Understanding Defense Costs in Employment Practices Liability
In the world of Employment Practices Liability Insurance (EPLI), the treatment of defense costs is one of the most critical concepts for candidates to master. Unlike a standard Commercial General Liability (CGL) policy, where defense costs are almost always provided in addition to the policy limits, EPLI policies frequently treat these costs as part of the limit itself.
Defense costs include attorney fees, court costs, expert witness fees, and any other expenses related to the investigation and legal defense of a claim. In employment law, these costs can be substantial, often exceeding the actual settlement or judgment. Understanding whether these costs are "inside" or "outside" the limits determines the total financial protection available to the policyholder. For a broader look at EPLI fundamentals, refer to our complete EPLI exam guide.
Defense Costs Inside the Limits (Eroding Limits)
When defense costs are Inside the Limits, they are often referred to as "eroding," "self-consuming," or "cannibalizing" limits. In this structure, every dollar the insurance company spends on legal defense reduces the remaining amount of money available to pay a settlement or judgment.
For example, if an employer has a $1,000,000 limit and incurs $400,000 in legal fees defending a wrongful termination suit, only $600,000 remains to pay the actual claimant. If the jury awards $700,000, the employer would be responsible for the $100,000 shortfall out of pocket. This structure is common in professional liability and specialty lines like EPLI because legal fees in these areas are highly unpredictable and often very high.
- Risk for Insured: The primary risk is that a prolonged legal battle will exhaust the policy limit before the case is even resolved.
- Premium Impact: Policies with inside limits typically carry lower premiums because the insurer's total exposure is strictly capped at the face value of the policy.
Visualizing Policy Erosion
Comparison of remaining funds for settlement after $250,000 in defense costs on a $500,000 policy.
Defense Costs Outside the Limits
When defense costs are Outside the Limits, the policy limit applies solely to the payment of settlements and judgments. The insurer pays for the legal defense as an additional benefit that does not deplete the stated limit of liability.
This is generally considered the "gold standard" for policyholders. In the same scenario as above—a $1,000,000 limit with $400,000 in legal fees—the full $1,000,000 would still be available to pay the claimant. This ensures that the business does not face a double-jeopardy situation where a vigorous defense leaves them unable to pay the final bill.
Insurance professionals must be able to identify which structure is in place to accurately advise clients on their true exposure. You can test your knowledge of these structures with our practice EPLI questions.
Inside vs. Outside Limits Comparison
| Feature | Inside Limits (Eroding) | Outside Limits (Additional) |
|---|---|---|
| Limit Depletion | Legal fees reduce settlement funds | Legal fees do not impact settlement funds |
| Premium Cost | Generally lower | Generally higher |
| Common Usage | Standard for Private/Small Firms | Available via Endorsement or Large Firms |
| Incentive | Incentivizes early settlement | Allows for more robust trial defense |
Exam Tip: The 'Duty to Defend'
On the EPLI exam, remember that the Duty to Defend is often linked to how limits are structured. Even if limits are eroding, the insurer usually maintains the right and duty to select counsel and control the defense strategy, unless the policy is written on a 'Reimbursement' basis (which is common in larger D&O/EPLI hybrid policies).
Key Financial Impacts
Frequently Asked Questions
Yes. If defense costs are Inside the Limits, it is possible for the entire limit to be spent on attorneys before a case reaches trial or settlement. This leaves the insured with no remaining coverage for the actual damages awarded.
Some policies offer a "Defense Cap" outside the limits. For example, a policy might provide $500,000 for defense costs outside the limits, but once that $500,000 is spent, any additional defense costs begin to erode the main policy limit.
Inside limits provide the insurer with certainty regarding their maximum possible loss. It prevents 'runaway' legal costs that could otherwise result in an insurer paying multiple times the policy limit in defense fees alone.
In most EPLI policies, the deductible (or retention) applies to both defense costs and indemnity payments. This means the insured must pay their retention amount first, regardless of whether the money goes to a lawyer or a claimant.