In Ali v. Fed. Ins. Co., 11-5000-CV, 2013 WL 2396046 (2d Cir. June 4, 2013), the Second Circuit held that coverage under an excess insurance policy, which provides an additional layer of coverage for losses that exceed the limits of a primary liability policy, is triggered when the liability limits of the underlying primary insurance policy have been exhausted by actual payment of losses. In other words, “payment of losses,” in exhaustion clauses of excess liability insurance policies under New York and Pennsylvania law, refers to actual payment of losses suffered, not mere accrual of losses in form of liability.

In Ali, the appellants (Directors) are the former directors and officers of Commodore International Limited, a computer technology company that ceased operations and filed for bankruptcy in 1994. Commodore had purchased a “primary” insurance policy to cover the first $10 million in liability, and eight “excess” insurance policies designed to cover potential liability above the primary insurance; the first excess policy provided $5 million of protection in excess of $10 million in liability payments, the second excess insurance policy provided $5 million in excess of $15 million in liability payments, and so on. Two of the “excess” insurers (Reliance Insurance Company and Home Insurance Company) ceased operations and liquidated their assets, hindering Directors’ ability to seek reimbursement for claims filed under the first, third, fourth, and sixth “excess” policies. Appellee Federal Insurance Company (FIC) is the still-operational provider of the Directors’ second and fifth excess insurance policies.

FIC filed an action against the Directors in the Southern District of New York, seeking a declaration that under the terms of the relevant insurance policies, FIC is not required to “drop down” to cover liability that would have otherwise been covered by Reliance and Home. In the same proceeding, Directors filed a counter-claim against FIC and also sued the provider of the seventh excess insurance policy: Travelers Casualty and Surety Company of America (Travelers). Directors sought a declaration that “Federal and Travelers’ coverage obligations are triggered once the total amount of [the Directors’] defense and/or indemnity obligations exceeds the limits of any insurance policies underlying their respective policies, regardless of whether such amounts have actually been paid by those underlying insurance companies.” Id. at 5. The Directors then moved for partial summary judgment with respect to this request for declaratory relief. The District Court granted FIC’s motion on the “drop down issue,” which Directors did not appeal, and denied the Directors’ motion for partial summary judgment, holding that “excess policies expressly state that coverage does not attach until there is a payment of the underlying losses.” Id. Following that decision, the parties agreed that all remaining claims and third-party claims should be dismissed with prejudice, which resulted in a Court order dismissing the case with prejudice. Id. The Directors appealed the judgment, contesting the Court’s denial of their motion for partial summary judgment with respect to their request for declaratory relief. The Second Circuit had appellate jurisdiction because “(1) the district court’s order denying the Directors’ motion for summary judgment plainly rejected the legal basis for the Directors’ counter-claim, (2) the district court had disposed of the claims with prejudice, and (3) the Directors’ consent to the final judgment was designed solely to obtain an immediate appeal of the prior adverse decision, without pursuing piecemeal appellate review.” Id. at 9.

Both FIC policies state that the excess liability coverage “shall attach only after all… ‘Underlying Insurance’ has been exhausted by payment of claim(s),” Id. at 10 (emphasis supplied), and that “exhaustion” of the underlying insurance occurs “solely as a result of payment of losses thereunder.” Id. The Second Circuit denied the Directors’ requested declaration that excess coverage obligations are triggered when “defense and/or indemnity obligations” reach the attachment point, because “obligations” are not synonymous with “payments” on these obligations. To hold otherwise, the Second Circuit reasoned, would make the “payment of” language in these excess liability contracts superfluous. Accordingly, the Second Circuit upheld the District Court’s conclusion that the “express language” of the relevant contract terms “establishes a clear condition precedent to the attachment of the Excess Policies,” by “expressly stat[ing] that coverage does not attach until there is payment of the underlying losses.” Id. at 12. The opinion, however, is deliberately silent on which party is obligated to make the requisite payments (the insured or underlying insurer).

Notably, the Second Circuit distinguished this case from Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 665 (2d Cir. 1928). Zeig involved a first-party property loss. That the insured had settled his claim with his primary insurer for less than the limits of the primary policy did not prohibit the insured from seeking to recover from his excess carrier, despite language in the excess policy that stated that the excess policy attached after the primary insurance was “exhausted by the payment of claims to the full amount of the expressed limits,” because the purpose of first-property insurance is to make the insured whole for a loss and the value of an insured’s loss in the first-party context is more easily ascertainable. In the third-party context, by contrast, the Ali Court concluded that the value of the claims against the insured are less clear and there is a danger that the insured may settle with the claimant for an inflated amount in an effort to make up for gaps in coverage created by insolvent insurers. Enforcing the plain language of the excess policy, requiring “payment of claims” and “exhaustion” of all underlying layers, may help avoid this problem.

The Second Circuit’s decision in Ali is important for companies that have structured their liability insurance in layers, with a tower of separate excess policies issued by different insurers. Such companies should be aware of the provisions in those policies governing each excess carrier’s obligation to (or not to) drop down in the event of the insolvency of any of the underlying policies and under what circumstances that excess policy would be triggered. Arent Fox LLP, with offices in Los Angeles, New York, San Francisco, and Washington, DC, is well placed to assist its clients in understanding the intricacies of their excess liability policies.