In June 2013, the United States Court of Appeals for the Second Circuit issued an opinion about excess insurance that was unfavorable to policyholders. As policyholder advocates, we believe the court got it wrong. Fortunately, Second Circuit authority is not controlling in Ohio, but unfortunately, the Second Circuit carries some persuasive clout as the circuit sitting over the federal courts of New York. Consequently, we recommend that risk managers and their brokers become aware of the Ali, et al., v. Federal Ins. Co., et al., No. 11-5000-cv (2nd Cir. 2013) decision and take the steps identified at the end of this article to avoid potentially suffering the same fate as the policyholders in the Ali case.
In Ali, the former directors and officers of a bankrupt computer technology company sought coverage from excess insurance carriers that sat over insolvent underlying insurance. Most often, when a policyholder seeks coverage from an excess insurer sitting above an insolvent insurer, the fight is over whether the insurer must “drop down” to cover the policyholder starting at the point where the underlying carrier became insolvent versus simply filling the insolvency gap by subtracting the insolvent limits from what the excess carrier owes.
But Ali rejected both of these approaches and instead adopted a third approach: requiring that the insolvency gap actually be paid as opposed to simply subtracting the value of the gap from what the excess carrier owes. In reaching its conclusion, the Ali court strictly construed the policy language at issue, which said that the excess coverage would attach “solely as a result of payment of losses” allocable to the underlying policy. (Emphasis court’s.) It further reasoned that allowing the insolvency gap to be subtracted from the excess carrier’s liability rather than requiring the actual payment of that amount creates an incentive for policyholder defendants to collude with plaintiffs to create settlements far larger than otherwise would be agreed upon, with the mutual understanding that the plaintiff will never receive the insolvency gap money, but will instead receive the excess coverage proceeds.
Notably, the Ali court left open the possibility that the required insolvency gap payment need not be paid by the insolvent carrier, apparently recognizing that would mean that the excess carrier could never become liable given that insolvent carriers rarely, if ever, pay out the limits of their policies. To this point, it observed that “[t]he District Court never held that the underlying insurers must make payments before the obligations under the relevant excess policies are triggered.” (Emphasis court’s.) So, although the Ali court does not explicitly say so, apparently its holding means that if a policyholder (or its contractual indemnitor) pays the third-party plaintiff the amount of the insolvency gap, then the excess carrier’s obligations will attach for any amount above that.
We believe that the Second Circuit’s approach is misguided. The moral hazard of collusion is already addressed by most insurance policies, which specifically prohibit collusion, voiding coverage. Thus, the real issue the court should have considered is whether the risk of an insurer becoming insolvent should be borne by an excess carrier or a policyholder. As a practical matter, often policyholders cannot afford to pay an insolvency gap. Our view is that the risk of an insolvency gap should be allocated to excess carriers. By agreeing to sit above an underlying carrier, an excess carrier assumes the risk of an insolvency and must be prepared to drop down and cover the policyholder’s losses starting at the point of insolvency. Indeed, the purpose of a policyholder buying a stack of insurance is to cover its losses in its hour of need, and the purpose of insurance companies issuing policies of insurance is to protect policyholders at that time. The draconian requirement that policyholders actually must pay the often unaffordable insolvency gap out of their own pockets before an excess insurer has any liability undermines this protective purpose of insurance.
At the very least, excess carriers should pay after the insolvency gap is subtracted from the excess carrier’s liability because otherwise an excess carrier stands to gain an unfair windfall by not having to assume payments at the same point that it otherwise would have if the underlying carrier had not gone insolvent.
Ultimately, it is better not to have to engage in an argument with excess carriers over whether the Ali approach or some other approach should apply. Instead, we recommend that companies ensure that their risk managers and brokers buy excess insurance that explicitly acknowledges an obligation to drop down when an underlying insurer goes insolvent, or that at least agrees to provide coverage subject to a credit being given for an insolvency gap without requiring actual payment of the gap. Such policy language is readily available in the marketplace, and should be insisted upon.
It is also worthwhile for companies to have their risk managers, brokers, or insurance coverage lawyers review their historical policies and seek an endorsement modifying any excess policy language similar to that at issue in the Ali case now rather than waiting until an insolvency gap disaster strikes.