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Insurance is a part of the general insurance system of risk financing to protect the purchaser (the "insured") from the risks of liabilities imposed by lawsuits and similar claims. It protects the insured in the event he or she is sued for claims that come within the coverage of the insurance policy. Originally, individuals or companies that faced a common peril, formed a group and created a self-help fund to pay compensation should any member incur loss (in other words, a mutual insurance arrangement). The modern system relies on dedicated carriers, usually for-profit, to offer protection against specified perils in consideration of a premium. Liability insurance is designed to offer specific protection against third party insurance claims, i.e., payment is not typically made to the insured, but rather to someone suffering loss who is not a party to the insurance contract. In general, damage caused intentionally as well as contractual liability are not covered under liability insurance policies. When a claim is made, the insurance carrier has the duty (and right) to defend the insured. The legal costs of a defense normally do not affect policy limits unless the policy expressly states otherwise; this default rule is useful because defense costs tend to soar when cases go to trial.
Liability insurers have three major duties: 1) the duty to defend, 2) the duty to indemnify and (in some jurisdictions), 3) the duty to settle a reasonably clear claim.
The duty to defend is triggered when the insured is sued and in turn "tenders" defense of the claim to its liability insurer. Usually this is done by sending a copy of the complaint along with a cover letter referencing the relevant insurance policy or policies and demanding an immediate defense. At this point, the insurer has three options, to:(1) seek a declaratory judgment of no coverage;(2) defend; or (3) refuse either to defend or to seek a declaratory judgment.
If a declaratory judgment is sought, the issue of the insurer's duty to defend will be resolved.
If the insurer decides to defend, it has thus either waived its defense of no coverage (later stopped), or it must defend under a reservation of rights. The latter means that the insurer reserves the right to withdraw from defending in the event that it turns out the claim is not covered, and to recover from the insured any funds expended to date.
If the insurer chooses to defend, it may either defend the claim with its own in-house lawyers (where allowed), or give the claim to an outside law firm on a "panel" of preferred firms which have negotiated a standard fee schedule with the insurer in exchange for a regular flow of work.
The choice to do nothing can be very risky because a later determination that the duty applied often leads to the tort of bad faith. (So, insurers often prefer to defend under a reservation of rights rather than simply do nothing.)
The duty to indemnify means the duty to pay "all sums" for which the insured is held liable, up to a set policy limit.
In some jurisdictions, there is a third duty, the duty to settle a reasonably clear claim against the insured. The duty is of greatest import during situations in which the settlement demand equals or exceeds the policy limits. In that case, the insurer has an incentive not to settle, since if it settles, it will certainly pay the policy limit. But this interest is at odds with the interest of its insured. The company has incentive not to settle since if the case goes to trial, there are only two possibilities: its insured loses and insurer pays the policy limits (nothing gained nothing lost), or its insured wins, leaving the insurer with no liability. But, if the insurer refuses to settle, and the case goes to trial, the insured might be held liable for a sum far exceeding the settlement offer. In turn, the plaintiff might then attempt to recover the difference between the policy limits and the actual judgment by obtaining writs of attachment or execution against the insured's assets.
This is where the duty to settle comes in. To avoid endangering an insured to gain a remote possibility of avoiding paying on the policy, the duty to defend obligates the insurance company to settle reasonably clear claims. The standard judicial test is that an insurer must settle a claim if a reasonable insurer, notwithstanding any policy limits, would have settled the claim.
An insurer who breaches any of these three duties may be held liable for the tort of insurance bad faith in addition to breach of contract.
Traditionally, liability insurance was written on an occurrence basis, meaning that the insurer agreed to defend and indemnify against any loss which allegedly "occurred" as a result of an act or omission of the insured during the policy period. This was originally not a problem because it was thought that insureds' tort liability was predictably limited by doctrines like proximate cause and statues of limitations. In other words, it was thought that no sane plaintiff's lawyer would sue in 1978 for a tortuous act that allegedly occurred in 1953, because the risk of dismissal was so obvious.
In the 1980s, a large number of major toxic tort scandals (primarily involving asbestos and diethylstilbestrol) resulted in numerous judicial decisions and statutes which radically extended the so-called "long tail" of potential liability chasing occurrence polices. The result was that insurers who had long-ago closed their books on policies written 20, 30, or 40 years earlier now found that their insureds were being hit with hundreds of thousands of lawsuits which implicated those old polices. The insurance industry reacted in two ways to these developments. First, premiums on new occurrence policies skyrocketed, since the industry had learned the hard way to assume the worst as to those policies. Second, the industry began issuing claims-made policies, where the policy covers only those claims that are first made against the insured and re-posted by the insured to the insurer during the policy period. (There is usually a 30-day grace period for reporting after the end of the policy period to protect insureds who are sued at the very end of the policy period.) Claims-made policies enable insurers to again sharply limit their own long-term liability on each policy and in turn, to close their books on policies and record a profit. Hence, they are much more affordable than occurrence policies and are very popular for that reason. Of course, claims-made policies shift the burden to insureds to immediately report new claims to insurers. They also force insureds to become more proactive about risk management and finding ways to control their own long-term liability. Claims-made policies often include strict clauses that require insureds to report event potential claims and that combine an entire series of related acts into a single claim. They can timely report every "potential" claim (i.e., every slip-and-fall on their premises), even if those never become actual lawsuits, and thereby protect their right to coverage, but at the expense of making themselves look more risky and driving up their own insurance premiums. Or they can wait until they actually get sued, but they run the risk that the claim will be denied because it should have been reported back when the underlying accident first occurred. Claims-made coverage also makes it harder for insureds to switch insurers, as well as to wind up and shut down their operations. It is possible to purchase "tail coverage" for such situations, but only at premiums much higher than for conventional claims-made policies, since the insurer is being asked to re-assume the kind of liabilities which claims-made policies were supposed to push to the insureds.
One way for businesses to cut down their liability insurance premiums is to negotiate a policy with a retained limit or self-insured retention (SIR), which is somewhat like a deductible. With such policies, the insured is essentially agreeing to self-insure and self-defend for smaller claims, and to tender only for liability claims that exceed a certain number. However, writing such insurance is itself risky for insurers.
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