By Jordan S. Stanzler

Insurance policies that provide "defense within limits" present inherent conflicts of interest between the insurance company and the policyholder in selecting counsel, defending the case, and settling the case. Because of their unique provisions, these policies often pit the policyholder against its own insurance company over fundamental decisions such as the choice of counsel to defend a claim, the decision to settle or not, and the amount of money to be spent on defense or settlement.. To deal with these conflicts, policyholders are entitled to "independent counsel" who should control decisions about the defense of a claim.

The typical general liability policy, whether automobile insurance, homeowners insurance, or commercial liability insurance, provides for unlimited defense expenditures that are separate from, and in addition to, the limits of the policy and so are referred to as policies where "defense is outside limits". In contrast, professional liability policies and directors and officers' policies very often provide that the limits of indemnity will be reduced by any cost expended in defense of the insured. Such policies are called "defense within limits", "wasting", "self-consuming", or "self- liquidating" policies, since every dollar spent on defense is one less dollar that is available to settle the case or pay a judgment. Thus, for example, if a policy provides coverage of $1 million, that sum will be reduced. by every dollar spent on defense costs. If $1 million is spent on defense, then nothing will be left of the policy. The policy will be completely liquidated, even if the litigation is still in progress.

Therefore, the "defense within limits" ("DWI") policy presents an inherent conflict which arises between the policyholder and its insurance company in every case where the defense costs and liability, combined, have the potential to exceed the limits of the policy. Who should control the defense and how should the insurance money be spent - on defense or settlement? The insurance company in our example is only at risk for $1 million and may not care whether the money is spent on defense or settlement. Its preference may be to spend everything on defense and not one penny on tribute, to discourage other lawsuits against this policyholder or other insureds who might be sued. But the policyholder who realizes that defense costs will eat away at the limits of the policy may well prefer to settle while there is still money left in the policy to pay for the settlement. Who is right and who gets to decide?

To begin with, the insurance company must let the policyholder control the defense and thus must provide "independent counsel" pursuant to Civil Code section 2860. That statute provides that an insurance company must pay for "independent counsel" chosen by the policyholder, when there is a dispute over coverage which can be controlled by counsel. See generally San Diego Federal Credit Union v. Cumis Ins. Society, 162 Cal. App. 3d 358, 366 ( 19 84 ). It would be foolish for the insurance company to do otherwise. If the insurance company appoints defense counsel and instructs defense counsel on how to conduct the defense, ( or allows defense counsel to make those decisions), then the insurance company is deciding for itself how much money will be left for the payment of a settlement or judgment. In plainest of terms, the insurance company is deciding how much coverage there will be for defense and how much there will be remaining for indemnity. If there is not enough money left to settle the case, or not enough money left to pay a judgment, then the insurance company will surely, and perhaps rightly, be blamed. But that is only half of the problem. If the policyholder tells the defense attorney, "don't waste my limits", while the insurance company tells the defense attorney, "keep defending the case", the attorney is hopelessly conflicted and cannot represent both interests.

It is not difficult to imagine nightmarish scenarios. Suppose the insurance company appoints defense counsel, who proceeds to spend all of the limits of the policy on defense, which become depleted on the eve of trial. The insured now finds that there is no attorney being paid for by the insurance company; and no money left to pay for settlement or judgment. Are the insurance company and the defense attorney going to abandon the policyholder because the insurance benefits have now been consumed, selfishly it would now seem, by the defense attorney, at the expense of the client ? If the insurance company cannot see a death spiral in the making, with every dollar spent on defense, then the defense attorney surely should. To avoid this scenario, the insurance company should gladly and readily concede, from the outset, the policyholder's right to choose an attorney who will control the defense and decide how the defense will be conducted -i.e., how much money will be spent on defense.

Presumably, every insurance company which receives notice of a claim under a "defense within limits" policy will issue a reservation of rights letter advising of the "wasting limits" and asserting the right to withdraw from the case when the limits are exhausted through expenditure of defense costs. This presents a classic conflict of interest requiring the appointment of "independent counsel".

Section 2860(b) states that "when an insurance company reserves its rights on a given issue and the outcome of the coverage issue can be controlled by counsel first retained by the insurer for the defense of a claim, a conflict of interest may exist." Under DWI policies, the appointed counsel is indeed able to control the outcome of coverage, every time the attorney decides to incur a dollar in defense costs, since that means one less dollar for indemnity. The appointed counsel is thus deciding what the indemnity limits of the policy will be - something the policyholder may not agree with. See Cumis Ins. Society, 162 Cal. App. at 366 :"[n]o matter how honest the intentions, counsel cannot discharge inconsistent duties".

Even when "independent counsel" is appointed, the conflicts will still persist when offers to settle are made. The risk-averse policyholder may well insist that any settlement offer up to the limits of the policy be paid. Even if the insured is certain of a victory at trial, the prospect of running out of money to fund the defense is chilling. Conversely, the insurance company must weigh not only the merits of the case, but the cost of continued litigation, and the prospect that refusing a settlement offer will lead to continued litigation and thus continued depletion of the insurance coverage available under the policy.

In the landmark case of Communale v. Traders and General Ins. Co., 50 Cal. 2d 654 (1958) the Supreme Court held that settlement of litigation is one of the benefits a policyholder secures in purchasing liability insurance; and that the duty to settle is implied in every policy: "The obligation of good faith and fair dealing requires the insurer to settle in an appropriate case although the express terms of the policy do not impose such a duty". Id. at 659. The insurance company must give the insured "at least as much consideration as it does its own interest"; and "[w]hen there is great risk of recovery beyond the policy limits so that the most reasonable manner of disposing of the claim is a settlement which can be made within those limits, a consideration in good faith of the insured's interest requires the insurer to settle the claim". Id.

These concerns are magnified by the added complexity of the DWI policy. The very nature of the self-consuming policy itself puts a premium on considering how the continued prospect of litigation will diminish the limits available for defense or settlement. Consider the problems raised where the insurance company has issued a $1 million policy, defense costs have totaled $500,000, and the plaintiff offers to settle for $500,000 midway in the litigation. Suppose further that the reasonable settlement value of the case is only $250,000, but it will take an additional $500,000 to defend the case through trial. The policyholder demands that the offer be accepted , but the insurance company refuses to "overpay". The offer is rejected, the case is defended at a cost of another $500,000, the plaintiff wins $250,000 at trial, and the policyholder has no insurance proceeds left to pay the judgment.

A good argument can be made that the insurance company is just gambling with the insured's money, in violation of its duty to settle. The verdict exceeds the limits, as those limits (zero) exist at the time when the verdict is rendered. The offer to settle cannot be considered in a vacuum, without considering the cost of continued defense. Here, the offer to settle cannot simply be limited to the $500,000 actually offered; but must also factor in the continued defense costs that will be incurred by rejecting that offer. From its perspective, the policyholder was facing a total liability of $750,000 (factoring in both the continued cost defense and the reasonable value of the settlement alone), which it could settle for $500,000. From the insurance company's perspective, the $500,000 settlement offer was unreasonable, since it exceeded the value of the case. The insurance company would argue that the verdict was less than the policy limits, as they existed at the time of the offer, and that the company was justified in refusing to pay an unreasonable, excessive sum to settle. Either argument begs the question of when to judge the limits of a DWI policy, since the limits are always diminishing with each dollar spent on defense costs. Perhaps one deciding factor is that the duty to settle is not limited to situations involving a judgment in excess of policy limits. See Shade Foods, Inc. v. Innovative Products Sales & Marketing, Inc., 78 Cal. App. 4th 847, 905-906 (2000). In the final analysis, the insurance company must be deemed to have violated the duty to settle, because under these facts it knew that the policy limits would be completely spent, under either outcome (settlement or trial). That being so, the insurance company should have put the remaining limits on the table and let the policyholder decide how to spend them.

In this hypothetical the plaintiff's attorney is getting a "windfall", if the case settles early for $500,000, when the case itself (without regard to defense costs) is only worth $250,000. Conversely, the plaintiff's attorney will have a hollow victory by winning a trial, but having no insurance proceeds to pay for the judgment. The prospect of such a pyrrhic victory therefore provides plaintiff's counsel with an incentive to settle early, before the proceeds of the policy are consumed by the cost of defense. Can one fault the plaintiff's attorney for making the same case evaluation early on - adding both the value of the case itself and the cost of defense, to make a combined settlement offer that exceeds the value of the case alone? Later on, the ability to settle will diminish as the defense costs eat away at the remaining policy limits. Inevitably, then, the DWI policy forces both sides to factor in the cost of continued litigation, more critically than would otherwise be the case under a "defense outside limits" policy. Not surprisingly, the insurance company may feel more pressure to settle in cases it would otherwise refuse to settle.

These considerations question the value of a "defense within limits" policy in the first place; and whether the putative reduced premium cost (compared to a policy with unlimited defense costs) is really worth it. See generally Munro, Defense Within Limits: The Conflicts of "Wasting" or "Cannibalizing" Insurance Policies, 62 Mont. L. Rev. 131 (2001). Under a DWI policy, the burden of managing the defense and settlement of a claim is actually shifted, as a practical matter, to the insured. The insured must continually monitor the case and decide how much to spend on defense and how much to spend on settlement. These decisions cannot be left to the insurance company. In effect, the policyholder functions as its own insurance company. The insurance company functions as not much more than a stakeholder, albeit a stakeholder with heightened, quasi-fiduciary duties. Consequently, the attorney representing the policyholder has heightened duties to consider how the policy proceeds will best be spent. For all parties concerned, the ethical considerations present a minefield. to be navigated with care. At present there are hardly any cases dealing directly with the conflicts presented by DWI policies; but it seems only a matter of time before the cases will emerge.

Jordan Stanzler is a partner in the San Francisco office of Stanzler Funderburk & Castellon LLP which represents policyholders in disputes with insurance companies. He is the co-author of "Insurance Coverage Litigation" (Aspen 2004).

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