To Defend Or Not To Defend: That Is The Question

Defense costs are a tricky topic when it comes to certain types of insurance, including private company D&O and Employment Practices Liability insurance policies. The choice of whether it's the insurance carrier's duty-to-defend a claim, or whether that duty falls to the insured party, can result in meaningful tradeoffs at the time of a claim. My colleague Scott Goettelman, a management liability claims expert in Woodruff Sawyer's Denver office, provides a timely reminder in this guest post. -Priya

Practically every business obtains some type of insurance to protect against claims brought by third parties. Director & Officer Liability insurance (D&O) and Employment Practices Liability insurance (EPLI) of course fall into this category, as does Commercial General Liability (CGL) insurance. One of the reasons these policies are so valuable is their ability to pay legal defense costs when businesses are sued by third parties.

Many insurance buyers are familiar with the "duty-to-defend" language typically associated with a CGL  policy; however, it may surprise you that this language can also be found in private company and not-for-profit D&O policies and many EPLI policies.

The term "duty-to-defend" essentially means that in the event a claim is made against an insured for an alleged wrongful act, the insurance carrier has the right and duty-to-defend the claim—even if the claim is groundless, false, or fraudulent.

The insurance marketplace also offers "indemnity/reimbursement" or "non-duty-to-defend" language, which is typically found in virtually every public company D&O policy and some EPLI, and errors and omissions (E&O) policies. This kind of policy provides that it is the insured's responsibility to defend a claim, subject to the insurance carrier's written approval or consent.

Misconceptions can arise when company executives, business owners, risk managers, and insureds do not completely appreciate the differences of how these two defense clauses function, which can lead to friction during a claim.

The Devil Is in the Details

Some manuscript or negotiated policies contain hybrid-defense language, which states the insurance carrier has the right, but not the duty, to defend a claim. This language permits an insured to choose its preferred option at the time of the claim and may result in a different self-insured retention (SIR) depending on which defense option the insured selects.

How Does an SIR or Deductible Influence the Decision to Defend or Not Defend?

Deductibles and SIR are tools underwriters use to account for claims frequency and insureds use to manage premium costs. In essence, both tools hold the insured responsible for partial payment of a loss. It is important to understand the difference between SIR and deductibles, as well as the roles they play in the defense of a claim, as I will explain below.

The Impact of Defense Costs and Settlement

Most often, duty-to-defend policies use a deductible.  When a deductible is used, that amount is subtracted from the amount an insurance carrier will pay for a claim as defense costs are incurred. A deductible is not normally "first dollar" defense, as often perceived.

When an insurance carrier has a duty-to-defend its insured, the carrier will advance all defense costs on the insured's behalf until a settlement is reached, at which point the insurance carrier will subtract the amount of the deductible.

When a claim is settled within the deductible amount, the insurance carrier will require the insured to reimburse it for the defense costs incurred. This is advantageous from the insured's perspective because it bears no out-of-pocket expense until settlement, helping cash flow.

Conversely, an SIR is used almost exclusively in an indemnity/reimbursement or non-duty-to-defend policy. In these circumstances, the insured pays defense counsel's "reasonable and necessary" expenses directly from its treasury from the onset of the claim until the SIR is exhausted.

After the SIR is exhausted, the insurance carrier will either reimburse the insured for "reasonable and necessary" (typical policy language) defense costs incurred, or it will pay the law firm directly once the SIR is exhausted.

Which Defense Provision Should I Choose?

Now that you understand the basic differences, which defense option should you choose? It depends. Some insureds might not have a choice given their risk profile, the way a particular carrier handles this particular line of insurance, and other factors. Often, but by no means always, the lesser the premium, the more likely you are to have a duty-to-defend policy. Insureds will need to analyze the trade-offs such as the differences in premium and other factors that we’ll describe further.

Duty-to-Defend Policies

In duty-to-defend policies, for example, the insurance company hires counsel for the insured, commonly from a panel of defense firms that the insurance company has pre-selected. This panel commonly grants access to law firms at preferred insurance carrier rates, not available to Jane Q Public. In some cases, the law firms will be well-known, prominent firms. In other cases, the firms may be less well-known, and usually still entirely competent.

This type of panel arrangement provides benefits to both the insurance carrier and insured by keeping the cost of defense in check. This decelerates both the erosion of the SIR and policy limit. Panel counsel is also familiar with the insurance carrier's billing practices, which tends to result in fewer billing disputes with the insurance carrier. To stay on a carrier's panel these firms have to comply with a carrier’s interpretation of what is "reasonable and necessary."

Some insureds are concerned that when the insurance company selects counsel, there may be a conflict of interest; they may also be concerned that defense counsel's loyalties are to the insurance carrier instead of the insured.

At the risk of oversimplifying a complex issue, insureds can take solace from the fact that if there is an actual conflict of interest between defense counsel's representation and the insured's interests, most states agree the insured has the right to independent counsel paid by the insurance carrier even under a duty-to-defend policy.

Indemnity or Reimbursement Policies (Non-duty-to-defend)

In contrast to a "duty-to-defend" policy, an indemnity/reimbursement or non-duty-to-defend policy commands the insured to hire its own defense counsel, subject to the insurance carrier's written consent. Under this arrangement, the insured controls its own defense, something that tends to be especially important in "bet the company" litigation commonly associated with D&O insurance.

The process for defense cost reimbursement for indemnity policies is more involved and sometimes drags out because the insurance company conducts a detailed bill review and then makes adjustments or "haircuts" to time entries for any number of reasons such as "reasonableness," block billing, multiple timekeepers attending a meeting, or even billing rates.  Unsurprisingly, all of this can lead to friction during the claim life cycle.

One more thing: A carrier still has to approve the insured's choice of counsel and the rates that counsel is charging under an indemnity/reimbursement policy. Carriers will react poorly if they believe an insured is using an "unqualified" law firm (read: a firm with which the carrier has no experience) or if they believe the rates are above market—and what is "market" can be subject to significant disagreement. The rate issue tends to be somewhat less of an issue for public company D&O policies, and a significant issue for basically every other indemnity/reimbursement policy including EPL, CGL, and private company D&O policies.

Getting your choice of counsel approved before work commences is critical. Otherwise, the insurance carrier may try to snub your choice of counsel after they've already commenced work, or balk at what is a "reasonable" hourly billing rate. Changing lawyers in mid-stream or learning you'll need to pay the difference between the rates the insurance carrier deems "reasonable," and the rate you agreed to pay, is frustrating for insureds.

In addition, be mindful that some indemnity/reimbursement or non-duty-to-defend policies also have a panel counsel requirement, which means the insured needs to select a lawyer from the insurance carrier's list. As with panels for duty-to-defend policies, there are some good reasons for insureds to like using a panel. In a perfect world, you will consider whether the panel works for you before you bind your policy. Even carriers with panel requirements that might agree to allow you to use non-panel counsel at a pre-specified (and usually lower than the actual cost) rate are often unwilling to make exceptions to the panel requirement once you are hit with a claim. If you have a "go-to" law firm that is not on the carrier's panel, you may be able to get that firm endorsed onto your policy. Your trusted insurance advisor can help guide you through this process during your renewal.

The key is to understand if your company, its legal department, or its executives believe that controlling counsel selection is crucial so that you select the appropriate policy form before a claim is made.

Best Practices to Mitigate Friction during the Invoice Review Process

To mitigate friction, we recommend submitting defense invoices to the insurance carrier each month as incurred, even if you're well within your SIR. This permits the insurance carrier's claims analyst an opportunity to review the invoices, and you can address any potential billing issues up front.

This monthly process is far superior to delivering a wheelbarrow full of invoices to the insurance carrier when you think you've breached your SIR, only to find out it will take the claims analyst several weeks or months to review the bills.

Worse still is to only then find out that you are in for further frustration as the claims analyst starts to make "haircuts" to your defense invoices because of perceived issues with "reasonable" billing rates, staffing issues, time entry descriptions, or "time creep" from other matters not related the claim.

The Allocation Effect: Who Pays for Uncovered Claims

As much as some insureds might prefer the control of their own defense that an indemnity/reimbursement policy provides, notwithstanding the potential for disputes with the insurance carrier, there is an additional downside to an indemnity policy that is worth noting: allocation.  When a third party brings a claim, some of the allegations and/or parties may not fall within the policy and, hence, are technically "uncovered." As a result, an indemnity/reimbursement policy or non-duty-defend policy permits the insurance carrier to allocate defense cost coverage from the inception of the claim.

In other words, an allocation provision enables the insurance carrier to pay only that portion of a claim or lawsuit (the cost of defense or the settlement payment) that is attributable to covered persons or entities or covered claims.

Some insureds find allocation puzzling because it feels like they and their carriers are pitted against one another while defending a claim in which both have a common goal to resolve. In my experience, however, ultimately, counsel selection usually trumps allocation for some insureds who believe the flexibility they gain with their own choice of counsel is worth the allocation trade-off.

Is There A Right Or Wrong Answer To The Question: To Defend Or Not Defend?

No.

Most public company D&O policies are written on an indemnity/reimbursement or non-duty-to-defend basis. Other management liability policies permit the insured's choice, which may take into account several factors, including the company’s balance sheet and expectations.

The insured's size also influences decisions. Larger companies with established risk management philosophies usually lean towards an indemnity/reimbursement or non-duty-to-defend form, while smaller to middle market companies are more inclined to choose duty-to-defend policy forms.

Several points are worth deliberating when selecting a defense provision contained in an insurance policy form:

• Is a specific law firm or lawyer important to you in the event of a claim? If so, is that law firm listed on the insurance carrier's panel?
• Are your favored law firm’s billing rates similar to the insurance carrier’s panel counsel rate?
• Does your company have the experience and resources to actively manage defense counsel throughout the claim?
• Can your company's balance sheet withstand the supplemental costs related to the allocation of uncovered matters/parties or the insurance company's "haircuts" to defense invoices?
• In the event of a protracted billing dispute, do you have the cash flow to pay counsel while you wait for the insurance carrier to reimburse your expenses?

Even though there is no right or wrong answer, it is critical to have this dialogue with your leadership team and trusted insurance adviser before you have a claim. This way every stakeholder understands how the policy will perform, and your role (or lack thereof) in selection of defense counsel in the event of a claim. For guidance on this process, reach out to your Woodruff Sawyer Account Team.