Like a Rolling Stone – You Don’t Always Get What You Want

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On June 4, 2013, the Second Circuit Court of Appeals ruled in favor of excess insurers and against former directors and officers (collectively, the “Directors”) when it concluded that the excess insurers did not have to “drop down” based on the “plain language of the relevant excess insurance policies required the ‘payment of losses’ – not merely the accrual of liability – in order to reach the relevant attachment points and trigger the excess coverage.”  Ali v. Fed.  Ins. Co., No. 11-5000-CV, 2013 WL 2396046 (2d Cir. June 4, 2013). 

In an unusual procedural posture, the Second Circuit was asked to review a final judgment that resulted from a voluntary dismissal following the denial of the Directors’ motion for summary judgment.  After the Second Circuit concluded it had appellate jurisdiction to review the District Court’s decision, it addressed the merits of the “drop down” argument that the Directors raised when two of their excess insurers in an eight-layer insurance tower, Reliance Insurance Company (“Reliance,” which insured the first and fourth excess layers) and Home Insurance Company (“Home,” which insured the third and sixth excess layers), ceased operations and liquidated their assets.  

Federal Insurance Company (“Federal,” which insured the second and fifth excess layers) filed a declaratory relief action against the Directors in the Southern District of New York.  Federal sought a declaration that, under the terms of the relevant polices, it was not required to “drop down” to cover liability that would have otherwise been covered by Reliance and Home.  The Directors filed a counter-claim and also brought in the Travelers Casualty and Surety Company of America (“Travelers,” which insured the seventh excess layer), seeking a declaration that Federal’s and Travelers’ coverage obligations were triggered after the total amount of the Directors’ defense and/or indemnity obligations exceeded the limits of any insurance policies underlying their respective policies, regardless of whether such amounts were actually paid by the underlying insurance companies. 

Federal’s and Travelers’ policies provided that their coverage would only attach after the Underlying Insurance has been exhausted by “payment” of claims or losses.  The Second Circuit readily affirmed the District Court’s holding that the excess coverage was not triggered until the underlying insurance was exhausted “solely as a result of payment of losses,” and not solely by the “aggregation” of the Directors’ covered losses.  The Directors unsuccessfully argued that the excess liability coverage was triggered when “defense and/or indemnity obligations” reach the attachment point.  The Second Circuit did not have any difficulty concluding that “obligation” was not synonymous with “payments” of those obligations.  It also noted, however, that the District Court did not specify which party was obligated to make the requisite payment because that issue was not raised by the Directors in the underlying proceeding. 

Significantly for insurers, the Second Circuit did not find persuasive the Directors’ reliance on the oft-cited decision in Zeig v Massachusetts Bonding & Insurance Co., 23 F.2d. 655 (2d Cir. 1928) and related cases, addressing situations in which policies were deemed exhausted as a result of an insured’s below-limit settlement of indemnity claims.  While not overruling Zeig, the Second Circuit found that the Directors neglected to address the critical distinction that Zeig involved a first-party property insurance policy as opposed to an excess liability policy.  The Second Circuit agreed with the District Court that the Directors’ requested relief, which focused on their obligations to pay third parties as opposed to seeking indemnification for out-of-pocket losses, was a relevant distinction for purposes of policy interpretation. 

While a favorable decision for insurers, the Second Circuit did not address the ramifications of the “drop-down” argument when payment is made by someone other than an insolvent underlying excess insurer.  The Second Circuit did, however, note the District Court’s observation that the relevant excess insurance policies contemplated continued coverage even if the Directors failed to maintain the underlying policies.   Accordingly, whether payment by someone other than a nonoperational insurance company will trigger attachment will depend upon the specific language of an excess policy.