In Search of Excess Coverage

Legal exposures have increased over the past several years for directors and officers, and, as a result, more companies are purchasing directors’ and officers’ (D&O) insurance — including excess coverage. Advisors serving those companies have quite properly focused on the terms and conditions of the primary policy; then, when required, they have constructed “towers” of coverage based on essentially standardized excess policy wordings. Commonly referred to as “follow form” policies, D&O excess policies typically incorporate the terms of the primary policy and any other policy that is written above that primary placement. It is readily becoming apparent, however, that potentially significant coverage issues can arise from the form and structure of a D&O excess policy.

Recent decisions by the following three U. S. courts have highlighted some of these issues:

• the Massachusetts Supreme Judicial Court, in Allmerica Financial Corporation & Others v. Certain Underwriters At Lloyd’s, London.

• the United States District Court for the Eastern District of Michigan, in Comerica Inc., v. Zurich American Insurance Co. and Houston Casualty Co. , and

• the Superior Court of North Carolina, in BankofAmericaCorp. v. SRIntern Business Ins. Co.

Each of the above decisions considered circumstances in which an insured had settled an underlying claim with the primary insurer and then sought coverage from the excess insurer. Common to each case was the excess insurer’s refusal to allow the insured to access excess coverage in a situation in which a settlement had exceeded the limit of liability available under the primary policy.

CASE 1: ALLMERICA

Allmerica Financial in 1999 settled a class action lawsuit for US$39.4 million. In this case, Allmerica faced allegations that it had engaged in improper business practices with respect to the sale of certain life insurance products. Allmerica had primary insurance of US$20 million, with a US$2.5-million retention, and a follow form excess insurance with Lloyd’s for US$10 million. Lloyd’s declined to provide coverage for the settlement due to exclusions in the primary policy, even though the insurer providing the primary coverage had agreed to the settlement. The trial court concluded, later affirmed on appeal, that an excess insurer was not bound by the primary insurer’s decision to extend coverage for a particular loss and settle under the policy. According to the court, an insurance program involving a primary policy and one or more excess policies divides risk into “distinct units,” and each unit is insured individually. Individual insurers do not (absent a specific provision) act as “coinsurers” of the entirety of the risk. Rather, each insurer contracts with the insured individually to cover a particular portion of the risk. The use of a “follow form policy” simply makes an excess policy a “carbon copy” of the primary policy, the only difference being the names of the parties and the coverage limitations. However, the follow-form language does not bind the various insurers to a form of joint liability should coverage at a prior layer fail.

CASE 2: COMERICA INC.

Comerica Inc. was insured under a primary and excess D&O liability insurance policy. The defendant, Zurich American Insurance Co., issued an excess policy that required the company to maintain the primary insurance policy. The excess policy stated that: “[c]overage hereunder shall attach only after all such ‘underlying Insurance’ has been reduced or exhausted by payments for losses.” The excess policy provided that coverage was available only if the primary policy were exhausted “solely as a result of actual payment of loss thereunder by the applicable insurers.” In addition, the excess policy said it “does not provide coverage for any loss not covered by the ‘underlying insurance’ except and to the extent that such loss is not paid under the ‘underlying insurance’ solely by reason of the reduction or exhaustion of the available ‘underlying insurance’ through payments of loss thereunder.”

Comerica was the subject of two sets of securities class actions. Over the objection of the primary insurer, it ultimately settled those actions for US$21 million. The primary insurer disputed coverage for the settlement, but ultimately contributed US$14 million of its US$20 million limit, presumably in exchange for a full and final release. Comerica then contributed US$6 million to the settlement; in addition, it sought US$1 million of the settlement and US$2.6 million in defense costs from Zurich. Zurich declined coverage, saying the underlying limits had not been exhausted and because US$6 million of the settlement represented amounts that Zurich did not consider to be covered “loss.”

The United States District Court for the Eastern District of Michigan held that although Comerica had settled with its primary insurer for less than the limits of the primary D&O policy, it was not entitled to recover part of the cost of its settlement in the underlying action. Furthermore, the court found, Comerica could not recover its defense costs from Zurich, since the excess policy stated it was triggered only when the underlying insurance was “reduced or exhausted by payments for losses.”

In so holding, the court first rejected Comerica’s contention that Zurich’s denial of coverage was a repudiation of the excess policy, which, in turn, justified Comerica’s decision to settle in a manner that did not fulfill the condition of exhausting the underlying limits through payment by the primary insurer. The court also rejected Comerica’s position that its contribution of the remainder of the underlying limits should be sufficient to trigger the excess policy. Zurich’s policy language imposed a specific exhaustion requirement and the court reasoned that “payments by the insured to fill the gap, settlements that extinguish liability up to the primary insurer’s limits, and agreements to give the excess insurer ‘credit’ against a judgment or settlement up to the primary insurer’s liability limit, are not the same as actual payment.” Finally, the court rejected Comerica’s position that the excess policy was ambiguous, noting that the excess policy “plainly requires the [primary] policy to be exhausted by payment of losses by [the primary insurer].” Although the court observed it was open to Comerica to have sought an excess policy requiring Zurich to pay its limit of liability even if the underlying insurer did not actually pay its limit, or which allowed it to “fill the gap,” the policy it purchased did not so provide and could not now be rewritten.

CASE 3: BANK OF AMERICA

The Superior Court of North Carolina considered a coverage dispute involving

the Bank of America (B of A) and a number of insurers who had provided professional liability coverage under three excess policies, each of which provided limits of liability of US$50 million, US$75 million and US$100 million, respectively. Multiple insurers subscribed to each excess policy. Following a US$460 million settlement, into which B of A entered following a series of class action lawsuits related to the collapse of Enron Corporation and Worldcom Inc., B of A sought coverage from the insurers who had underwritten its insurance program. There was no issue with respect to the insurer of the primary policy; B of A was able to settle with all but one of its excess insurers that subscribed to the first, second and third excess layers of coverage. The remaining insurer, SR International Business Insurance Company SE (SR), had an aggregate exposure of US$225 million, which consisted of 40% of the first excess policy, 30% of the second excess policy and 17.5% of the third excess policy.

SR’s principal defence to the request for coverage for the settlement of the class a ctions was that the amounts paid were simply uninsurable as a matter of law and that certain specific exclusions also applied. The court rejected these defences outright and then considered whether SR had acted in bad faith by denying coverage when other insurers had ultimately settled and paid discounted amounts. The court concluded the actions of the other excess insurers were “an indication that it was more than likely than not that coverage existed.” The court did not find that the settlements by the other excess insurers, even if strongly suggestive of coverage existing, supported the view that SR had acted in bad faith since it was simply not probative of the issues of bad faith involving SR. However, that finding was qualified on the basis that the circumstances of some of the other excess insurers differed from SR’s position: the other excess insurers had been insurers on prior policies; therefore they had knowledge of the history of prior claims that SR did not have, which may have resulted in them reaching different conclusions with respect to coverage.

These recent issues surrounding excess insurance, particularly in the context of D&O coverage, raise important considerations for both insureds and insurers alike. Insureds are increasingly frustrated by what is perceived to be a lack of contractual certainty for a coverage that can be critical for resolving outstanding litigation and protecting personal assets and reputations. The increasing size and complexity of D&O insurance placements in particular often necessitates the involvement of numerous insurers, each adhering to slightly different terms upon which coverage is being underwritten. Excess insurers quite properly want to ensure the basis upon which they have structured and priced their placement is not undermined by a compromised settlement that results in a discount for the underlying insurers without any notification or understanding as to the basis for the compromise. The ability to engineer a better way to structure excess placements is challenging since it could raise potential competition (antitrust) law concerns, as well as pose significant challenges with respect to claims handling. It would seem that one possible way to balance these competing concerns would be to allow insureds to “fill the gaps” created by a compromised coverage settlement with an underlying insurer, provided it is done with full involvement and consent of the excess insurers and without prejudice to any other coverage terms and conditions under the excess insurance policies. .

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Excess insurers want to ensure the basis upon which they have structured and priced their placement is not undermined by a compromised settlement that results in a discount for the underlying insurers.

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The increasing size and complexity of D&O insurance placements in particular often necessitates the involvement of numerous insurers, each adhering to slightly different terms upon which coverage is being underwritten.