I'm So Tired of this Exhaustion Doctrine

Nevada recently passed a statute that further developed a trend that many in the insurance industry may find surprising: the relatively uneasy footing that eroding limits insurance policies may have in many American states.

Eroding limits policies, otherwise known as “defense within limits” policies, allow a liability insurer to reduce its policy’s limit available for indemnity coverage by the amount that the carrier spends in defense costs and fees.

Nevada’s new statute, labeled Assembly Bill 398, states that an insurer “shall not issue or renew a policy of liability insurance that contains a provision that … [r]educes? the? limit? of? liability? stated? in? the? policy? by? the costs? of? defense,? legal? costs? and? fees? and? other? expenses? for claims; or? … [o]therwise limits the availability of coverage for the costs of defense, legal costs and fees and other expenses for claims.” With this statute, Nevada joins a small but growing list of states that have prohibited, curtailed or sharply regulated the issuance of eroding limits policies. See e.g. Arkansas, Ark. Code Ann. § 23-79- 307(5)(A);? Minn. Stat. Ann. § 60A.08 Subd. 13; Montana, Mont. Code Ann. § 33-1-502(2); NY Comp. Codes R. & Regs. tit. XI § 71.3; Or. Rev. Stat. Ann. § 742.063.

Most states, however, have not prohibited eroding limits policies by statute. Indeed, many jurisdictions have expressly enforced insurance policies with eroding limits provisions without incident. See e.g. Continental Ins. Co. v. Bangerter, 37 Cal. App. 4th 69 (Cal. App. 1995); Weber v. Indemnity Insurance Co. of North America, 345 F. Supp. 2d 1139 (D. Haw. 2004); Federal Ins. Co. v. Singing River Health Sys., 850 F.3d 187 (5th Cir. 2017) (applying Mississippi law); Westport Ins. Corp. v. Mylonas, CIVIL ACTION NO. 14-5760 (E.D. Pa. Jul. 15, 2015).

Nonetheless, there is growing hostility to these provisions. Courts have not enforced eroding limits provisions on the grounds that they are ambiguous. See Illinois Union Insurance Co. v. North County Ob-Gyn Medical Group, S.D. California, CASE NO. 09cv2123 (S.D. Cal. May 18, 2010). They also have held that an insurer controlling the defense under such a policy without reserving rights loses the right to assert its coverage defenses. See Lexington Ins. Co. v. Swanson, No. C05-1614MJP (W.D. Wash. May 23, 2007). Moreover, if their retained defense counsel do not properly disclose the eroding limit in discovery in the underlying case, courts have chosen not to enforce these provisions. Nat’l Fire and Marine Ins. Co. v. Lindemann, No. 15-cv-910-DRH-DGW (S.D. Ill. Oct. 15, 2018); Harwell v. Fireman's Fund Ins. Co. of Ohio, 57 N.E.3d 671, (Ill. App. Ct. 2016).

The big worry—and we coverage lawyers always worry—is that an aggressive state appellate court will go ever further one day and hold that eroding limits policies violate public policy.

One can see the seed planted for such a holding in the West Virginia Supreme Court’s decision in Gibson v. Northfield Ins. Co., 631 S.E.2d 598 (W.Va. 2005). The court in that case held that an eroding limits provision in an automobile liability insurance policy issued to a municipality violated the requirements for such a policy set by statute. However, the court then offered this commentary on the subject of eroding limits policies:

But on a more general note, we believe that the inclusion of a defense within limits provision in a governmental entity's insurance policy offends traditional notions of fairness. Governmental entities purchase liability insurance to protect their employees and to protect the public fisc. The quiet inclusion of a defense within limits provision into a governmental entity's liability policy subverts that intent by using the liability coverage to pay the insurance company's litigation expenses and attorney fees, rather than protecting the governmental entity and its employees and making injured third parties whole against their losses.

This notion that an insurance company would rather exhaust its policy limits through payment of defense costs rather by settlement of claims is odd, but it seems to drive much of the objection to these policies.?

Indeed, several courts have allowed insureds to maintain bad faith claims against their insurers under a similar theory that the insurer improperly exhausted the policy limit through payment of unnecessary or wasteful defense costs rather than settling or resolving the claim. See Pueblo Country Club v. AXA Corporate Solutions Ins. Co., Civ. A. No. 05-cv- 01296 (D. Colo. March 28, 2007); Weber v. Indemn. Ins. Co. of N.A., 345 F.Supp.2d 1139 (D. Haw. 2004); Agape Senior Primary Care, Inc. v. Evanston Ins. Co., No. 3:16-cv-01610-JFA (D.S.C. Sep. 14, 2016).

So what is an insurance company with an eroding limits policy to do?

Simple. Handle the claim in good faith.

No, but really.

Given the right set of “bad facts,” courts in certain jurisdictions may be very amiable to the argument that eroding limits insurance policies violate public policy or that the insurer’s conduct under that policy is in bad faith. The goal, then, is not to give the court or the parties those “bad facts.”

In addition to the typical things that insurers do to handle claims in good faith, insurers may want to consider:

• Sending early correspondence to the insured that clearly outlines how defense costs may erode the policy limit;
• Issuing whether a reservation of rights may be required or advisable;
• Evaluating whether the insured is entitled to independent counsel;
• Considering whether early settlement or resolution of the claim is possible;
• When settlement demands are made, taking eroding limits into account when deciding how to respond;
• Developing a budget and defense strat4egy that takes the eroding limits into account;
• Discussing this defense strategy with the insured and its possible effect on the limits;
• Communicating with the insured about the potential for an excess judgment; and
• Providing the insured with a “running balance” of the defenses costs incurred to date and the remaining policy limit.

Of course, these items are merely things to consider. This is not an exclusive checklist, and the failure to do one or more of these items does not equate to bad faith. Considering these items, however, will go a long way towards convincing a court that it should enforce an eroding limits policy as written.

Michael L. Young is a litigation partner at Reichardt, Noce & Young LLC in St. Louis, Missouri, who focuses his practice on insurance coverage and extra-contractual matters. He represents insurer clients in Missouri and Illinois.

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