Liability Coverage and the Duty to Defend

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Most liability policies impose two obligations on the insurer. It must pay damages or settlements levied against you as a result of claims covered by your policy. If a covered claim results in a lawsuit, the insurer must defend you. It must pay various legal fees and courts costs associated with your defense.

Duty to Defend Under CGL

Many small businesses protect themselves against tort-related lawsuits by purchasing a general liability policy. Most liability policies are based on the standard ISO Commercial General Liability Coverage Form (CGL). The CGL provides two types of third-party liability coverage: Coverage A, Bodily Injury and Property Damage Liability and Coverage B, Personal and Advertising Injury Liability. Each of these coverages includes a duty to defend.

Coverage A applies to damages that you are legally obligated to pay because of bodily injury or property damage caused by an occurrence. The insuring agreement clearly outlines the insurer's obligation to defend. It states that the insurer has the right and duty to defend you (or any other insured) against any suit that seeks damages for bodily injury or property damage.

Coverage B applies to suits seeking damages for personal and advertising injury caused by a covered offense. The insurer has the right and duty to defend you against any suit seeking those damages.

Note that the insurer is not obligated to defend you against every claim. It has no duty to defend you or any other insured against claims seeking damages for bodily injury, property damage or personal and advertising injury that is not covered by the policy.

Duty to Defend is Separate From Duty to Indemnify

As mentioned previously, your insurer has two obligations under a liability policy: to indemnify and to defend. The insurer's obligation to defend you is separate from its duty to indemnify. That is, the insurer must indemnify you (pay damages or settlements) and it must provide a defense against lawsuits that are covered by the policy.

For example, suppose that you own a hardware store. Bill, a customer, is badly injured when a stack of paint cans falls on him from an overhead shelf. Bill files a lawsuit against your company. His suit claims that the bodily injury he sustained on your premises resulted from an accident (falling paint cans) caused by your negligence. Bill has filed a suit seeking damages for bodily injury or property damage caused by an occurrence. Assuming that his injury occurred while your liability policy was in force (and that the occurrence took place in the coverage territory), your insurer should defend you against Bill's lawsuit.

Suppose that Bill seeks $50,000 in damages. Can your insurer immediately send Bill a check for $50,000 and close its file? The answer is no. Your insurer must conduct a full investigation of the claim. It must fulfill its obligation to defend you until the damages or a settlement has been paid.

Insurer's Right to Control Your Defense

The liability policy gives the insurer both the duty and the right to defend you. Because it has the right to defend you, the insurer maintains control over your defense. It decides what defense strategy to follow and which attorney to assign to your case. Your insurer also decides whether to offer the plaintiff a settlement or to proceed with a trial.

In the hardware store example cited above suppose that your brother-in-law (Tom) is an attorney. You tell your insurer that you want Tom to manage your defense and that Tom will send the insurer a bill for his services when the suit has been resolved. Will your insurer agree to this arrangement? No! Your insurer will not relinquish control of your defense to someone else.

Now suppose that Tom believes that Bill faked his injury and has filed a false claim. Tom urges you to fight the claim rather than settle it. Your insurer wants to pay a small settlement to avoid the cost of contesting the suit. Can you stop your insurer from settling the claim? The answer is no. Your insurer has control over your defense and can settle the claim without your consent.

Defense Costs Not Subject To Limits

Under most general liability policies, expenses the insurer incurs to defend you are covered as Supplementary Payments. These expenses are not subject to the policy limits. In some cases, the amount your insurer pays to defend you against a lawsuit may exceed the amount it pays in damages or a settlement. Some claims generate defense costs only.

Broad Duty To Defend

An insurer's duty to defend is broader than its duty to indemnify. Generally speaking, your insurer must provide a defense if the allegations in the complaint are covered by the insuring agreement in the policy. The insurer must defend you even if it believes the claim isn't covered due to an exclusion or some other provision of the policy. It must continue to provide a defense until it can demonstrate that the claim isn't covered.

For example, suppose that you employ a worker named Sandy. Sandy is injured on the job and sues your firm for bodily injury. She demands $50,000 in compensatory damages. You forward Sandy's claim to your insurer. Your insurer believes that Sandy qualifies as an employee and consequently, her claim is excluded via the "employers liability" exclusion in your policy. You argue that Sandy is  not an employee but an independent contractor, so the exclusion doesn't apply. Your insurer must continue to defend you until the matter of Sandy's status has been resolved.

If a court determines that Sandy is an employee, your insurer may not have to pay her any damages. However, it will still have to pay for your defense.

Declaratory Judgment or Reservation of Rights

When you and your insurer disagree about some aspect of your insurance policy, you or your insurer may request a declaratory judgment. A declaratory judgment is a decision by a court regarding the matter of dispute. The court's decision is binding on both you and the insurer. You or your insurer may seek a declaratory judgment if say, you disagree whether the insurer has a duty to defend you.

For insurers, an alternative to a declaratory judgment is a reservation of rights letter. The letter is sent by the insurer to the policyholder. A reservation of rights typically states that the insurer will defend a claim but that it reserves its right to deny coverage for all or part of the claim in the future. If you receive a reservation of rights letter, a declination letter may soon follow.