Part 4 of 8
In liability claims, defense costs are often treated as background noise. Necessary, but secondary. Something to be managed later.
That mindset no longer works.
Under the AVOID Act, early defense decisions determine not just who defends, but how defense costs are paid and whether policy limits are preserved or consumed. Understanding defense costs under the AVOID Act starts with recognizing two very different scenarios.
Two Defense Cost Scenarios That Cannot Be Blended
Every defense obligation falls into one of two buckets. Confusing them is where exposure begins.
Scenario A: Defense Costs When There Is Additional Insured Status
When an entity qualifies as an Additional Insured under a liability policy, defense costs are typically paid as Loss Adjustment Expenses (LAE).
In this scenario:
- Defense costs are paid outside of indemnity
- Policy limits remain intact
- Defense spend does not reduce the dollars available to resolve the claim
This is the cleanest outcome from a coverage perspective. Defense is provided as part of the policy’s coverage grant, separate from any eventual settlement or judgment.
When AI status exists and applies, defense costs are not part of the indemnity mix.
Scenario B: Defense Costs When There Is No Additional Insured Status
When there is no Additional Insured status, defense obligations often arise, if at all, from contractual indemnity rather than insurance coverage.
In this scenario:
- Defense costs are treated as part of indemnity
- Those costs do erode policy limits
- Every dollar spent on defense reduces what remains to resolve liability
This is not a technical distinction. It is a financial one.
Defense costs and indemnity dollars now draw from the same pool.
Why Early Misclassification Is So Dangerous
The risk is not that defense is provided. The risk is why it is provided.
If defense is extended under the assumption of AI status that later turns out not to exist, defense costs may have been misclassified from the start. What should have been LAE may actually belong in the indemnity bucket.
Under the AVOID Act, there is less time to correct that mistake.
Once defense is underway, counsel is retained, and impleader deadlines pass, unwinding the classification becomes difficult. By then, limits may already be eroding.
How the AVOID Act Makes This Exposure Surface Faster
The AVOID Act does not change how defense costs are treated. It changes how quickly decisions must be made.
Compressed post-suit timelines force early determinations about:
- Whether AI status exists
- Whether defense is owed under the policy
- Whether defense is contractual rather than insured
If those questions are answered incorrectly at the outset, defense spend begins immediately, often from the wrong bucket.
That is how limits quietly erode before liability is resolved.
Why Claims Leadership Should Care
This is not an adjuster-level issue alone.
Defense costs that erode limits affect:
- Reserve accuracy
- Settlement leverage
- Reinsurance outcomes
- Portfolio performance
Once limits are reduced by defense spend, there is no way to restore them.
The Disciplined Approach to Defense Costs
Disciplined claims handling requires confirming why defense is owed before assigning counsel.
AI status must be verified under the policy. Contractual defense obligations must be evaluated under the contract. Defense costs must be classified correctly from day one.
Under the AVOID Act, this analysis must happen earlier, not faster.
The Takeaway
Defense costs are not interchangeable.
When AI status exists, defense costs are LAE and do not erode limits.
When AI status does not exist, defense costs often come out of indemnity and do erode limits.
Under the AVOID Act, claims teams that fail to make that distinction early will watch limits disappear before liability is ever resolved.
Thank you for reading. In the next article, we will examine why certificates of insurance fail when time pressure is highest and how reliance on them creates avoidable exposure.
How We Use Clio for Claims Files
Listen to The Art of Adjusting® Podcast
If this was useful, please consider liking, sharing, or commenting.