United States: Settling With Underlying Insurers For Less Than Policy Limits -- The Good, The Decent And The Ugly

Last Updated: June 16 2015
Article by Miles Karson

When a policyholder resolves or settles an insurance claim that implicates multiple layers of insurance, and not every layer is settled at once, trouble is bound to ensue. Unfortunately, for many policyholders, this issue is first considered on the eve of settling a large claim implicating multiple coverage layers. As a result, policyholder after policyholder has unwittingly forfeited their right to excess insurance coverage, because they failed to understand what the law required of them, and failed to see how to use the law to their advantage in settling with their underlying insurers.

The Problem

This primary-excess settlement issue is almost ubiquitous. It lurks behind settlement of most any claim that triggers more than one layer of coverage. The situation typically arises when a lower-level insurer will settle a claim, but still wants some "credit" – however small – for all of those coverage defenses that its lawyers have raised. That "credit" commonly comes in the form of settling for an amount less than policy limits.

All the while, the excess insurers sit, confidently asserting the same defenses as the primary insurer, hoping that the policyholder makes a mistake in settlement that arms them with an additional coverage defense. Excess insurers have the luxury of sitting on their doubtful defenses, with little-to-no incentive to engage in good faith settlement discussions, because they stand a chance that the policyholder will make a critical mistake and relieve them from liability.

Thus, a question arises – can the policyholder settle with the underlying insurer for less than policy limits, then itself "fill the gap" between the settlement amount and the policy's limits of liability? Perhaps not surprisingly, the answer to that question comes from the excess policies themselves.

The Good, The Decent, and The Ugly

Exhaustion language in excess policies varies but generally falls into one of three categories: (1) the good, (2) the decent, and (3) the ugly.

1. The Good

First, the "good" exhaustion language. A well-negotiated excess policy will clearly and unambiguously state that the policy is triggered after exhaustion of the underlying limits through payments by the underlying insurer, the insured or others on behalf of the insured. For instance, a good example of this exhaustion language reads:

This Policy shall provide insurance excess of the Underlying Insurance. Liability shall attach to the Insurer only after (i) the insurers of the Underlying Insurance, the Insureds or others on behalf of the Insureds shall have paid in legal currency amounts covered under the respective Underlying Insurance equal to the full amount of the Underlying Limit . . . .

See Axis Excess D&O Policy, Form XS 0001 12 10. A different, but also good example of favorable exhaustion language is found (in relevant part) in this AIG excess D&O policy:

The Insurer's coverage obligations under this policy attach to the Insurer only after the Total Underlying Limits have been exhausted through payments by, on behalf of or in the place of the Underlying Insurers of amounts covered under the Underlying Policies. This policy shall recognize erosion of an Underlying Limit of an Underlying Policy through payments by others of covered amounts under that Underlying Policy.

See AIG Excess Edge Policy, Form 103224 (02/10).

A policyholder with excess insurance policies containing these or substantially similar exhaustion provisions should feel confident that it will have access to its excess policy limits should it settle with its underlying insurers for less than underlying policy limits.

2. The Decent

Second is the "decent" exhaustion language. In contrast to the above unambiguous exhaustion language that unquestionably allows a policyholder to "fill the gap" left between a settlement for less-than-policy-limits and the underlying limits of liability, there is exhaustion language that arguably leaves things open to interpretation – at least in the minds of insurers. For example, some excess policies provide that:

[I]t is agreed that in the event and only in the event of a reduction or exhaustion of the Underlying Limits of Liability, solely as the result of actual payment of a Covered Claim pursuant to the terms and conditions of the Underlying Insurance thereunder, this policy shall . . . .

See RSUI Excess D&O Liability Policy, Form RSG 230003 0204.

An important pro-policyholder case interpreting and applying similar exhaustion language comes out of the Eastern District of Virginia. See Maximus, Inc. v. Twin City Fire Ins. Co., 856 F. Supp. 2d 797 (E.D. Va. Mar. 12, 2012). In Maximus, Maximus sought coverage from its primary and excess professional liability insurers for a settlement reached in an underlying lawsuit. Maximus settled with its primary insurer as well as its first and second level excess insurers for amounts less than the limits of coverage under those policies. In each settlement, Maximus "absorbed the difference between what the carrier agreed to pay and the policy limit." Id. at 799. Axis, Maximus' third-level excess insurer, however, refused to indemnify Maximus, arguing that its policy was not triggered because Maximus did not exhaust the underlying policies. Specifically, the Axis policy provided that it "shall apply only after all applicable Underlying Insurance with respect to an Insurance Product has been exhausted by actual payment under such Underlying Insurance . . . ." Id. Axis argued that the term "actual payment" clearly created a condition precedent to coverage, requiring payment by the underlying insurers of the full amount of their respective policy limits before the excess policy coverage attached. Id.

The court in Maximus concluded that the exhaustion language in the Axis policy was ambiguous in that it neither stated that "actual payment" required payment of the full limit by the underlying insurer, nor did it expressly preclude the policyholder from filling the gap to exhaust the underlying policy. Id. at 801-02. Thus, the court found that Maximus' settlements with its underlying insurers for less than the full limits of their respective policies, and agreeing to fill the gap so that the policy limits had been reached, satisfied the Axis policy's exhaustion requirement. Id. at 804.

In contrast to the Maximus decision, however, insurers have argued, with some success, that similar exhaustion language is not ambiguous and that it requires exhaustion of underlying limits through actual payments by the underlying insurers. See, e.g., Great Am. Ins. Co. v. Bally Total Fitness Holding Corp., No. 06-C-4554, 2010 WL 2542191 (N.D. Ill. June 22, 2010); JP Morgan Chase & Co. v. Indian Harbor Ins. Co., 2012 WL 2105915 (N.Y. App. Div. June 12, 2012) (applying Illinois law); Forest Labs., Inc. v. Arch Ins. Co., 953 N.Y.S.2d 460 (N.Y. Sup. Ct. 2012).

While the Maximus decision is an important (and correct) one for policyholders, policyholders must be aware that should their excess policies contain exhaustion language that does not expressly address who must make payments to exhaust underlying limits, excess insurers will undoubtedly argue that their policies are only exhausted through full payment of the underlying limits by the underlying insurers. This uncertainty highlights both the importance of negotiating the most favorable exhaustion language when placing insurance and also in being aware of the applicable exhaustion language and controlling case law when settling a claim with underlying insurers.

3. The Ugly

Finally, there is the "ugly" exhaustion language. In contrast to the examples above, there is exhaustion language that requires exhaustion of underlying limits through full payment by the underlying insurers. For example, some excess policies provide:

The coverage hereunder will attach only after all of the Underlying Insurance has been exhausted by the actual payment of loss by the applicable insurers thereunder and in no event will the coverage under this Policy be broader than the coverage under any Underlying Insurance.

See XL Insurance Excess Coverage Form EX 71 01 09 99. Courts interpreting similar exhaustion language have held that only payments made by the underlying insurers exhaust the underlying policy limits, leaving the policyholders unable to trigger excess policies when settling underlying policies for less than policy limits and then "filling the gap." See, e.g., Citigroup v. Federal Ins. Co., 649 F.3d 367 (5th Cir. 2011) (applying Texas law); Comerica Inc. v. Zurich Am. Ins. Co., 498 F. Supp. 2d 1019 (E.D. Mich. 2007); Qualcomm, Inc. v. Certain Underwriters at Lloyd's, London, 73 Cal. Rptr. 3d 770 (Cal. Ct. App. 2008).

Conclusions

There are a number of ways to deal with this situation, but policyholders must first recognize the problem. Then, they need strategies to solve that problem.

While some excess policy forms contain unfavorable exhaustion language, that language should be negotiated out of the policies on renewal. New language should unambiguously allow for exhaustion through payments by either the underlying insurer or the policyholder. We have successfully negotiated such policy changes on behalf of multiple clients numerous times.

If faced with "decent" or "ugly" exhaustion language and a desire to settle, extreme care must be taken. Policyholders must be cognizant of the risk they run in settling with underlying insurers for less than policy limits. By doing so, when faced with this kind of exhaustion language, the policyholder runs a real risk of forfeiting excess coverage. Under such circumstances, it is best to directly raise this issue with the excess insurers, and bring them to the settlement table along with the underlying insurers. Most excess insurers don't want to litigate a claim against a policyholder on their own. Once they know that you are aware of the issue, and are not going to grant them a get-out-of-jail free pass, they may soften to the idea of agreeing to settlement.

In sum, the variety in types of exhaustion language found in excess insurance policies underscores the importance of policyholders getting out in front of this issue when negotiating and placing their insurance programs. All too often, excess policies are an afterthought in the placement process only to become an issue when it's time to settle a significant claim. By being proactive during the placement and negotiation stage, a policyholder can ensure that it has the insurance it expects when faced with resolving a large claim. What is more, being aware of the type of exhaustion language in your policy and the manner in which courts have applied that language is critical when settling a claim with underlying insurers so as not to unknowingly forfeit otherwise accessible excess coverage.

Miller Friel, PLLC is a specialized insurance coverage law firm whose sole purpose is to help corporate clients maximize their insurance coverage. Our Focus of exclusively representing policyholders, combined with our extensive Experience in the area of insurance law, leads to greater efficiency, lower costs and better Results. Further discussion and analysis of insurance coverage issues impacting policyholders can be found in our Miller Friel Insurance Coverage Blog and our 7 Tips for Maximizing Coverage series.

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