One of the first things that a business owner looks at when buying insurance is the policy limit. However, the policy limit is not the only policy feature that affects how much coverage is available under the policy. Whether legal defense costs are included inside or outside the policy limits can determine how much coverage a policy actually provides.
If legal defense costs count against the policy limit, that reduces the amount of insurance available to pay a settlement or judgment. For a business facing a costly or prolonged lawsuit, this policy feature could have a significant financial impact.
Eroding insurance limits, also known as defense costs inside the limits, means that legal defense expenses and claim payments share the same policy limit.
Every dollar the insurance company spends defending a claim reduces the amount available to pay a settlement or court judgment. This is sometimes referred to as a diminishing or burning limits policy.
For example, consider a business with a $1 million Professional Liability insurance policy. If a lawsuit results in $400,000 in legal defense expenses, only $600,000 remains available to cover a settlement or judgment. If the case cannot be settled for $600,000 or less, the business will have to pay any amount in excess of $600,000.
Non-eroding insurance limits, also known as defense costs outside the limits, provide a different approach to covering legal expenses.
Under this type of policy, covered legal defense costs are paid in addition to the policy's stated liability limit. This means defense expenses do not reduce the amount of insurance available to pay a settlement or judgment.
Using the previous example, a business with a $1 million Professional Liability policy and $400,000 in legal defense expenses would still have the full $1 million policy limit available for covered damages.
While the additional premium represents a higher upfront insurance cost, maintaining the full policy limit for a potential settlement or judgment may provide meaningful financial protection.
The primary difference between eroding and non-eroding insurance limits is how legal defense expenses affect the remaining coverage available to the insured.
Neither type of policy is automatically right for every business. The best option depends on the organization's risk exposures, financial resources, industry, and tolerance for potential out-of-pocket expenses.
The treatment of legal defense costs can vary depending on the type of liability insurance and the specific policy language.
Some policies where this distinction is particularly important include:
Professional Liability Insurance: Also known as Errors & Omissions (E&O) insurance, this coverage protects businesses and professionals against certain claims alleging negligence, mistakes, or failure to perform professional services.
Directors & Officers (D&O) Insurance: D&O insurance helps protect company directors and officers against certain claims alleging wrongful acts in the management of an organization.
General Liability Insurance: Commercial General Liability insurance helps protect businesses against certain third-party claims involving bodily injury, property damage, and personal or advertising injury. Defense-cost treatment depends on the policy form and applicable coverage provisions.
For each of these coverages, it's important to understand whether defense expenses are included within the liability limits or in addition to the policy limits.
For many business owners, the decision between eroding and non-eroding insurance limits comes down to balancing the cost of coverage against the potential financial consequences of a significant lawsuit.
An eroding limits policy may offer immediate savings on insurance premiums. However, those savings should be weighed against the possibility that expensive legal expenses could substantially reduce the coverage available to resolve a claim.
A non-eroding limits policy typically costs more, but it preserves the full stated liability limit for covered settlements or judgments, subject to the policy's terms and conditions.
Consider the following questions when evaluating your business insurance coverage:
The answers can help determine whether the initial premium savings of an eroding limits policy are worth the additional financial exposure.
The amount of liability insurance listed on your declarations page doesn't always tell the entire story. Two policies with identical coverage limits can provide very different levels of financial protection depending on how legal defense costs are handled.
Understanding your policy's defense-cost provisions, liability limits, exclusions, and other coverage terms can help you identify potential gaps before a claim occurs.
At RMC, we help business owners evaluate their insurance programs, understand their liability exposures, and identify opportunities to strengthen their overall risk management strategy.
Not sure whether your insurance policy has eroding or non-eroding limits? Contact RMC Group to schedule a complimentary Risk Review. Our team can help you better understand your existing coverage and determine whether it aligns with your business's needs. Click here to schedule or call our office at 239-298-8210.