Second Circuit Finds Primary Carrier`s Insolvency Vitiates Excess


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.
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
[email protected]
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."
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