Understanding the Terms of Your Professional Liability Insurance

It pays to fully understand your professional liability insurance. Knowledge starts with knowing the meaning of terms like “claims made,” “extended reporting period” and “defense costs in or out.” Learn their significance here.

Companies of all sizes face numerous liability exposures that can lead to ruinous litigation. Fortunately, professional liability insurance mitigates those exposures, preventing a major lawsuit from consuming business and personal assets. 

Professional liability insurance, also known as malpractice insurance, is a specialized form of liability coverage that protects you against the financial impact of being sued. It provides money to pay for attorney fees and court-related expenses. Most importantly, it pays for the legal judgments or settlements you may face if you lose your case. Not only does malpractice insurance indemnity you against such losses, it also provides you with an attorney to make frivolous lawsuits disappear. 

However, being insured is just half the battle. You also need to fully understand your coverage—what your policy will and won’t do in the face of legal action. To increase your knowledge, start by reviewing your policy to determine what it covers, what it doesn’t cover and what’s required should you need to file a claim. In your reading you may encounter arcane terms for how your policy works. Three important ones are “claims-made policy,” “extended reporting period” and “defense costs in or out.” Let’s consider each of these in turn.

Claims-Made Policy 

A claims-made policy provides coverage as long as the alleged loss happened and you filed an insurance claim while your policy was active. In other words, your claims-made coverage gets triggered when you file a claim, not when the incident occurred. The following example will clarify how this works.

Two partners start a firm in January 2015. Early that month they purchase professional liability insurance from insurer A. They keep this policy in force continuously until January 2020, when they decide to replace it with upgraded coverage from insurer B. There was no coverage gap between the two policies. In June 2020, a client from 2018 notifies the partners she plans to sue them because their firm botched an important service. As soon as they hear this, they file a claim with insurer B under the provisions of their malpractice insurance policy. Why would the partners file with insurer B and not with insurer A? Because they have claims-made coverage. With this type of policy, insurance follows the claim, not the precipitating incident.

The fact that the partners had policies from two separate insurers is irrelevant. As long as they maintained continuous protection from a date prior to the incident (also known as the retroactive date), insurer B will investigate the claim and indemnify the loss, if the facts warrant it.

Although most professional liability policies are claims-made, some are written on an occurrence policy form. With this type of insurance, the policy that responds to an incident is the one in effect when the loss occurred, not when the claim gets filed. 

Here’s another way to think about claims-made insurance: it gives you a retrospective safety net. Let’s return to the example we discussed earlier. In January 2016, the partners renew their policy for the first time. Because it’s claims made, it will shield them against any loss that occurs from January 2016 back to the initial 2015 effective date, as long as the policy is in force when the claim gets filed. When they renew in January 2017, the policy will now protect them against losses that occur in 2015 and 2016. With each passing year, the policy has to cover more client work, which lays more risk on the insurer. This explains why claims-made policies are relatively inexpensive in the early years when less risk has built up and more expensive five or more years down the road, when more risk is on the table. The escalating premiums in claims-made policies are known as step-rated premiums.

With occurrence policies, your insurance gets triggered when an incident occurs, not when you file a claim. Unlike claims-made policies, occurrence protection is prospective. In other words, if the firm owners we’ve been discussing purchase an occurrence policy instead of a claims-made one, the coverage they bought in 2015 would cover all engagements completed that year, indefinitely into the future. So if someone sues them in 2025 for an incident that occurred in 2015, their 2015 policy would respond to the claim. They don’t need to have a policy in force in 2025 to access coverage. Because occurrence policies involve long risk tails, they tend to be more expensive than claims-made policies that have yet to reach maturity (roughly five years).

Extended Reporting Period

If you purchase a claims-made professional liability insurance, be careful when cancelling it or replacing it with another policy. If you cancel your coverage because you’re planning to retire or change careers, your prior work will now put you at risk. Why? Because your claims-made insurance needs to be active when you file a claim. If you cancel it, the litigation costs relating to your prior work will be on you. Similarly, if you’re planning to take a sabbatical and wish to cancel your malpractice insurance for six months or a year and then restart it later, watch out. If you leave a gap between your former and new claims-made insurance, you will lose protection for all of your work prior to the gap. 

An extended reporting period (ERP) is the solution to both scenarios. An ERP, also known as “tail” coverage, gives you the right to file a claim for your prior work even though you cancelled your policy. Because claims-made insurance doesn’t pay for claims filed after policy cancellation and before you’ve lined up replacement insurance, arranging for an ERP is the only way to make sure your prior work doesn’t blindside you legally.

Insurers sometimes offer a free ERP of 30 or 60 days after you cancel your insurance. But if you want to guarantee coverage for longer than that, you’ll need to purchase a supplemental ERP from your former insurer. Available for an additional fee, supplemental ERPs come in one- to five-year terms or longer.

Finally, if you purchase an occurrence policy and then cancel it, don’t worry about buying an ERP. You’re protected for future claims, even those filed many years in the future, as long as the alleged error or omission occurred while your policy was in force.

Defense Costs In or Out

This term refers to whether your malpractice insurance will consider the costs of defending you against a malpractice claim to be inside or outside your limit of liability (the maximum amount of money your policy will be able to pay to resolve claims against you). For example, if your limit is $1 million/$3 million ($1 million per claim and $3 million for all claims during the policy period), then a policy with defense costs inside the limit would subtract those expenses from your limit. This would reduce the money available to pay for your legal settlements or judgments. Under this scenario, your claim expenses—attorney and expert witness fees, court costs, document-related expenses, investigation fees and more—will decrease your coverage limit. 

A policy with defense costs outside the limits would pay for your legal costs without eroding your limits. The advantage of this arrangement: you have more coverage available to indemnify your losses. The disadvantage: such policies cost more.

Most prefer non-eroding limits to eroding ones. So why don’t they all go with the former? Because many insurers are reluctant to offer this feature, since defense costs can potentially get out of control. And when they do offer it, the extra cost involved can become unaffordable for policy owners.

So there you have it: explanation of three key terms you should know as a professional liability insurance policyholder. To further expand your knowledge, carefully read your policy document. Hopefully you’ll never get sued. But if you do, being a well informed policyholder will work in your favor during the claims process.