If an insured faces liability that demonstrably exceeds the limits of underlying insurance, can an excess insurer avoid its coverage obligations because underlying insurers have not actually paid their limits of liability? Common sense says no. But insurance industry bloggers, citing the recent decision by the Second Circuit in Ali v. Federal Insurance Co., No. 11-5000-cv, 2013 WL 2396046 (2d Cir. June 4, 2013), say yes. Misinterpreting the case, they contend that insureds can forfeit millions of dollars in excess coverage merely because they settle a disputed coverage claim with a primary or underlying excess insurer for less than 100 cents on the dollar.
Consider this scenario: Your company has been sued by purchasers of a product you manufacture. The purchasers allege that your product was negligently designed or made and caused them bodily injury as a result. You disagree and defend the claims, but ultimately you incur more than $10 million in liability.
Fortunately, you purchased several layers of insurance coverage to protect yourself from just such claims. You provided timely notice to your insurers. But, as insurers are wont to do, they have raised multiple defenses to coverage. Although you do not believe that the defenses are valid, for practical reasons you settle with your primary insurer for $950,000 on a $1 million policy.
You then turn to your first-layer excess insurer, which issued a $2 million policy in excess of the $1 million primary policy. Although your liability exceeds the combined limits of the primary and excess policies by $7 million, the first-layer excess insurer refuses to pay your claim, arguing that it was relieved of its coverage obligations because it is excess of a $1 million primary policy and the primary insurer did not pay its full limits. Your second, third, and fourth-layer excess insurers, providing total coverage of $7 million above the $3 million in underlying primary and first-layer-excess coverage, follow suit and deny coverage as well.
You are understandably outraged. As long as you give the excess insurers credit for $1 million in underlying liability before asking them to respond, what difference does it make if the primary insurer paid the million dollars? Indeed, what difference does it make if anyone has paid it? The purpose of the excess policies is to protect you from liability, and if your liability demonstrably exceeds the limits of the underlying insurance – and in our hypothetical it does so by $9 million – the excess insurers have no legitimate interest in requiring the primary insurer to actually pay its full limits.
Many courts agree. They have refused to issue get-out-of-jail-free cards to insurers seeking to avoid their coverage obligations due to below limits settlements with underlying insurers. In a seminal decision, the Second Circuit in the 1928 case of Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 665 (2d Cir. 1928), reached the commonsense conclusion that a policyholder does not forfeit excess coverage when it settles with underlying insurers for less than their policy limits, so long as the insured’s loss exceeds those policy limits. Zeig, 23 F.2d at 666.
Fast forward 85 years to Ali, also a Second Circuit case, decided last month. In Ali, the directors and officers (hereinafter “directors”) of defunct computer-maker Commodore International Limited sought a ruling that excess D&O insurers’ coverage obligations were triggered once the directors’ defense and indemnity “obligations” exceeded the liability limits of underlying D&O policies, regardless whether such amounts had actually been paid by the underlying insurers. Ali, 2013 WL 2396046 at *2. The excess policies contained language stating that excess liability coverage “shall attach only after all . . . [underlying insurance] has been exhausted by payment of claim(s),” or words to similar effect. Id. at *5.
The Second Circuit ruled that alleged “obligations” in excess of underlying limits were insufficient to trigger overlying excess policies that purported to require exhaustion of the underlying policies by payment of their limits of liability. Id. at *7. Bloggers for the insurance industry contend that, at long last, Ali has driven a stake through the heart of Zeig, at least in the context of third-party liability policies.
They are wrong. To paraphrase Mark Twain, the death of Zeig is greatly exaggerated. As set forth in an article on the FC&S Legal website by the author of this blog post, not only does Ali not constitute a blanket ruling that the holding of Zeig is inapplicable to third-party liability policies, it effectively reaffirms the fundamental principles underlying Zeig.
A fuller discussion of this issue can be found in the article on the FC&S Legal website, but the key points are these:
The Second Circuit’s decision turned largely on the Court’s view that the directors’ claimed “obligations” were too amorphous and unreliable, in the circumstances, to serve as a measure of the excess insurers’ obligations. Id. at *5. Whereas in Zeig the amount of the loss could be discerned objectively, in Ali the Court suggested that the insureds’ alleged “obligations” might be inflated. Id. at *7. The Court reasoned that “the excess insurers here had good reason to require actual payment up to the attachment points of the relevant policies, thus deterring the possibility of settlement manipulation.” Id. In contrast, where an insureds’ losses can be determined with a greater degree of confidence and objectivity, the Court’s reasoning indicates that the lack of actual “payment” of those losses should not be a bar to recovery of excess insurance. Id.
The Second Circuit’s decision upholds the principle that insurance policies should not be read in a rigid or rote manner that deprives the insured of coverage without fairly serving a significant and legitimate interest of the insurer. For example, one of the insurance policies at issue in Ali stated that “depletion” of the underlying insurance must occur “solely as the result of actual payment of losses thereunder by the applicable insurers,” yet the Court indicated, without expressly deciding, that payment by either the insurer or the insured would satisfy the payment obligation. Id. at *8 n.14 (emphasis added). The Court recognized that it was immaterial in the circumstances of the case who paid the settlements. Id. at *6. More generally, as noted above, the Court concluded its opinion by stating that “the excess insurers here had good reason to require actual payment up to the attachment points,” thus indicating that where doing so does not reasonably serve a legitimate interest of the insurer, such an alleged requirement will not be strictly enforced. Id. at *7 (emphasis added).
The Second Circuit also relied on the policies themselves in rejecting the notion that the underlying insurers necessarily had to make the payments in question. It observed that the insurance policies “contemplate continued coverage even if the Directors fail to maintain underlying insurance policies at all.” Id. at *8 n.15. Noting that a number of the underlying insurers in Ali were insolvent, the Court stated that “requiring nonoperational insurance companies to make payments as a condition precedent to the attachment [of the excess insurers] would be odd, effectively relieving [the excess insurers] of their policy obligations, and leaving the Directors without coverage . . . .” Id. The same rationale applies where there are below-limits settlements with underlying insurers: As long as the insured’s liability exceeds the underlying limits, overlying excess insurers are not prejudiced by the below-limits settlements and should not be relieved of their coverage obligations.
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Insureds should of course be mindful of Ali (and other cases dealing with the Zeig issue) when settling with excess insurers. But insureds also should vigorously contest excess insurer claims that below-limits settlements with underlying insurers automatically result in forfeitures of valuable coverage and windfalls for excess insurers. As the above discussion indicates, insureds have strong arguments that insurer efforts in this regard should not succeed.