Most management liability insurance policies are written on a defense-costs-inside-the-limits basis, meaning that covered defense costs erode the limits of liability as the expenses are incurred. Though this is a well-established arrangement within the industry for this type of insurance, the erosion of limits by defense expenses sometimes comes as an unwelcome surprise to a policyholder, usually in the middle of a serious claim. A recent federal appellate case involved an effort by a community hospital system in Mississippi to try to argue that its expenses incurred in defending an underlying claim did not erode the limits of its management liability insurance policy.
In a March 1, 2017 opinion (here), the Fifth Circuit, applying Mississippi law, rejected the hospital system’s arguments and held that under the terms of the policy, the system’s expenses defending the underlying claim did erode the applicable policy limits. While the Fifth Circuit’s conclusion in that regard arguably is unremarkable, it does provide an opportunity to step back and consider the limits erosion feature of these kinds of policies.
Background
Singing River Health Systems and Singing River Health System Foundations (collectively referred to in the appellate opinion as the “Medical Insureds”) operate a community hospital system. The Medical Insureds were sued in various underlying lawsuits arising from the hospital system’s alleged underfunding of its Retirement Plan and Trust. The underlying lawsuits alleged various claims, including breach of fiduciary duty, breach of contract, and violations of the U.S. and state constitutions.
The hospital systems maintained a Health Care Portfolio insurance policy, which contained a Fiduciary Liability section, which had a $1 million limit of liability, and an Executive Liability, Entity Liability, and Employment Practices Liability coverage section (“ELI/EPL coverage”), with a $5 million limit of liability.
The Fiduciary Liability coverage section provides that the insurer “shall pay, on behalf of the Insureds, Loss for which the Insureds become legally obligated to pay on account of any Fiduciary Claim.” The policy also contained the following language:
The applicable limit(s) of liability to pay “loss” will be reduced, and may be exhausted by “defense costs” unless otherwise specified herein. …
In no event will the company be liable for “defense costs” or other “loss” in excess of the applicable limit(s) of liability. …
If the Optional Separate Defense Costs Coverage is not purchased, Defense Costs shall be part of, and not in addition to, the Limits of Liability set forth … for this coverage section, and the payment by the Company of Defense Costs shall reduce and may exhaust such applicable Limits of Liability.
The Insured did not purchase the Optional Separate Defense Costs Coverage.
Exclusion 7(e) in the ELI/EPL coverage section preclude coverage for Loss arising from any claim “for any actual or alleged violation of the responsibilities, obligations, or duties imposed by any federal, state, or local statutory law or common law anywhere in the world (including but not limited to the Employee Retirement Income Security Act of 1974 … and the Consolidated Omnibus Budget Reconciliation Act of 1985) …that governs any employee benefit arrangement, program, policy, plan or scheme of any type … including but not limited to any … retirement income or pension benefit program … [or] similar arrangement, program, plan or scheme.”
The insurer defended the hospital systems subject to a reservation of its rights under the policy. The insurer initiated a federal court action seeking a judicial declaration that the Fiduciary liability coverage section’s $1 million limit of liability was the policy limit applicable to the underlying claims, and that defense expenses erode or deplete the limits. The Medical Insureds filed a counterclaim alleging breach of contract and bad faith, among other things. The parties in the insurance coverage action filed cross-motions for summary judgment, which the district court granted in part and denied in part. The parties filed cross appeals.
The March 1, 2017 Opinion
In a March 1, 2017 opinion written by Judge Catharina Haynes for a unanimous three judge panel, the Fifth Circuit rejected the Medical Insureds arguments that the ELI/EPL section’s $5 million limit of liability applied to the underlying claims and agreed with the insurer that under the terms of the policy defense costs erode the applicable $1 million limit of liability in the Fiduciary Liability coverage section.
In reaching these conclusions, the Fifth Circuit rejected the Medical Insureds argument that the Mississippi Supreme Court’s 1996 opinion in Moeller v. American Guarantee & Liability Insurance Co. mandates that the payment of defense costs should be separate and apart from the policy limit. In Moeller, a law firm’s insurer was defending the firm in a business dispute, subject to a reservation of rights. In addition to being represented by the insurer’s choice of counsel, the law firm retained separate counsel in the business dispute and sought to be reimbursed by insurer for the cost of separate counsel. The Mississippi Supreme Court held that the insurer was responsible for this cost.
The Fifth Circuit said that Moeller merely “reflects that commonly accepted rule that where a conflict of interest exists, the insurer must pay for the insured’s separate counsel.” Moeller “did not speak to the ability of an insured to include Defense Costs as eroding the policy limit” and it “does not create an absolute right to reimbursement of all defense costs.”
Subsequent case law has established that the general duties described in Moeller are “subject to the terms of the applicable policy,” and in this case, the policy “states in multiple locations that Defense Costs erode policy limits,” and the insureds “specifically declined to purchase separate coverage for Defense Costs.” Accordingly, the appellate court said, “we reject Medical Insureds’ argument that Moeller and the policy language required Federal to pay Defense Costs without regard to policy limits.”
The appellate court also rejected the Medical Insureds argument that the erosion of the limits of liability by the payment of defense expenses is against Mississippi public policy. The Medical Insureds sought to rely on various Mississippi statutory provisions dealing with the authority of the boards of community hospital systems to purchase insurance. The appellate court said “the policy states that Defense Costs erode policy limits, and public policy does not bar such a provision.” The court concluded that the district court erred in determining that Defense Costs did not erode the policy limit.
Finally, the Fifth Circuit rejected the Medical Insureds’ argument that the Exclusion 7 (e) in the ELI/EPL coverage section precludes coverage for the underlying claims, and therefore concluded that the district court did not err in determining that there was no coverage for the claims under the ELI/EPL coverage section.
Discussion
The only thing remarkable about this case is that it had to go all the way to the Fifth Circuit. Actually, that is not quite right – it is also remarkable (to me at least) that the hospital system managed to convince the district court, despite the express policy language, that defense costs do not erode the policy limits. The hospital system’s arguments to disregard the express policy language are, from my perspective, unconvincing.
Though the policyholder’s argument here that the defense-inside-the-limits feature of this policy is against public policy did not succeed, it is worth noting that there are jurisdictions where this type of arrangement is regarded as contrary to public policy. For example, as I understand it, Quebec does not allow defense-inside-the-limits arrangements.
While there are jurisdictions where these kinds of arrangements are not permitted, in general, these arrangements are otherwise pretty standard. Certainly, other than perhaps in Quebec (and other places that I am sure readers will be happy to point out), policyholders should assume under insurance policies with the kind of language involved here that defense costs will erode the limits of liability.
The difficulty for everyone is that the practical meaning of this feature of these kinds of policies often is not apparent to policyholders until they are deep into the depths of a serious claim. Those of us who live with these claims can sometimes forget that to others who don’t live with these things it can come as a huge shock when they see how fast defense fees can accumulate and how quickly the limits of liability can be eroded.
The eroding limits feature typically found in most management liability policies is one of those fundamental issues that has to be addressed with the policyholder at the time they are buying the policy. This isn’t just a question of having a well-educated insurance buyer that understands how the policy works, although that is obviously highly desirable. It is even more fundamental than that – it is a question of the insurance buyer understanding what they need to know in order to make an intelligent and informed decision about limits adequacy.
I will put it this way – any prospective insurance buyer that (a) understands that defense costs erode the limits of liability and (b) understands in the context of a serious claim how quickly defense costs can erode the limits of liability is probably going to understand that they need more insurance than they might otherwise assume. Simply put, the discussion of the defense-inside-the-limits issue is an indispensable part of the limits selection issue for every management liability insurance buyer.
It is also worth noting in this context that some policies, including the policy at issue here, include an options separate defense cost coverage option. This option it typically not offered to most commercial enterprises, but it is sometimes available for non-profit organizations (and sometimes for some smaller private companies). There is usually an additional premium charge associated with this option. This option and the associated additional expense may not make sense for smaller non-profit organizations. But as this case highlights, this could be a valuable coverage for many other buyers, and it is the kind of thing that should be seriously considered when available.
One thing I am sure was a problem here for this policyholder was trying to understand once the claims came in why the $1 million fiduciary limit of liability was applicable and the $5 million ELI-EPL limit of liability did not apply. I can easily picture some policyholders saying, wait a minute, I have $5 million of insurance. From my perspective, it is absolutely clear that the $5 million limit didn’t apply and that the policyholder only had $1 million of insurance for this claim. But while it is clear to me, I can see why some policyholders might be confused. That is one of the problems with split limits insurance structures, it can create confusion for the policyholder about how much insurance they have.
I want to make clear that I am not remotely suggesting that I think that there was something wrong with the way this program was structured, because I don’t think that. I know from experience that because of insurance buyers’ decision making, structures like this can sometimes result. Just the same, it is a bit of head scratcher to me why any buyer would recognize the need for $5 million limits for ELI and EPL but then choose to buy only $1 million of fiduciary, especially since the incremental cost of an additional $4 million more of fiduciary liability coverage (particularly on a combined aggregate basis) would have been relatively slight.
All of that said, the most important point here is that, while management liability insurance can sometimes be viewed as expensive, buying the insurance is not nearly as expensive as it is to not have it or not have enough of it when a serious claim hits.
Management liability insurance is a catastrophic claim protection tool. You don’t want a structure rated up to a category 1 storm when a category 5 storm hits.