Second Circuit Finds Primary Carrier`s Insolvency Vitiates Excess
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Second Circuit Finds Primary Carrier`s Insolvency Vitiates Excess
2013 Issue 8 Second Circuit Finds Primary Carrier’s Insolvency Vitiates Excess Coverage by John C. Kilgannon The bankruptcy or insolvency of an insured or insurer can have a dramatic impact on coverage obligations. In bankruptcy proceedings, insurers often face unanticipated risks that amplify potential exposure. In other instances, insolvency may present coverage defenses that would not otherwise exist in the typical coverage setting. An example of such insolvency-related coverage defenses arose in the recent Second Circuit decision, Ali v. Federal Insurance Co., Case No. 11?5000, 719 F.3d 83 (2d Cir. 2013), where the insolvency of a primary insurer gave rise to effective coverage defenses for the excess insurers. The Ali decision is also significant insofar as the Second Circuit adopted a plain meaning approach to policy interpretation and enforced the policies as written even though doing so resulted in a finding of no coverage for the insured. Ali also serves as a stark reminder to counsel litigating insurance disputes to closely scrutinize policy language to discern the parties' respective contractual obligations. Facts of Ali The Ali decision arises out of the bankruptcy of Commodore Limited International ("Commodore"). Before it filed for bankruptcy protection, Commodore purchased a series of director and officer policies (the "D&O Policies"). The D&O Policies were arranged in a tower of liability protection with several layers of excess coverage above a primary policy. Significantly, two of the underlying insurers ceased operations and liquidated their assets. Thus, both the bankrupt insured and primary insurers were insolvent. Significantly, the excess policies at issue included an exhaustion clause which stated that the excess insurance coverage attached only after the threshold amount of underlying insurance coverage was exhausted "as a result of payment of losses thereunder." In other words, under a strict interpretation of the excess policies, coverage was triggered only when liability limits in the underlying policy were exhausted through payment of the initial threshold liability.[1] Anticipating that the directors would seek coverage under the excess policies, Federal Insurance Company ("FIC"), an excess insurer, filed a declaratory judgment action seeking a declaration that the terms of the excess policies did not require FIC to drop down and cover any liability that would have otherwise been covered by the insolvent underlying insurers. The district court granted FIC's motion for judgment on the pleadings and the directors appealed that decision to the Second Circuit. Second Circuit's Holding The critical question on appeal was what constitutes exhaustion: actual payment of the threshold obligations or simply the incurrence of covered liabilities reaching up to the attachment point? The directors argued that the excess obligations were triggered when "defense and/or indemnity obligations" reached the attachment point. In support of their argument, the directors cited Zeig v. Massachusetts Trading & Insurance Co., 23 F.2d 665 (2d Cir. 1928), where the court held that the insured's settlement of a property insurance claim below the primary limits (and the amount of the subject loss) did not preclude the insured from seeking coverage under the excess policy. In Zeig, the insured purchased property insurance totaling $15,000 and an excess policy that attached after the primary policy was exhausted. After the policies were issued, the insured was burglarized and sustained over $15,000 in losses. The insured filed a claim with the primary insurer for $15,000 but ultimately settled that claim for $6,000. Because the extent of the actual losses exceeded the primary coverage, the insured also filed a claim with the excess insurer, attempting to recover those loses that exceeded the $15,000 primary limit. The Zeig court held that the settlement below the primary policy limits did not preclude the insured from recovering under the excess policy. The court explained that requiring actual payment of $15,000 before the excess layer could be reached would be "unnecessarily stringent" and served no rational interest of the excess insurer so long as it was only called upon to cover those losses that exceeded the limits of the primary policy. The court reasoned that the insured could only damage his own interest by settling his primary claims for less than the face value and decided that a natural reading of the insurance policy – which would require actual payment in full of the primary level loses – would serve no purpose. Thus, the Zeig court ruled that the insured need only prove that his claims exceeded the primary limits, not that the primary insurer paid the full amount of those claims. In Ali, FIC made a simple and straightforward counterargument asserting that the excess policies, as written, compelled a finding that excess coverage was not available. Specifically, the plain meaning of the policies required payment of the underlying amounts and failure to make such payment relieved the excess insurer of any indemnification obligations. In essence, FIC sought a departure from Zeig's flexible approach and urged a strict interpretation of the policy language. The Ali court held that the excess coverage had not attached. In support of its holding, the court reasoned that the insured's incurrence of obligations beyond the primary threshold was not synonymous with "payment" of those obligations. Id. at 91. To hold otherwise, the Second Circuit reasoned, would render the "payment of" language in the excess policies superfluous. Id. at 92. Thus, the Second Circuit concluded that the express language of the excess policies established a clear condition precedent to attachment of the excess policies: payment of the underlying losses. Id. In reaching this conclusion, the Second Circuit distinguished the Zeig holding, supra, on the grounds that first-party property policies are often interpreted differently from excess liability policies. Id. at 93. Additionally, because the loss in Zeig was fixed by the losses sustained in the burglary before any settlement with the primary insurers, there was little risk that the primary insurers could shift part of their burden to the excess carriers. In the third party setting, the Ali court explained, excess insurers have a clear interest in ensuring that the underlying policies are exhausted by actual payment. Otherwise, the directors could trigger the excess layer by inflating settlements with their adversaries that would require the excess insurers to drop down and provide first dollar coverage for the insolvent primary insurers. Id. at 93-94. Conclusion While insurer insolvency is a relatively rare occurrence, coverage counsel would be well advised to examine any defenses that may arise from a primary insurer's or insured's insolvency. Depending upon the express terms of the subject policy, the insolvent primary insurer's inability to pay the primary level losses may have significant implications on excess coverage obligations. This may also hold true for an insolvent insured's inability to pay a self-insured retention. The Ali decision is also significant insofar as a circuit level court sanctioned a strict interpretation of policy terms regardless of the impact on insurance coverage. John C. Kilgannon Stevens & Lee, P.C. Philadelphia, Pennsylvania jck@stevenslee.com [1] Specifically, the excess policies at issue stated that excess liability coverage "shall attach only after all . . . 'Underlying Insurance' has been exhausted by payment of claims(s) and that "exhaustion" of the underlying insurance occurs "solely as a result of payment of losses thereunder." To learn more about DRI, an international membership organization of attorneys defending the interests of business and individuals in civil litigation, visit www.dri.org.