Driving the defense: insurers and policyholders can differ on the best way to manage a defense. (Property/Casualty: Loss/Risk Management Insight).

One of the most important components of liability insurance is the insurance company's promise to provide the policyholder with a defense when it is sued. Unfortunately, in many circumstances, policyholders and their insurers can find themselves in conflict on any number of issues regarding management of the defense.

For example, these two parties often have very different views on the quality of the defense--and the resulting level of defense expenditure--that is necessary and appropriate. Moreover, the insurer and policyholder may have different financial interests in the defense and outcome of the underlying claim, such as when judgment on one claim against the policyholder would be covered, but judgment on another claim would not. In such cases, the insurance company may want to steer the defense toward judgment on a noncovered claim or coverage-defeating factual allegation.

A difficult conflict can arise when a policy provides an aggregate indemnity limit, but no limit on the amount of defense costs which the insurance company must pay. Then it is in the insurance company's interest to settle a few cases quickly and cheaply, exhausting its indemnity limits and ending its defense obligations. For policyholders faced with significant product liability or mass-tort claims, a quick settlement can not only eliminate funding for their defense, but eventually damage the reputation of their product or bring on additional lawsuits filed in the hope of obtaining quick and easy settlements.

Ethical rules for attorneys require the defense counsel to be loyal solely to the policyholder client, rather than to the insurance company that is paying the legal bills. But this protection may have limited value since counsel's loyalty can be sorely tested when a significant portion of its practice depends upon receiving continued assignments from the insurance company's claims handlers.

Accordingly, the vast majority of courts have held that when a conflict of interest exists, the policyholder must be allowed to select its defense counsel and to manage the defense of an underlying action.

A policyholder should also give thought to the defense issue when it comes to buying insurance. First, policies can include endorsements that address this issue, such as allowing the policyholder to select counsel for particular types of claims. Second, the policyholder and the insurer may be able to negotiate a side agreement regarding the handling of underlying claims. Third, the policyholder should ask to review and, if necessary, revise the billing- and claims-handling guidelines that the insurance company uses. Even if it means having to pay a higher premium for these concessions, it could be worth the cost for businesses vulnerable to claims that will be costly to defend.

Once the policyholder has been sued, it should analyze the underlying claims, the insurance policy, and any Reservation of Rights letter to determine whether there is a conflict between its interests and those of the insurance company. If there is, the policyholder may want to insist on maintaining control of the defense, and asserting its right to select independent counsel.

Even if no conflict is apparent, and the insurance company is controlling the defense, policyholders should regularly evaluate the defense offered by the insurance company, including the counsel selected. They should demand status reports on a regular basis, as well as copies of all pleadings, discovery demands and correspondence with the underlying plaintiff's counsel--and, especially, all communications defense counsel has with the insurance company.

If the stakes are high enough, a policyholder may consider employing "shadow counsel"--a separate law firm to monitor the conduct of defense counsel and warn the policyholder if it appears that the defense is being adversely affected by the insurance company's protection of its own interests. Policyholders also must insist on notification of any settlement offers received from the plaintiff, and of any planned or proposed settlement activity by the insurance company.

The right to a vigorous defense is one of the most important parts of purchasing liability insurance. And the preservation and protection of that right means keeping a watchful eye on those providing, and paying for, that defense.

Randy Paar and Elizabeth Sherwin are partners in the New York office of Dickstein, Shapiro, Morin & Osbinsky LLP, and regularly represent the interests of business policyholders. They can be reached at [e-mail].