98-04: Defense Within Limits Provisions of Liability Insurance
To: All Missouri Liability Insurers
From: Susan Schulte, Supervisor, Property & Casualty Section
Re: Policy Statement Regarding Defense Within Limits Provisions of Liability Insurance Policies
Date: August 1, 1998
The Missouri Department of Insurance (Department) has been asked by representatives of the insurance industry to re-examine its position against allowing insurers to use "defense within limits" provisions in liability insurance policies. While in the past, the Department has routinely disapproved such provisions, upon re-examination, the Department has concluded that such provisions may be acceptable in certain limited circumstances. Therefore, the Department may approve them in the future, on a case-by-case basis. This Bulletin is intended to provide insurers with some guidance as to the factors the Department will consider in evaluating these provisions, and, generally speaking, what types of defense within limits provisions are likely to be approved.
"Defense within limits" (DWL) provisions provide that any legal defense costs incurred by the insurer in defending the insured against a liability claim under the policy will be set off against the policy's coverage limits. Under such a provision, the cost of a legal defense could in theory exceed the policy's limits of liability, leaving nothing in the policy to reimburse the claimant for damages should the claimant ultimately prevail on the liability claim. The Department has taken the position that such provisions violate the public policy of the state of Missouri in a number of respects. Because of this, such provisions were routinely disapproved by the Department's Property & Casualty staff for use in policies delivered or issued for delivery in Missouri.
Arguments For and Against Using DWL Provisions
Insurers argue that DWL provisions provide two advantages. First, because they essentially cap an insurer's ultimate pay-out on liability policies, they allow insurers to more accurately anticipate their costs and, as a result, price their products appropriately. In addition, they provide plaintiffs with an incentive to avoid lengthy litigation, so as to also avoid exhausting the resources available under the insurance coverage, (which may be the only available source of payment for any damages).
The Department's chief argument against allowing such provisions is that they violate the reasonable expectations of policyholders, who would assume that any defense costs are covered under a liability policy independent of the policy's coverage limits. Historically, this has been true. In a sense, a DWL provision in a liability insurance policy can, potentially, effectively transform a "liability" policy, designed to provide coverage for bodily injury or property damage the insured becomes legally obligated to pay to another person, into a "defense-costs-only" policy, while still retaining the "liability insurance" label. From the Department's perspective, such a label can be misleading to unsophisticated insurance buyers.
In addition, under ordinary liability policy language, the management of the legal defense of a liability claim against an insured is under the control of the insurance company, not the insured. Where the policy has a DWL provision, an insured may have no option but to watch as defense costs slowly consume the monetary protection provided under the policy, leaving the insured personally responsible for any damages for which he is ultimately held responsible, out of his own pocket.
Finally, for certain mandated coverages like automobile liability insurance, DWL provisions erode the minimum level of liability coverage required under state statute. These minimum liability coverage limits were not set at a time when DWL provisions were in use. Given that some critics argue that the minimum statutory coverage levels are, in many cases, already woefully inadequate to make an injured claimant whole again after an accident, to further diminish what the claimant might receive through the application of a DWL clause would run contrary to the public policy objectives of these laws of assuring that the claimant receives at least something.
DWL Provisions Permissible for "Sophisticated" Insureds
The Department recognizes that the topic of the deregulation of the commercial casualty insurance market is being debated before the National Association of Insurance Commissioners (NAIC). Under the current draft of a "white paper" on this topic, commercial insurance marketed to "sophisticated" insurance buyers would be exempt from regulation. However, the standards for such "Exempt Commercial Policyholders" or "ECPs" under the draft are significant; to qualify, an ECP must possess at least two of the following characteristics:
- A net worth of over $50 million;
- Net revenues or sales of over $100 million;
- More than 500 employees per individual company or 1000 per holding company;
- Either an employee- or contract-risk manager;
- Aggregate premiums in excess of $500,000;
- If a not-for-profit entity or public entity, an annual budget or assets in excess of $45 million; or
- If a municipality, a population in excess of 50,000.
While such strict standards may be appropriate for exemption from all rate and form regulations, they are also considerably higher than the thresholds proposed by proponents arguing in favor of allowing the use of DWL clauses, who apparently deem an insurance buyer with $5 million in net revenues or sales to be a "sophisticated" buyer.
This disparity illustrates the dilemma faced by the Department; while we are willing to accept the premise that DWL provisions may be acceptable when marketed to "sophisticated" insurance buyers, it is difficult to define with precision just who these "sophisticated" purchasers might be.
Factors to Be Analyzed in Reviewing DWL Provisions
Rather than attempting to adopt a standard definition applicable in all circumstances at this time, the Department instead has decided to indicate, in a general manner, the kinds of factors it will weigh in deciding whether an insurer has provided a rationale for including a DWL provision which is so compelling and reasonable that it outweighs the Department's concerns about protecting the public. The Department evaluate the surrounding circumstances, including but not limited to:
- The type of policy under consideration (e.g., personal or commercial, D&O, E&O, Malpractice, Employment Practices, Pollution, etc.).
- Whether there is currently an availability or affordability problem in this line of insurance.
- Whether the insured has requested the DWL option.
- The nature and size of the business of the target policyholders.
- The litigation environment, including any recent policy shifts by the courts, the complexity of the cases, the typical expense of this type of litigation, the success rate on the litigation, etc.
- The wording of the DWL provision and its relationship to the other provisions of the policy, including any limits on the percentage of the coverage limits which will be used to pay legal defense costs.
- The nature of the disclosure statement provided by the insurer to the insured explaining the possible effect of the DWL provision, including what happens when the costs of litigation exceed the policy coverage levels.
- The wording of the DWL provision and the extent to which it allows the insured to direct his own litigation.
- How the policy is rated and the extent to which the cost of the coverage is discounted due to the inclusion of the DWL provision.
A case-by-case review of filings involves considerable time and effort. Reviewing DWL provisions will be especially difficult given the complexity of the factors involved. As such, insurers should provide complete factual support (including data on market demand) and actuarial support of any DWL filing. Insurers should expect that the Department will disapprove filings which are poorly explained and supported.
The Department also recognizes the importance of providing guidance to insurers in developing any DWL policy language. Thus, the Department is willing to set forth a limited "safe harbor" of conduct for DWL as stated in Appendix I, attached; the Department will generally not challenge DWL filings which fall within these guidelines, absent extraordinary circumstances. Filings falling outside this limited safe harbor will be more closely evaluated.
The Department hopes that this Bulletin will serve the dual purposes of allowing DWL provisions where appropriate and protecting the insurance-buying public. The Department welcomes comment regarding this Bulletin and its implementation by the Department. The Department may revise the Bulletin in the future as public comments warrant; however, if its experience under this Bulletin indicates that a more rigid set of standards for DWL provisions is required in order to make the approval process more administratively workable, or, is necessary in order to protect the interest of the public in general and commercial insured in particular, it will initiate a formal rulemaking procedure designed to promulgate an official regulation to replace the Bulletin.
MISSOURI DEPARTMENT OF INSURANCE
BULLETIN 98-04, Appendix I
Liability Insurance Policies - Defense Within Limits Provisions
Liability insurance policy filings made before the Missouri Department of Insurance which contain "defense within limits" provisions will normally be approved by the Department if they contain the following features and any other factors relevant to the intended use of the defense within limits provision also support approval:
- The insured employs more than 500 employees per individual company or 1000 per holding company.
- The insured is not a public entity or not-for-profit entity.
- The coverage is for a "professional liability" policy which includes but is not limited to the following classes: directors and officers, errors and omission, legal malpractice, architects and engineers, pollution and environmental impairment, or employment practices.
- The legal defense costs offset against the stated liability limits do not exceed forty percent (40%) of such limits, the maximum percentage of such offset is specified in the policy, and the insurer assumes all legal defense costs in excess of such offset percentage.
- A disclosure of such offset shall be made in prominent type both in the application and the policy and acknowledged in writing by the applicant at the time of original application or next renewal if the insurance company issued the original policy before the date of this bulletin.
- "Legal defense costs" shall mean reasonable and necessary fees, costs and expenses consented to by the insured resulting solely from the investigation, adjustment, defense and appeal of a claim against the insured, but excluding salaries of officers and employees of the insurer. Extraordinary circumstances would include cases involving forgery or fraud.
- The insurer agrees to collect data on any liability policies written with DWL provisions, which will be made available to the Department at its request. The data to be collected shall include but not be limited to the types and number of policies with DWL provisions written, the premium collected for each type, the aggregate losses incurred for these policies, the defense costs incurred as compared to the actual claim payment.