E&O Liability or Malpractice Insurance

April 13, 2006

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A small business owner may need to purchase specialized liability insurance to cover gaps in a comprehensive general liability policy.

An errors and omissions, or E&O, liability policy (often called malpractice insurance) covers liability for negligent acts, errors and omissions committed by professionals, including physicians, accountants, lawyers, etc.

An E&O liability policy may be mandatory. State law sometimes requires that certain professionals maintain an E&O policy with a certain minimum amount of liability coverage. The requirement may only extend to certain professionals (e.g., physicians). In some cases, the obligation applies to anyone practicing in the profession, irrespective of the business form in which they operate. In other cases, the obligation may be imposed by the state's code that empowers professionals to form professional corporations, limited liability partnerships, or possibly limited liability companies. In this case, professionals operating outside of these business forms may not be compelled to obtain liability coverage. State laws differ significantly in these respects, so make sure you check your state's particular laws.

State licensing boards and professional organizations in each state are good sources for information on liability insurance requirements imposed on particular professions.

Where E&O liability coverage is optional, the professional must weigh the risk of being self-insured against the costs of insurance. In doing so, the professional must remember that the personal commission of a tort, such as malpractice, represents a significant exception to the limited liability that otherwise applies in a limited liability company (LLC) or a corporation.

To protect against other forms of liability, the professional will have to undertake other asset protection measures described here in this small business guide, including strategically structuring and funding the business entity, exemption planning, the use of asset protection trusts, etc.

When the cost of insurance is especially significant (e.g., some physicians pay annual premiums of $50,000 or more for E&O liability insurance) and an effective asset protection plan is in place, consideration may be given to foregoing insurance, if this is an option in your particular state. Clearly, this decision should only be made after very careful deliberation.

Negligent Acts v. Errors and Omissions. An E&O policy will cover both "negligent" acts and errors and omissions that result in loss to another person. Thus, coverage should extend to all causes of action that arise from the insured's professional services and not merely a cause of action based on negligence.

Insurance companies sometimes attempt to limit coverage to a cause of action based on negligence, arguing that only negligent errors and omissions are covered. The courts generally have rejected this argument from insurance companies.

Definition of Professional Services. An E&O policy will only cover liability arising out of "professional services." Insurance companies sometimes attempt to disclaim coverage on the grounds that the insured's activities did not amount to professional services.

As discussed elsewhere, the courts generally have ruled that any ambiguity must be construed in a way that favors coverage. Thus, a definition of professional services will be broadly construed. Courts have ruled that any activity that requires mental or intellectual skill meets the definition of "professional services."

Claims-Made Basis v. Occurrence Basis. An E&O liability insurance policy will usually be issued as a "claims-made" policy. This is not the standard form of coverage with which most people are familiar.

Rather than coverage applying to any "occurrence" during the policy period, coverage instead applies to any claim made during the policy period.

Thus, in a claims-made policy, coverage will not continue after the policy period has expired. So if something happens while covered, but a claim isn't made until sometime after the policy period, the claim isn't valid. By contrast, in a comprehensive general liability policy that covers occurrences arising during the policy period, claims made after the expiration of the policy period, but based on events that occurred during the effective period of the insurance, are covered by the policy.

On the surface, it may appear that a claims-made policy enjoys an advantage with respect to events that took place prior to the effective date of the policy. A comprehensive general liability policy will not apply to these claims. However, a claims-made policy also will not apply to these claims, even when the claims are made during the policy period. This apparent contradiction is explained by the fact that the claims-made policy will exclude from coverage any claims based on an event that occurred before the effective date of the policy.

In short, a claims-made policy usually offers less effective coverage, but accordingly is less expensive for an insurance company to issue. This savings may result, in theory anyway, in lower premiums for the insured party.

Nevertheless, because of the superior protection generally offered by an occurrence-based policy, the small business owner should inquire as to whether an occurrence-based, as opposed to a claims-made, E&O policy is available. If such coverage is available and the premium is not cost-prohibitive, the small business owner should consider paying the additional premiums and purchasing the occurrence-based E&O policy.

Work Smart

In determining the policy limits of an E&O policy, the small business owner should remember that a professional will be personally liable for malpractice (i.e., negligence) he commits while providing professional services irrespective of the business form in which he is operating. This represents a significant departure from the limited liability that otherwise exists in the LLC or corporation.

An LLC or corporation offers protection from personal liability for malpractice committed by other owners and other employees of the business entity, provided of course that arrangements among the owners and with the employees are properly structured.

However, a professional who negligently hires or supervises an employee may be held personally liable if the employee commits an act of malpractice or some other act of negligence. Here, the professional is not being held liable for the employee's act of negligence, but instead for his own separate act of negligence, in failing to reasonably hire or supervise the employee.

Of course, the nature of the professional's specific activities will dictate the exact extent of the exposure to personal liability and, thus, the recommended dollar amount for the policy's limits. In short, however, in deciding on the policy's limits, the professional must consider the fact that despite operating in the form of an LLC or a corporation, he may still have significant exposure to unlimited, personal liability.