Excess D&O Insurance: What’s Up With That?

As average D&O claims severity has increased and accompanying defense expense has escalated in recent years (about which refer here), excess D&O insurance has become an increasingly critical part of D&O claims resolution. Perhaps because of the increasing claims involvement of excess D&O insurance, it seems as if the number of D&O coverage disputes involving excess insurers is growing. Two recent court decisions – one in Michigan federal court involving Comerica Incorporated and one in the Supreme Judicial Court of Massachusetts involving Allmerica Financial Corporation – illustrate the kinds of excess insurance coverage disputes that are arising, and also underscore the problems these disputes create.

Allmerica: In an August 6, 2007 opinion (here) written by Justice Robert Cordy, the Massachusetts Supreme Judicial Court addressed an "issue of first impression in Massachusetts," the question "whether a ‘follow form’ insurer is bound by the decision of a primary insurer to settle a claim." The coverage dispute arose out of an underlying class action lawsuit alleging improper practices in the sale of life insurance. The underlying case ultimately settled. The total value of the underlying settlement plus litigation expense was $39.4 million.

Allmerica’s primary liability insurance policy’s limit of liability was $20 million, over a $2.5 million self-insured retention. Allmerica’s liability insurance program also included an additional $10 million layer of "follow form" excess insurance over the primary policy. The excess policy’s follow form language provided that "this Policy is subject to the same conditions, limitations and other terms…as are contained in or may be added to the Polic(ies) of the Primary Insurer(s)."

Following the class action settlement, Allmerica and its primary insurer reached an agreement in which the primary insurer agreed to pay its full $20 million policy limits. However, Allmerica’s excess liability insurer "generally disclaimed coverage for any loss encompassed by the settlement," in reliance upon certain policy exclusions. Allmerica filed a declaratory judgment action against the excess insurer in Massachusetts state court.

On consideration of cross-motions for summary judgment, the trial court ruled that the excess carrier was not bound by the primary carrier’s actual or implied coverage determination, and also ruled that certain exclusions and coverage defenses precluded coverage under the excess policy. The trial court judge granted summary judgment in favor of the excess insurer, and Allmerica appealed. (For procedural reasons not entirely clear from the opinion, Allmerica’s appeal wound up before the Supreme Judicial Court rather than the intermediate appellate court).

The appeals court agreed with the trial court’s ruling that the "follow form" excess insurer was not bound by the primary carrier’s decision to provide coverage, but the appeals court also found that disputed issues of material fact remained with respect to the excess insurer’s coverage defenses, and so remanded the case back to the trial court for further proceedings.

In ruling that the excess carrier was not bound by the primary carrier’s coverage determination, notwithstanding the excess policy’s "follow form" language, the appeals court emphasized that the two policies are "separate and distinct contracts," in which each insurer had agreed "individually to cover a particular portion of risk." The follow form language "allows an insured to have coverage for the same set of potential losses" but the follow form language "does not…bind the various insurers to a form of joint liability." The "layer of risk" each insurer covers is "defined and distinct." The appeals court specifically noted that "primary and excess insurers act independently of each other with respect to decisions about their policies including coverage determinations and settlements."

With respect to the excess carrier’s "follow form" language, the appeals court also said:

An excess carrier’s intent to incorporate the same words used in a separate agreement between the primary insurer and the insured does not imply an intent by the excess carrier to accept decisions made by the primary carrier about the extent of obligations under its own agreement. By adopting the form of words used by [the primary carrier], [the excess carrier] did not also cede to it the right to make decisions about the [excess carrier’s] obligation to perform in certain circumstances. To conclude otherwise would undermine the distinct and separate nature of each insurer’s contract with Allmerica.

Comerica: The July 27, 2007 opinion (here) by Eastern District of Michigan Judge David Lawson in the coverage dispute between Comerica and its excess D&O insurer addresses the issue of the enforceability of an excess insurance policy when a compromise between the policyholder and the primary insurer creates a "coverage gap" that is funded by the policyholder.

The dispute arose out of securities class action lawsuits (about which refer here and here) that were filed against Comerica and certain of its directors and officers. The class actions ultimately settled following mediation for $21 million.

Comerica’s primary D&O insurance policy had a $20 million limit of liability, and Comerica also had an additional "follow form" $10 million policy excess of the primary coverage. (Comerica had additional excess coverage beyond that, but the additional coverage is nor relevant here.) By its terms, the excess policy recognized "depletion" or "exhaustion" of the underlying policy "solely as a result of payment" under the underlying policy. The excess policy also specifically noted that it did not provide coverage for any loss that is covered under the underlying policy but that is not paid by the underlying insurance.

Both before and after the underlying settlement, the primary carrier disputed coverage. The primary insurer contended that Comerica had violated the policy’s cooperation and consent requirements. The primary insurer also contended that $6 million of the settlement had been paid in resolution of claims under Section 11 and Section 12 of the ’33 Act and was restitutionary in nature and therefore not covered under the primary policy. The primary insurer also contended that Comerica had made misrepresentations in the application process. Comerica and the primary insurer ultimately resolved their coverage dispute, with the primary insurer agreeing to pay $14 million toward the $21 million underlying settlement.

Comerica then demanded that the excess insurer pay $1 million toward the underlying settlement plus $2.1 million in defense costs. The excess carrier refused to pay on the grounds that the primary policy had not been exhausted and that Section 11 damages are not covered. Comerica filed a declaratory judgment action against the excess carrier.

In his July 27 opinion addressing the declaratory judgment action parties’ cross-motions for summary judgment, Judge Lawson, applying Michigan law, ruled in favor of the excess insurer and granted the excess carrier’s summary judgment motion.

Comerica had made three arguments: first, that the excess carrier had repudiated its policy by its coverage position; second, that allowing the excess insurer to disclaim coverage would violate public policy, and third, that the excess carrier’s policy was ambiguous. Judge Lawson rejected all three of these arguments.

Comerica’s repudiation argument was based on the excess carrier’s contention that Section 11 damages are not covered. Essentially, Comerica contended that this coverage position represented an "anticipatory repudiation" by the excess carrier of its intent to perform under its insurance contract, giving Comerica the right to sue for breach. Judge Lawson found however that the excess carrier’s position was not an unequivocal declaration of intent not to perform, but was merely a statement that "Comerica had not yet fulfilled the condition precedent on the excess policy" – that is, exhaustion of the underlying policy. Judge Lawson concluded that Comerica had not shown that the excess carrier had repudiated the policy.

Comerica’s public policy argument was based on the contention that Comerica’s own payment of the $6 million "gap" between the $14 million compromise with the primary carrier and the $20 million excee policy attachment point was the "functional equivalent of exhausting the primary policy." Comerica argued that to require exhaustion of the underlying policy, triggering payment obligations under the excess policy, would violate public policy by causing delay, promoting litigation, and preventing dispute adjustment. Judge Lawson found that the cases on which Comerica relied generally involved only excess policies with ambiguous definitions of "exhaustion." Judge Lawson found that Comerica’s excess policy unambiguously "requires that the primary insurance be exhausted or depleted by the actual payment of losses by the underlying insurer. Payments by the insured to fill the gap …are not the same as actual payment."

Judge Lawson added that Comerica could have sued the primary carrier and tried to establish that the primary carrier was obligated to pay its entire $20 million limit, but instead Comerica compromised for a $14 million payment, about which Judge Lawson noted:

Comerica seeks the certainty that its settlement [with the primary insurer] brought and the benefit of coverage from its excess carrier as if it had won its dispute with the primary insurer, despite language in the excess policy to the contrary. No public policy argument says that Comerica may have its cake and eat it too.

Comerica’s argument that the excess policy’s exhaustion language is ambiguous was based on the contention that other policy provisions allow the insured to fund gaps with its own payment (for example, if the underlying policy lapses). Judge Lawson found that the fact that the policy provided elsewhere for policyholder gap funding but that the exhaustion provision did not suggests that the omission of policyholder gap funding in the exhaustion provision was deliberate. Judge Lawson said that to find the excess policy to be ambiguous "would require a holding that parties simply cannot contract for an excess policy to be triggered only upon full, actual payment by the underlying insurer." He noted that Comerica could have, but did not, bargain for an excess policy that would pay for any liabilities over $20 million, even if the underlying insurer did not pay the entire $20 million – "the present agreement does not say that, and it cannot be rewritten now."

The most prominent parallel between these two cases (other than the odd similarity of the two companies’ rather awkward names) is that in both cases the excess carriers substantially prevailed and the companies’ arguments were largely rejected. An apologist for the carriers would contend that the carriers prevailed because their positions were meritorious, and there undoubtedly is some truth to that. My concern is that these two insurer-friendly decisions could embolden other excess carriers to resist coverage in other cases, even where their positions are not as meritorious.

It is of course true, as the Massachusetts court noted, that the primary policy and the excess policy are separate contracts of insurance and each carrier has the right to make its own separate coverage determination. The problem I see is that disputes with excess carriers are becoming all too frequent and are threatening to become a virtually standard part of the D&O claims process.

The reason an insurance buyer acquires "follow form" excess insurance is, as the Massachusetts court noted, because it wants "to have coverage for the same set of potential losses." If the different carriers in an insurance program with "follow form" excess coverage are effectively not going to cover the same losses in the same way, the intent of the insurance acquisition process is frustrated. The insurance buyer certainly does not expect to have to fight its way through each successive layer in the program. The prospect of compulsory separate fights with separate carriers not only threatens undesirable burden and vexation for the policyholder, it hazards the deeper threat that one of the disputes with one of the carriers will result a coverage "gap" of the kind that defeated Comerica’s excess coverage.

Clearly these kinds of concerns need to inform the D&O insurance acquisition process. Both the Allmerica and the Comerica courts expressly noted that they reached their decisions in reliance upon policy language and absent other language to the contrary – the inference is that different excess policy language could have produced a different result. One particularly important area of concern, as demonstrated in the Comerica case, is the excess policy’s exhaustion language. There clearly is a need for more flexible language, to reduce restrictions surrounding the kinds of payments of loss that could trigger the excess carrier’s payment obligation. The need for these issues to be addressed in the insurance acquisition process is yet another reminder of the need for the involvement of skilled insurance professionals in the acquisition process.

The possibility of addressing, in the language of the excess policy, the problem that Allmerica faced with its excess carrier is more problematic, because few excess carriers likely would be willing to cede to another carrier their right or ability to make their own separate coverage determination. But the recent ramp up in coverage disputes in which excess carriers are taking coverage positions not asserted by the primary carrier is a problem for policyholders and for the D&O industry as a whole. I do not mean to suggest in any way that the excess carriers in the Allmerica or Comerica cases did anything improper. There are, however, serial coverage deniers out there; as an industry we ought to do a better job keeping score. When it threatens to become routine for excess carriers to take positions that primary carriers do not, the industry has a problem it needs to address, whether through modification of the policy language or through the development of serial denier league tables. Given the increasing importance of excess insurance in D&O claims resolution noted above, these issues are likelier to become increasingly more critical.

I suspect that my friends in the D&O underwriting community might have a lot to say about my observations here -- I can almost hear the sputtering and indignation while I type this. I hope that any underwriters out there who are particularly exercised by my remarks will take the time to post a comment. I am very interested in hearing others’ thoughts on this topic.

The Comerica court did not reach the merits of the issue of the insurability of the settlement of Section 11 liability. This issue was however addressed in the recent CNL Hotels case, about which I previously wrote here. As I noted in my prior post, the need for D&O policies to expressly address the question of Section 11 settlements is another issue with which the industry needs to grapple.

An August 7, 2007 Business Insurance article discussing the Allmerica decision can be found here. An August 7, 2007 Insurance Journal article can be found here.

Thanks to a loyal reader who prefers anonymity for alerting me to the Allmerica opinion. Thanks to Dan Standish of the Wiley Rein law firm for alerting me to the Comerica decision, and to Adam Savett of the Securities Litigation Watch blog for providing a link to the Comerica decision. I should probably emphasize that while these fine gentlemen provided me with copies of the cases, the views about the cases in this post are solely my own. I suspect that one or more of these guys would want to distance themselves from my analysis, big time. Don't blame them, OK?