When a lawsuit hits a company or its directors and officers, the most common question on in-house counsel’s lips is, “Do we have the right amount of insurance?” Companies often obtain the “right” amount of insurance coverage based on potential exposure to particular types of claims, with the goal of balancing the total amount of insurance (both primary and excess) against the cost of coverage. However, the amount of coverage, while important, is not and should not be the predominant question. If a company’s insurance coverage is not structured correctly, the level of coverage may prove to be irrelevant when addressing a live claim. Recent cases bear this out.
In the context of insurance, the term “exhaustion” does not refer to feeling winded after a long (or perhaps short) run. Rather, a fundamental issue is whether or not the first layer of insurance coverage is completely exhausted so that the obligations of excess coverage are triggered.
Consider the common circumstance in which a dispute exists as to coverage and the carrier issues a reservation of rights. This issue is usually resolved via a settlement between the primary insurance carrier and the insured. But if the policy limits are not exhausted as a result of the settlement, then in all likelihood the excess insurance policies will not be triggered, creating a coverage gap.
In recent years this scenario has ensnarled a number of significant companies, as courts have held that a settlement with the primary carrier for less than the policy limits does not cause an exhaustion of the primary policy, thus preventing a triggering of the excess coverage. The same result occurs if the policyholder absorbs the resulting gap between the settlement amount and the primary policy’s limits. As one court noted, there is “no way to determine that a settling underlying insurer paid the full amount of its policy.” In the end, the insured is left holding the proverbial bag.
Most excess insurance policies are a variation of “follow form” policies, meaning the excess policy terms should track with the terms of the primary policy. But these policies often contain limiting language that provides for the form to follow except where the excess policy contains different terms than the primary policy. This distinction is crucial in considering whether a claim will be actually covered by each policy. Consider, for example, the situation where the definition of loss is different, or the particular language of a certain exclusion differs between policies (even if the same substantive exclusion exists in both the primary and excess policy). The lesson is that in obtaining excess insurance coverage, the overall structure of the policies is crucial to ensuring that sufficient coverage exists at the time a claim arises.
When a claim is filed, the question is whether an umbrella or excess insurer is obligated to “drop down” and provide primary coverage when the underlying primary coverage does not afford coverage, but the umbrella or excess policy does. This issue can also develop if the underlying insurer becomes insolvent.
Several West Coast courts have required dropping down in such instances. As a result, the excess insurance policy steps into the primary policy’s shoes for all purposes. On the other hand, at least one court on the East Coast has held that the insolvency of an underlying insurer does not require an excess insurer to drop down and provide coverage, meaning that an insured cannot count on the excess or umbrella policies to necessarily provide coverage.
An ounce of prevention
A crucial step in mitigating risk is absolutely having appropriate insurance coverage. The time to discover a potential problem is before a claim is filed, not after one arises. A company can avoid unintended limitations in coverage and other issues by effectively structuring its insurance policies. The amount of coverage and related costs remain important considerations when choosing coverage, but those are the beginning questions, not the deciding factors.