Liability Coverage and the Duty to Defend

If Sued Due to Act Covered by Your Policy, Insurer Must Defend You in Lawsuit. Getty Images/Tetra Images

Under most liability policies purchased by small business owners, the insurer has a duty to defend. If you are sued by a third party that seeks damages because of an act that is covered by the policy, the insurer must defend you against the lawsuit.

In the standard ISO general liability policy, the insurer's duty to defend you against suits for bodily injury or property damage is outlined in the insuring agreement under Bodily Injury and Property Damage Liability.

The policy affords the insurer the right and duty to defend you (or any other insured) against any suit. The insurer must provide a defense when the suit seeks damages for bodily injury or property damage caused by an occurrence. The insurer also has a duty to defend you under Personal and Advertising Injury Liability. The insurer must defend you against suits seeking damages for personal and advertising injury caused by a covered offense.

Duty to Defend is Separate From Duty to Indemnify

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's lawsuit seeks $50,000 in damages. Can your insurer simply pay Bill the $50,000 he wants and then close its file? The answer is no. Your insurer must fulfill its duty to defend. This means that the insurer must conduct a full investigation of the claim. It must also provide you an attorney and pay for your defense.

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.

Defense Costs Not Subject to Limits or Exclusions

In most general liability policies, expenses the insurer incurs to defend you are not subject to the  limits in the policy.

Such expenses are covered as Supplementary Payments. The amount your insurer pays to defend you against a lawsuit may exceed the amount the insurer pays in damages or a settlement. Some claims involve defense costs only.

As a general rule, your insurer must provide a defense if the allegations in the complaint are covered by the insuring agreement in the policy. If the insurer believes that the claim is precluded by a policy exclusion, it must continue to defend you until it can demonstrate that the claim is not 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 compensation. You forward Sandy's claim to your insurer. Your insurer believes that Sandy is an employee of yours. If Sandy is indeed an employee, her claim will be excluded via the "employers liability" exclusion in your policy.

You argue that Sandy is an independent contractor, not an employee and that the exclusion does not 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 a controversy exists between you and your insurer over an issue concerning your policy, your insurer might ask a court for a declaratory judgment. A declaratory judgment is a decision by a court on the issue at hand. The court's decision is binding on both you and the insurer. Generally, an insurer will seek a declaratory judgment before it pays any damages.

An alternative to a declaratory judgment is a reservation of rights letter sent to you by the insurer. A reservation of rights typically states that the insurer will defend a claim but that it reserves it 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.