to the limits of liability, courts generally will review the entire policy to determine if the intent to include defense costs within the limits is clear and unambiguous.(8) In Helfand, the insuring clause promised to pay "against loss ... arising from any claim or claims which are first made against the insureds ... during the policy period by reason of any wrongful act." Other clauses in the policy clearly stated the limit of the insurer's liability. In addition, an endorsement entitled "Costs, Charges and Expenses and Defense" had been replaced with an endorsement captioned "Costs, Charges, and Expenses and Defense Included in Limit of Liability," stating that when payment must be made "to dispose of a claim, costs, charges, expenses and settlements shall be payable up to the limit of liability."

The court held that the insurer clearly expressed its intent to include defense costs within the policy's limit of liability.

ADVANTAGES AND DISADVANTAGES OF DWL POLICIES

1. Insurer's Perspective

   Insurers have been strong supporters of the DWL policy as a means of cost containment. Faced with sky-rocketing defense costs, particularly with respect to environmental and latent injury claims, insurers have advocated the DWL policy as a mechanism for encouraging early settlement, thereby reducing defense costs. Insurers also like the fact that under a DWL policy, they can limit their risk exposure with accuracy. The DWL policy enables them to set fixed premiums with knowledge of the maximum dollars they potentially might be required to pay, regardless of the occurrence or loss, the intricacy of the claim or the difficulty of defending it.

   There has been a concern, however, that use of DWL policies could result in increased bad faith claims against primary insurers based on alleged inflating of legal fees to reach the aggregate limits,(9) and also based on gaps in coverage because excess policies usually are written to attach only when the primary policy limits are exhausted by the payment of judgments and settlements.(10) A successful bad faith claim usually renders the insurer responsible for an insured's entire liability, without regard to policy limits. Therefore, according to some critics, DWL policies may not limit the insurer's liability but actually may increase it beyond the policy limits.(11)

   There are other ways in which a DWL policy can expose an insurer to a bad faith claim. If the insurer controls the defense of the claim, it must be mindful of the duty to settle the claim within the policy limits when possible. The insurer must be aware that its direction of the defense could create a situation in which there are not sufficient funds remaining to settle a claim. Since its own actions can cause depletion of the limits and a concomitant inability to settle, the insurer is in danger of increasing the possibilities of a bad faith claim against it. A DWL policy, therefore, places additional pressure on a primary insurer to make an early evaluation of a case and, in appropriate situations, to initiate settlement discussions to enhance the chances of a settlement within the policy limits.

   In addition, because the policy's aggregate limits are subject to exhaustion by defense costs, an issue regarding the integrity of certificates of insurance has been raised. Certificates of insurance are used as a convenient way of proving financial responsibility to a third party and may be required by financial institutions, customers, owners or contractors to demonstrate compliance with a contractual requirement that the insured procure insurance for a particular risk. A certificate usually states the name and address of the insurer, the types of policies held by the insured, the coverages and the limits of liability of each of these policies, but it usually does not include the insuring agreement. Unless the certificate of insurance specifically notes that the policy listed is a DWL policy, the recipients may be under the false impression that the full limits are available for judgments and settlements and that defense costs are supplementary. Certificates that do not set forth the DWL language could be another source of litigation.

   Finally, many opponents to the DWL policy are quick to point out the potential conflict of interest that exists between the insurer and the insured. This conflict arises because...