A limit of liability is a central component of a policy and an important consideration for an organisation and its management. Having enough coverage when it’s required can mean the difference between effective protection and potential ruin. Despite its significance, the process of selecting an adequate limit of liability remains part art, part science.
In this article, we will explore the concept of a limit of liability within the context of the following coverages:
- Directors and officers liability insurance
- Employment practices liability insurance
- Management liability insurance
- D&O insurance for nonprofits
You may also find that similar concepts apply to a broad range of financial lines insurances, such as professional indemnity insurance, cyber insurance, and even crime insurance to a certain extent. Keep in mind, however, that each policy is strictly interpreted according to its own terms and conditions.
Limit of liability: A definition
A limit of liability is the maximum amount that an insurer has agreed to pay to, or on behalf of, an organisation and its management for covered claims throughout a policy period. In other words, it represents the amount of protection that an insurer will provide for any claim made against an insured in a policy period, alleging a wrongful act.
A policy’s limit of liability sits in excess of a self-insured retention. A self-insured retention, also known as a deductible or excess, is the amount of loss an organisation is required to sustain for a covered claim before a policy will respond. Once a self-insured retention has been eroded, an insurer will pay up to, but not exceeding, the limit of liability.
Put another way, a limit of liability is the maximum liability an insurer has to an insured. Once a claim is notified to an insurer and after a self-insured retention has been incurred, an insurer will be required to pay up to a limit of liability. Once a limit of liability is exhausted, an organisation and its management will not be covered for any further loss.
Components of a limit of liability
A limit of liability typically consists of three individual components.
Any one loss limit
An any one loss limit is the maximum amount an insurer will pay for any single covered claim over and above the self-insured retention. Each and every claim made against an insured will be subject to an any one loss limit. Any claim arising from a single act will be considered a single claim, while multiple claims arising from a single act are likely to be treated as related claims.
An aggregate limit is the maximum amount an insurer will pay for all covered claims in a policy period. As individual claims are incurred throughout a policy period, they will gradually erode an aggregate limit until it is finally exhausted. Once an aggregate limit is exhausted, an organisation and its management will not be covered for any further loss.
A policy’s any one loss limit and aggregate limit are typically the same amount; for example, $1 million any one loss and $1 million in the aggregate. In this scenario, the maximum amount an insurer would pay for any one covered claim is $1 million, and the most it would pay for all claims combined in a policy period is also $1 million.
Sublimits place an additional restriction on an insurer’s liability to an insured for certain risks. It allows an insurer to offer coverage for claims of a certain type but only up to a specified amount. In other words, a claim will be covered but the entire limit of liability is not available.
Common sublimits include:
- Workplace health and safety investigation costs
- Environmental damage claims against management
- Cyber-related claims against management
Sublimits can apply to any one claim or all claims in the aggregate. They are often closely linked to a policy’s extensions, and are can be listed on the schedule, included in the wording, or added by endorsement.
A limit of liability is likely to be shared across all coverage sections of a policy. Most policies will include at least two coverage sections – Side A coverage and Side B coverage. However, some will include others, such as Side C coverage and employment practices liability insurance. Despite the convenience of this, having multiple coverages within the same policy can be problematic.
Not all coverage sections have the same intent. For example, Side A and Side B coverage focus predominately on protecting the personal assets of individuals, as well as the assets of an organisation while defending those individuals. Side C coverage, however, focuses on protecting an organisation from its own liability, and presents a very different risk to that of individuals.
An organisation should consider the effect of having multiple coverages insured under one policy. This will not only influence the selection of a limit of liability but also a programme’s structure. If not carefully considered, claims against an organisation may erode and eventually exhaust the limit of liability, exposing the very individuals a policy is intended to protect.
Selecting a limit of liability
When it comes to selecting a limit of liability, there is no scientific formula for calculating what is right for any particular organisation. There are, however, a few factors that should be weighed up and considered, given a particular risk profile.
Common considerations include:
- The relative risk of an organisation’s business activities and industry
- The size of an organisation, as measured by revenue, asset position and/or market capitalisation
- An organisation’s ownership structure; e.g. public, private or nonprofit
- Comparison of programmes purchased by other organisations of a similar type; i.e. benchmarking
- An organisations tolerance for uninsured loss (in excess of the limit of liability)
- An organisation’s budget
The following factors should also be considered:
- General litigation trends
- The possibility of defending multiple concurrent claims against multiple insureds
- Whether the limit of liability will be shared by individuals and the entity
An organisation should not only consider the severity of potential losses but also their frequency. By entering into an open discussion with its broker and insurer, an organisation can be guided in its decision-making process. Its goal should be arriving at a suitable limit of liability for its risk profile, and one that can reasonably be facilitated by the market.
How much coverage is enough?
While no organisation is a carbon copy of another, many share characteristics common enough that we can generalise about their requirements.
The needs of private companies will vary significantly, depending on the industry in which they operates and their relative size. It is not unusual for small and medium enterprises to carry a limit of liability of $1-5 million. As private companies becomes larger and more complex, higher limits of liability such as $10-20 million are often required to address this additional exposure.
Publicly listed companies, by comparison, are much higher risk than their private counterparts. Accordingly, it is not unusual for them to carry a limit of liability of $20-50+ million, often using multiple insurers. As these companies get larger, the threat of shareholder claims become more significant. As a result, they will work closely with a broker to construct a suitable programme.
Nonprofit organisations have a similar risk profile to that of private companies. A typical nonprofit organisation will often carry a limit of liability of $1-10 million, depending on its size and activities. Nonprofits can be somewhat unique in that they often attract volunteers with a high public profile, leading to interesting exposures when egos become entangled.
If organisation requires a limit of liability too large for any one insurer to satisfy, a broker will need to construct a solution. This can typically be achieved in two ways.
Excess insurance involves having a broker layer the capacity of various insurers, one on top of another, until the desired limit of liability is acquired. A lead underwriter will set the terms of the primary layer. Subsequent insurers then view these terms and price their excess layer to attach above the primary. An excess insurer will often follow the primary terms, adding endorsements to its own layer.
Co-insurance is when one or more insurers agree to share the risk of an organisation proportionally. Once again, a lead underwriter will set the terms of a policy. Subsequent insurers will then view these terms and agree to accept a portion of the risk. Any subscribing insurer will receive a share of the premium, and will be liable for paying claims in the same proportion.
How do defence costs interact with the limit of liability?
Defence costs contribute significantly a claim’s overall cost, therefore it is important to understand how they interact with the limit of liability.
Defence costs inclusive limit
A defence costs inclusive limit means that defence costs erode the limit of liability. This means that as a claim is defended the limit of liability will reduce, leaving less funds available for the defence and settlement of all other claims. For example, if a limit of liability is $1 million, and $250k is spent on defence costs, $750k of the limit of liability remains.
Defence costs exclusive limit
A defence costs exclusive limit means that defence costs are paid in addition to the limit of liability. This means that as a claim is defended the limit of liability will not change, leaving the full amount available for claim settlement. For example, if a limit of liability is $1 million, and $250k is spent on defence costs, the $1 million limit of liability remains.
It is reasonable to assume that the limit of liability of most policies will be defence costs inclusive; i.e. that defence costs will erode the limit of liability. The costs involved in defending a claim can be significant and often more than any claim settlement. A policy’s duty to defend provision will also play an important role in determining how an insured’s defence is handled.
Policy lifecycle and the limit of liability
A limit of liability will come up for discussion at various times throughout a policy’s lifecycle.
An organisation will request a desired limit of liability during the application process. A submission will indicate what type of coverage is required, while also forming part of an organisation’s duty of disclosure. Depending on the capacity available from a single insurer, a broker may need to construct a limit of liability involving excess layers or co-insurance.
An insurer will consider its willingness to provide a desired limit of liability during the underwriting process. Depending an organisation’s risk profile, an insurer may engage in limit control – i.e. artificially restricting capacity – to manage its own exposure. After assessing an organisation’s control environment, an insurer will eventually arrive at terms that it is comfortable with offering.
Mid-term adjustment to coverage
Once coverage is bound, a limit of liability will be set for the duration of the policy period. If an organisation would like to increase its coverage mid-term, a satisfactory signed no known loss letter will be required. An insurer is likely to be wary of any unusual requests for mid-term alterations due to the fact that a claims made policy naturally includes prior acts coverage.
Expiry and replacement
As a policy period comes to an end, a replacement policy will need to be arranged. An organisation should review the adequacy of its limit of liability while considering how its requirements may have changed. If there are any unreported circumstances, a claim notification should be made under the expiring policy, as not to contaminate the limit of liability of the replacement.
Emergency provision: An additional limit of liability
A policy may include an emergency provision, known as an additional limit of liability, to protect management in the event that all insurance coverage is exhausted (including excess layers) and indemnification from an organisation is not available.
An additional limit of liability often comes in two forms:
Side A excess of limit
Side A excess of limit is an additional limit of liability that may be available for continuing the defence and settlement of claims against individuals, including the defence and settlement of any claim which led to the exhaustion of all insurance coverage (and for which an organisation can no longer indemnify them).
Side A reinstatement
Side A reinstatement is an additional limit of liability that that may be available for the defence and settlement of claims against individuals, but only for claims that did not contribute to the exhaustion of all insurance coverage (and for which an organisation can no longer indemnify them).
To qualify for either of these emergency provisions, the following needs to occur:
- Exhaustion of all insurance coverage, including excess layers
- Exhaustion of all indemnification from an organisation
Any additional limit of liability provided is likely to be included as an additional insuring clause or within a policy’s extensions. The sublimit of this benefit will often be listed on the policy schedule.
Limit of liability: An example
Now that we have explored the concept of a limit of liability and the various factors that influence coverage, we can tie it all together.
An organisation purchases an insurance policy to protect its management from board of directors liability. The policy period is twelve months, from 31 December last year to 31 December this year. The limit of liability is $1 million any one loss and in the aggregate. The self-insured retention is $10,0000 for Side B coverage, defence costs inclusive.
The organisation has been operating for many years in the construction industry. After a recent project, its management become aware that a competitor intends to make a claim against them. They receive a letter of demand alleging that misrepresentations were made during a tender process, constituting a breach of directors duties.
The insurer of the organisation is notified of the claim. Legal counsel are appointed and the organisation indemnifies its management from these costs, incurring the first $10,000. Once the self-insured retention is eroded, reimbursement is sought from the insurer. The claim is eventually settled for a total cost of $150k, leaving $850k of the limit of liability remaining.
A limit of liability is a central component of a policy and an important consideration for an organisation and its management. Having enough coverage when it’s required can mean the difference between effective protection and potential ruin. The process of selecting an adequate limit of liability remains part art, part science, despite its significance