Are Defense Costs Included in Insurance Limits?

Understanding how defense costs interact with insurance coverage limits is crucial for policyholders. This relationship directly influences potential out-of-pocket expenses in the event of a claim or lawsuit. Insurance policies vary significantly in how they address defense costs, requiring a clear understanding of your specific coverage.

Understanding Insurance Policy Limits

Insurance policy limits define the maximum amount an insurer will pay for covered losses. These limits apply to the indemnity portion of a claim, which is the amount paid to an injured party for damages.

Policies include different types of limits, such as a “per occurrence” limit and an “aggregate” limit. The per occurrence limit represents the maximum amount the policy will pay for any single incident or claim. The aggregate limit is the total maximum amount the policy will pay for all claims combined over the entire policy period, which is one year. For example, a general liability policy might have a $1 million per occurrence limit and a $2 million aggregate limit. If multiple incidents occur, the insurer will pay up to the per occurrence limit for each incident, but the total payout for all claims during the policy year will not exceed the aggregate limit.

Defense Costs Included Within Limits

In some insurance policies, defense costs are included within, or erode, the stated policy limits. This means every dollar the insurer spends on legal defense, including attorney fees, court costs, and expert witness fees, reduces the amount remaining for any potential settlement or judgment. These policies are referred to as “eroding limits” or “burning limits” policies.

If defense costs become substantial, little or no money may be left from the policy limits to pay for damages owed to the claimant. This could leave the policyholder responsible for a portion of the settlement or judgment out of their own funds. This structure is found in certain types of liability coverage, such as professional liability (errors and omissions), Directors & Officers (D&O), and sometimes cyber liability policies. For instance, a professional liability policy with a $1 million limit might see $200,000 spent on defense, leaving only $800,000 for any settlement or judgment.

Defense Costs Separate From Limits

Other insurance policies are structured so that defense costs are paid in addition to the stated policy limits. In these policies, the insurer covers legal defense expenses separately, and these costs do not reduce the amount available for settlement or judgment. This arrangement ensures the full indemnity limit remains available to cover damages awarded to the claimant, regardless of how much is spent on legal defense.

For example, if a policy has a $1 million limit with defense costs outside the limits, and $300,000 is spent on defense, the full $1 million remains available for damages. This type of coverage is common in many commercial general liability policies and in auto and homeowners insurance.

Identifying Policy Provisions

To determine how defense costs are handled, a policyholder must review the insurance document. Look for sections or clauses addressing “Defense,” “Limits of Liability,” or “Coverage.” The policy language will state whether defense costs are included within or are separate from the limits.

The policy might use phrases such as “defense costs are included in the Limits of Liability” or “defense costs are paid in addition to the Limits of Liability.” If the policy language is unclear, contact your insurance agent or broker. They can provide clarification and help you understand your coverage terms.