Adequacy of Insurance Limits

Among the distinctions between these layers of coverage, an important point to bear in mind is that primary policies typically (though not necessarily always) provide protection against the cost of defending the insured party or parties against claims involving covered risks. A general liability policy, for example, may cover the costs of defending litigation against an owner and occupant arising from injuries and other damages caused by alleged negligence or other wrongful acts or omissions that occurred at the leased premises. At the primary layer, these defense costs usually are not charged against the policy limits, which can only be exhausted by the so-called “indemnity” payments made by the insurance company under the policy for settlements or judgments. As anyone who has been embroiled in litigation or even encountered a meaningful threat of litigation can attest, this can be a significant benefit. It is unfortunately the case that the legal costs incurred in defending a lawsuit or even resolving a claim short of litigation can greatly eclipse the amount paid to the claimant. Even a groundless “slip-and-fall” lawsuit will cost money to defend, which of course no one wants to pay out of pocket.

The defense that may be provided can be a hidden benefit of primary policies: In some instances, these policies may provide defense coverage that is essentially unlimited until the policy limits are exhausted by paying claims. However, as more fully discussed below, this benefit may not exist at the umbrella and excess layers. For this reason, tenants and landlords that have previously been satisfied with the procurement of minimal amounts of coverage at the primary level in reliance upon larger amounts of coverage under umbrella or other excess policies may wish to reconsider that approach and instead opt for higher amounts of primary coverage in order to leverage more highly the benefit of dollars spent for insurance premiums.

DWL Policies

Beginning in the mid-1980s, insurers began including so-called “defense within limits” (“DWL”) language in certain types of policies, including some umbrella and excess policies. A DWL policy is one where defense costs are charged against and reduce the policy limits. These policies are also variously referred to as “eroding,” “wasting,” “spend-down” or “cannibalizing” policies. The effect, of course, is that the benefit provided under the insurance policy may be substantially less than is assumed by the insured parties. Although less common at the primary level, DWL language provides another example of the importance for landlords and tenants to be familiar with all aspects of insurance policies required under leases.

Several jurisdictions have, to varying degrees, restricted the use of DWL policies:

Arkansas

Section 23-79-307(5)(A) of the Arkansas Code, for example, requires a separate limit for defense costs to prevent the depletion of indemnity limits, and forbids the approval of any policy in which defense expenditures deplete policy limits, unless a separate limit for defense costs equal to 100% of the annual aggregate limit of liability stated in the policy for judgments or settlements is offered for defense costs or claims expenses to the insured.

Montana

Section 33-1-502 of the Montana Code prohibits any provision in a casualty insurance from “permitting defense costs within limits, except as permitted by the commissioner.”

Minnesota

Section 60A.08, subdivision 13, of the Minnesota Code provides that “[n]o insurer shall issue or renew a policy of liability insurance in this state that reduces the limits of liability stated in the policy by the costs of the legal defense,” but excepts “large commercial risks,” defined as an insured with gross annual revenues of “at least $10,000,000.”

Missouri

Missouri Insurance Bulletin 98-04 allows DWL policies in the state only if approved and in circumstances involving “sophisticated” insureds.

New York

Section 71.3 of the New York Insurance Department regulations allows DWL provisions only in certain circumstances, and then defense costs can reduce the policy limits by only 50% unless the insured is given full control of its defense.

Oregon

Section 742.063 of the Oregon Code provides that a liability policy that includes defense costs within policy limits “may not be delivered or issued for delivery unless approved by [the] director,” and mandates the inclusion of a statement disclosing that costs of defending claims are included in policy limits.

Enforceability

Ultimately, the enforceability of DWL language depends on state law. This in turn can lead to questions of applicable law. In the absence of definitive choice of law provisions in an insurance policy, a determination of applicable law may require reference to the laws of multiple jurisdictions, including the law of the states where the insured, the insurer, and the insured premises are located.

If DWL language is enforceable, it affects the amount of coverage available to the insured because every dollar spent on defense of litigation depletes the policy limits and diminishes the amount of coverage remaining to pay claims. This in turn should affect the insurance purchasing decisions of the landlord and tenant. A sophisticated purchaser should carefully read the defense language in insurance policies and sophisticated landlords and tenants in a lease negotiation must pay attention to the coverage being purchased by the other party to the lease. If DWL language is present, then those policies may not be worth as much as initially contemplated from a risk management perspective. If this DWL language cannot be negotiated and extensive litigation risk is a concern, it may be prudent to purchase or require additional coverage that covers defense costs in addition to policy limits or to increase the required limits.

Conclusion

At a time when frugality is in vogue, risk managers acting for landlords and tenants need to be mindful of all elements that can affect the potential value of insurance coverage to be required pursuant to leasehold covenants. Now more than ever, it is essential for both parties to become familiar with and take into account the actual language of underlying insurance policies and not just rely upon the surface information set forth in declarations or certificates that have previously often represented the point at which examination has ended.

David A. Grossberg is Chair of the Real Estate Practice Group of Schiff Hardin LLP. He is based in the firm's Chicago office.

Commercial leases almost invariably contain provisions requiring the tenant to purchase and maintain insurance coverage, and in some cases require the landlord to purchase insurance with regard to occurrences in the common areas. Although the scope of these provisions can vary widely, a fundamental purpose at the heart of the clauses is to protect both the tenant and the landlord from claims for, or related to, personal injuries and property damage at the leased premises. Property managers, practitioners and others involved in day-to-day operations involving leases are familiar with the myriad provisions typically included for this purpose. These usually range across coverage specifications, ratings requirements to be met by the insurers, designation of the landlord as an additionally protected party, and exceptions to the so-called “insured versus insured” exclusion often found in commercial insurance policies. Insofar as each of them desires to maximize the amount of available protection, insurance procurement can be a matter of which landlords and tenants have a commonality of interest. However, the care taken by landlords and tenants when reviewing and negotiating lease provisions that relate to insurance coverage often ends with the basic considerations mentioned above. When contemplating or assessing the degree of desired protection, both landlords and tenants often fail to take into account the effect of certain aspects of the underlying insurance policy. Instead, they frequently are familiar only with the coverage summary set forth in a declarations page or certificate evidencing the existence of the policy. Although an examination of all of the significant aspects of the underlying policy that should be of interest is beyond the scope of this article, two important points are identified below that should be factored into the risk management decisions of both landlords and tenants with respect to underlying insurance.

Layers of Coverage

First, each party should consider the value in obtaining the protection of multiple layers of insurance coverage. The so-called bottom layer is commonly referred to as the primary insurance policy, which is the initial policy triggered by a claim. Next are the “umbrella” policies, which provide additional coverage that comes into play only after a predetermined amount of primary coverage has been exhausted. Umbrella policies, unlike other excess coverage insurance policies, may also provide additional primary coverage for gaps or exclusions in the underlying primary policy. Ascertaining whether this is the case can and should be a key element in assessing the adequacy of the coverage requirements imposed by a lease. Finally, when the potential risks being managed are extensive, which may more commonly be encountered in the case of larger commercial properties such as shopping malls or office complexes, there are excess coverage policies. This top layer, unlike an intermediate umbrella coverage layer, often provides coverage only of the same type as was provided by the primary insurance policy.

Among the distinctions between these layers of coverage, an important point to bear in mind is that primary policies typically (though not necessarily always) provide protection against the cost of defending the insured party or parties against claims involving covered risks. A general liability policy, for example, may cover the costs of defending litigation against an owner and occupant arising from injuries and other damages caused by alleged negligence or other wrongful acts or omissions that occurred at the leased premises. At the primary layer, these defense costs usually are not charged against the policy limits, which can only be exhausted by the so-called “indemnity” payments made by the insurance company under the policy for settlements or judgments. As anyone who has been embroiled in litigation or even encountered a meaningful threat of litigation can attest, this can be a significant benefit. It is unfortunately the case that the legal costs incurred in defending a lawsuit or even resolving a claim short of litigation can greatly eclipse the amount paid to the claimant. Even a groundless “slip-and-fall” lawsuit will cost money to defend, which of course no one wants to pay out of pocket.

The defense that may be provided can be a hidden benefit of primary policies: In some instances, these policies may provide defense coverage that is essentially unlimited until the policy limits are exhausted by paying claims. However, as more fully discussed below, this benefit may not exist at the umbrella and excess layers. For this reason, tenants and landlords that have previously been satisfied with the procurement of minimal amounts of coverage at the primary level in reliance upon larger amounts of coverage under umbrella or other excess policies may wish to reconsider that approach and instead opt for higher amounts of primary coverage in order to leverage more highly the benefit of dollars spent for insurance premiums.

DWL Policies

Beginning in the mid-1980s, insurers began including so-called “defense within limits” (“DWL”) language in certain types of policies, including some umbrella and excess policies. A DWL policy is one where defense costs are charged against and reduce the policy limits. These policies are also variously referred to as “eroding,” “wasting,” “spend-down” or “cannibalizing” policies. The effect, of course, is that the benefit provided under the insurance policy may be substantially less than is assumed by the insured parties. Although less common at the primary level, DWL language provides another example of the importance for landlords and tenants to be familiar with all aspects of insurance policies required under leases.

Several jurisdictions have, to varying degrees, restricted the use of DWL policies:

Arkansas

Section 23-79-307(5)(A) of the Arkansas Code, for example, requires a separate limit for defense costs to prevent the depletion of indemnity limits, and forbids the approval of any policy in which defense expenditures deplete policy limits, unless a separate limit for defense costs equal to 100% of the annual aggregate limit of liability stated in the policy for judgments or settlements is offered for defense costs or claims expenses to the insured.

Montana

Section 33-1-502 of the Montana Code prohibits any provision in a casualty insurance from “permitting defense costs within limits, except as permitted by the commissioner.”

Minnesota

Section 60A.08, subdivision 13, of the Minnesota Code provides that “[n]o insurer shall issue or renew a policy of liability insurance in this state that reduces the limits of liability stated in the policy by the costs of the legal defense,” but excepts “large commercial risks,” defined as an insured with gross annual revenues of “at least $10,000,000.”

Missouri

Missouri Insurance Bulletin 98-04 allows DWL policies in the state only if approved and in circumstances involving “sophisticated” insureds.

New York

Section 71.3 of the New York Insurance Department regulations allows DWL provisions only in certain circumstances, and then defense costs can reduce the policy limits by only 50% unless the insured is given full control of its defense.

Oregon

Section 742.063 of the Oregon Code provides that a liability policy that includes defense costs within policy limits “may not be delivered or issued for delivery unless approved by [the] director,” and mandates the inclusion of a statement disclosing that costs of defending claims are included in policy limits.

Enforceability

Ultimately, the enforceability of DWL language depends on state law. This in turn can lead to questions of applicable law. In the absence of definitive choice of law provisions in an insurance policy, a determination of applicable law may require reference to the laws of multiple jurisdictions, including the law of the states where the insured, the insurer, and the insured premises are located.

If DWL language is enforceable, it affects the amount of coverage available to the insured because every dollar spent on defense of litigation depletes the policy limits and diminishes the amount of coverage remaining to pay claims. This in turn should affect the insurance purchasing decisions of the landlord and tenant. A sophisticated purchaser should carefully read the defense language in insurance policies and sophisticated landlords and tenants in a lease negotiation must pay attention to the coverage being purchased by the other party to the lease. If DWL language is present, then those policies may not be worth as much as initially contemplated from a risk management perspective. If this DWL language cannot be negotiated and extensive litigation risk is a concern, it may be prudent to purchase or require additional coverage that covers defense costs in addition to policy limits or to increase the required limits.

Conclusion

At a time when frugality is in vogue, risk managers acting for landlords and tenants need to be mindful of all elements that can affect the potential value of insurance coverage to be required pursuant to leasehold covenants. Now more than ever, it is essential for both parties to become familiar with and take into account the actual language of underlying insurance policies and not just rely upon the surface information set forth in declarations or certificates that have previously often represented the point at which examination has ended.

David A. Grossberg is Chair of the Real Estate Practice Group of Schiff Hardin LLP. He is based in the firm's Chicago office.