The concept of excess insurance seems simple enough at first glance but one issue has proved contentious: just what must happen, vis-a-vis the underlying policies, to trigger the excess coverage? Previous commentary had summarized the uncertain state of play as of the beginning of 20131 but the exhaustion issue has since been squarely confronted by one influential court.
The U.S. Court of Appeals, Second Circuit (which includes New York) held on 4 June 2013 in Mehdi Ali, et al. v. Federal Ins. Co.2 that the insureds' mere liability extending into excess layers of cover does not trigger excess D&O liability policies that provide they attach "only after all ... Underlying Insurance has been exhausted by payment of claim(s)." (Court's emphasis.) The court's distinguishing between liability and payment may seem unremarkable, but it resolves at least part of an 85-year old quandary and gives welcome commercial guidance to insureds, their brokers and insurers.
The facts are simple enough: Commodore International, the one-time computer manufacturer, filed for bankruptcy in 1994. Its directors and officers were sued. They had incurred at least $14 million in losses (comprising legal expenses and settlement obligations) and rising, by the time the coverage dispute reached court. Commodore had purchased a tower of D&O policies including a primary and eight excess policies. Unfortunately, certain excess layers were written respectively by Reliance and The Home, both liquidated and not paying losses. The directors sued higher excess insurers Federal and Travelers for a declaration that their policies were triggered "once the total amount of defense and /or indemnity obligations exceeds the limits of any [underlying] insurance policies, regardless of whether such amounts have actually been paid by those underlying insurance companies."
The directors relied in part on the venerable (1928) Second Circuit decision in Zeig v. Massachusetts Bonding & Ins. Co.3 In that case, plaintiff Zeig had purchased excess property insurance above a $15,000 primary policy. His business suffered a burglary resulting in losses exceeding $15,000. However, Zeig compromised with his primary insurer for $6,000. He also filed a claim under the excess policy for the portion of losses exceeding $15,000. The Second Circuit held that the excess must respond, even though the excess policy provided that it would attach after the primary had been "exhausted in the payment of claims to the full amount of the expressed limits." The court held that requiring actual payment of the $15,000 by the primary insurer would be 'unnecessarily stringent' and serve 'no rational interest' of the excess insurer; rather, the primary could be exhausted by a settlement agreement, i.e. a compromise, and the excess was still exposed for that part of the loss exceeding the full limit of the primary.
The Zeig decision has been cited, especially in New York, for this principle ever since. But in the Commodore suit (Ali v. Federal Ins. Co.) the Second Circuit limits Zeig, by citing the differences between liability policies and first-party property coverage. In first-party property cover, the insured's loss is fixed and certain; therefore if the insured compromises with its primary insurer, the excess insurer still is paying only that portion of the loss that extends into its excess layer. In liability cover, however, the amount of loss often is the result of negotiations, i.e. settlement of the underlying claim. Therefore the insured has an incentive to agree an inflated settlement, compromise coverage with its primary, and dump the balance of the settlement onto its excess carrier. This would in effect force the excess insurer to drop down. The Second Circuit held this is impermissible; the court held that someone (the primary and/or the insured itself) must actually pay the primary limit, in order for the excess to be obligated.
This decision should effectively eliminate the continued reliance upon Zeig in liability insurance cases. Excess insurers can breathe easier that their policies will not be called upon before they should be.
Footnotes
1 See for example, C. Connolly and R.M. Flannery, "Settlement and the Requirement of Underlying Exhaustion," ILO Newsletter, 5 March 2013, access at http://www.internationallawoffice.com/Newsletters/Detail.aspx?g=f4881e6b-837e-4cfa-9772-459a43b8bac7 or see http://70.32.105.154/news_events.php?NewsID=19#
2 2013 U.S. App. LEXIS 11384, 719 F.3d 83 (2d Cir. 2013)
3 23 F.2d 665 (2d Cir. 1928)
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