In its recent decision in Preferred Constr., Inc. v. Ill. Nat'l Ins. Co., 2012 U.S. App. LEXIS 18395 (2d Cir. Aug. 30, 2012), the United States Court of Appeals for the Second Circuit, applying New York law, had occasion to consider when an excess insurer’s duty to defend is triggered, particularly in the context of New York’s anti-subrogation rule.

Preferred Construction was a subcontractor on a construction project involving a cemetery owned by the Diocese of Rockville Center.  One of Preferred Construction’s employees was injured while on the job, and brought suit against the cemetery, the Diocese, and the project’s general contractor.  Each of these entities tendered their defense to Preferred Construction, which was insured under a primary general liability policy issued by Nova Casualty Company and an excess liability policy issued by Illinois National.  Nova undertook a defense of each of these entities.

Each of these three parties subsequently asserted third-party claims for contribution and indemnification against Preferred Construction, but only for “any recovery that plaintiff may obtain in excess of the primary policy limits of [Preferred Construction].”  Presumably, the third-party complaint was alleged in such a fashion so as to circumvent New York’s anti-subrogation rule, which prohibits one insured from suing another insured under the same policy for amounts within the policy limits.  Nova tendered the third-party complaint directly to Illinois National, asserting that Illinois National had a duty to defend Preferred Construction because the third-party complaint sought amounts only in excess of the Nova policy, i.e., amounts that only could be paid under the Illinois National policy.

In considering Illinois National’s duties to Preferred Construction, the Second Circuit observed the general rule that an excess insurer’s obligations are not triggered until exhaustion of underlying limits, and that while an excess insurer may elect to participate in the defense of its insured, it generally has no obligation to do so.  Such duties were clearly stated in the language of Illinois National’s excess policy.  Thus, the court concluded, Illinois National’s obligations under its policy, including its duty to defend, could only be triggered upon full exhaustion of the Nova policy.  That the third-party complaint sought amounts only in excess of the Nova policy’s limits was irrelevant, as the court explained:

The fact that the third-party complaint seeks indemnification only for "any recovery that plaintiff may obtain in excess of the primary policy limits" does not change this result. Requiring Illinois National to defend in these circumstances would effectively permit any claim of excess damages to preemptively trigger the excess insurer's duty to defend—regardless of when (or whether) the limits of the primary policy are exhausted. Such a result would appear to eviscerate the general rule that the excess insurer "may elect to participate in an insured's defense to protect its interest, [but] . . . has no obligation to do so."

In reaching its holding, the court considered Nova’s and Preferred Construction’s argument concerning New York’s anti-subrogation rule, which states that “[a]n insurer… has no right of subrogation against its own insured for a claim arising from the very risk for which the insured was covered.”  N. Star Reins. Corp. v. Cont'l Ins. Co., 604 N.Y.S.2d 510 (1993).  The Second Circuit acknowledged that pursuant to the anti-subrogation rule, Preferred Construction could only be sued by the additional insureds under the Nova policy for amounts in excess of that policy’s $1 million limits.  The court nevertheless concluded that this rule did not trump the more basic rule of underlying exhaustion:

Whatever effect the anti-subrogation rule might have on Nova's duty to defend (an issue on which we express no opinion), it is clear enough for our purposes that the rule cannot operate to defeat the reasonable expectations of Preferred Construction and Illinois National. We find no authority permitting us to depart from New York's well-settled rule that an excess carrier has a right, not an obligation, to assist in the defense of its insured when the primary insurance has not yet been exhausted.