Choose Liability Insurance Effectively

April 13, 2006

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The civil litigation system itself represents a significant risk factor and exposure to liability. Therefore, it is important that small business owners employ the various strategies that allow them to control the risk factors in litigation.

To that end, insurance can be considered a protection of last resort in that it will cover a loss in the event that other measures have failed. Clearly, if liability insurance fully covers a claim, the business owner will suffer no loss (except, of course, with respect to higher future premiums).

Whether the policy will cover the loss will depend on the policy's limits, as well as the scope of its coverage and exclusions (strategies involving coverage and exclusions are covered in detail in our discussion of insurance).

Other strategies involving insurance, outside of coverage and exclusions issues, can provide significant benefits to small business owners. For example, a liability policy should have a duty to defend clause. When a claim is made against the insured, this clause requires the insurance company to defend the insured against the claim. In particular, the insurance company must hire an attorney for the insured, and pay the attorney's fees and related costs of litigation. The clause is especially important because the costs of defending against a claim, which can be significant, generally will not be reimbursed, even in the event the defendant prevails in the case, due to the lack of loser pays system in the United States.

In addition, the small business owner may be able to rely on other people's insurance. Here, a contract would require another party to secure and pay for a liability policy that also insures the small business owner. The arrangement might be used, for example, where a small business owner with superior bargaining power enters into a joint venture with another party. In this instance, the small business owners enjoy all of the benefits of the policy, but at no cost.

Finally, the small business owner may be able to compel reimbursement of his litigation losses through an indemnification agreement. This type of agreement compels another party to reimburse the small business owner for any litigation losses he suffers. Indemnification may offer less security, as compared to relying on other people's insurance, because an individual's ability to cover the losses will almost never equal the ability of an insurance company to cover the losses. However, in practice, indemnification clauses are frequently used in conjunction with other people's insurance. When both strategies are used together, indemnification adds a second layer of protection.