Ninth Circuit Limits Rights of Excess Insurers to Contest Underlying Exhaustion

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This week, the Ninth Circuit of the United States Court of Appeals addressed an issue of first impression in the circuit: under what circumstance may an excess insurer argue improper erosion of underlying policy limits to limit the amount of its obligation?  The Ninth Circuit rejected an excess insurer’s attempt to exclude settlement amounts paid by underlying insurers for allegedly uncovered claims in calculating exhaustion of underlying limits, absent the excess insurers’ showing of fraud or bad faith by the underlying insurers or policy language allowing the excess insurer to challenge the propriety of the underlying exhaustion.

In AXIS Reinsurance Co. v. Northrop Grumman Corp., No. 19-55135, 2020 WL 5509743 (9th Cir. Sept. 14, 2020), Northrup Grumman Corporation carried an Employee Benefit Plan Fiduciary Liability Insurance program in which AXIS Reinsurance Company issued a second layer excess policy.  Northrup faced two lawsuits, one by the Department of Labor and one brought on behalf of two Northrup savings and pension plans.  The first lawsuit was settled within the primary and first layer excess limits.  The second lawsuit was settled for the remainder of the first layer excess limits and required more than $9.7 million from AXIS’ second layer excess coverage.

AXIS paid its share  of the settlement of the second lawsuit and then filed suit against Northrup, seeking reimbursement for the amounts paid.  AXIS argued that there was “improper erosion” of underlying limits so that coverage under the AXIS policy was not triggered and Northrup should reimburse it for the amounts AXIS contributed to the settlement of the second lawsuit because the amounts paid in the first lawsuit were not covered by the underlying policies. (at *3) The District Court agreed that the amounts paid in settlement of the first suit were not covered and thus could not be credited against exhaustion and granted summary judgment in favor of AXIS. Id.   Northrup appealed. The Ninth Circuit reversed without reaching the issue of whether the settlement was covered.

The Ninth Circuit first adopted a “general rule” that “an excess insurer may not challenge the underlying insurers’ payment decisions in order to argue that their policy limits were not (or should not have been) exhausted … unless there is an indication that the payments were motivated by fraud or bad faith.” (at *4, quoting Costco Wholesale Corp. v. Arrowood Indem. Co., 387 F. Supp. 3d 1165 (W.D. Wash. 2019). The Court reasoned that: allowing an excess insurer to second guess other insurers’ payments, absent bad faith or fraud, would be inefficient and undermine confidence in settlements; instances where underlying insurers would pay limits on uncovered claims for reasons other than coverage (and absent fraud or bad faith) were few; and, that an excess insurer was free to increase premium to account for the risk of improper exhaustion by underlying insurers and/or include clear contract language reserving the right to contest coverage decisions by underlying insurers and exclude amounts improperly paid.

The Ninth Circuit then addressed whether the AXIS policy included such express language.  The AXIS policy required the exhaustion of underlying insurance limits “for covered loss” as a prerequisite to coverage and AXIS argued that such a requirement could not be satisfied by payment of uncovered loss.  The Ninth Circuit found the policy was ambiguous with respect to whether the excess insurer could challenge the payments by other insurers and thus construed the provision against AXIS.

The AXIS decision raises some interesting questions.  If a policy term expressly stating that underlying limits are eroded by payment of “covered loss” is insufficient to preclude erosion by “uncovered loss,” what must a policy say?  Ironically, the Ninth Circuit cited to a case brought by AXIS which had a policy that stated:  “only losses which, except for the amount thereof, would have been payable under this Policy contribute to the satisfaction, reduction or exhaustion of underlying amounts or deductibles.” Axis Surplus Ins. Co. v. Innisfree Hotels, Inc., No. CIV.A. 05-0527-WS-C, 2006 WL 2882373, at *7 (S.D. Ala. Oct. 6, 2006).  Perhaps the policy itself must contain a reservation of rights to challenge payments by underlying insurers?  Aside from re-drafting policies, what can an excess insurer do to protect itself from underlying insurers’ improper coverage determinations, especially, like here, a second layer insurer?  By discouraging suits against the insured when (or after) an excess insurer is actually called upon to pay, the Ninth Circuit may be encouraging earlier suits to challenge the propriety of a settlement, at the time a settlement within underlying limits is being considered (assuming the excess insurer knows of it) and even  before the excess insurer is being asked to respond; thus, at a time when its concerns are not truly ripe.  The latter seems an unsatisfactory approach, suggesting excess insurers might be well advised to review their policy forms to address and make much more clear their exhaustion requirements.