Should an excess carrier pay out anything on a directors and officers liability claim, if the primary carrier below it has not paid out its full limit?

While courts are ruling in favor of excess carriers on the seemingly uncontroversial question, excess insurers say settlement deals worked out between primary carriers and policyholders without their consent are increasingly forcing them into unnecessary battles with policyholders.

“Our policy should only respond when the underlying is exhausted, not tired,” said John Kuhn, chief executive officer of AXIS Professional Lines, speaking at the D&O Symposium of the Professional Liability Underwriting Society earlier this year.

Mr. Kuhn was referring to concerns that excess carriers have with an increasing number of deals known as “workouts” or “shaved limits deals” being struck between policyholders and primary carriers. In these deals, insureds contribute to large settlements of D&O claims, agreeing to pay a percentage of their limits of liability–often in recognition of the fact that some portion of their losses are technically excluded under their policies.

Related concerns addressed by a trio of court cases within the last year have favored the positions of excess insurers, prompting brokers to express their own sense of outrage on behalf of insureds.

“The buyer does not expect to have to fight its way through each successive layer of the program,” said Kevin LaCroix, a broker of Oakbridge Insurance Services in Beachwood, Ohio, referring to the likely outcome of the insurer-friendly decisions

In Comerica v. Zurich, decided in July 2007, and in Qualcomm v. Lloyd's, decided in March this year, the U.S. District Court of the Eastern District of Michigan and the California Court of Appeal both ruled that excess carriers had no obligation to pay when underlying limits were not paid by underlying carriers. These courts were guided in their decisions by specific language contained in the exhaustion clauses of the excess policies clearly spelling out the need for underlying limits to be paid in full–and solely by underlying insurers before excess carriers would respond.

Mr. LaCroix noted that the situation can be fixed with more flexible exhaustion language, but a related issue raised in an earlier case, Allmerica v. Lloyd's, is more difficult to address. There, the primary carrier paid its entire limit, but the Massachusetts Supreme Court held that an excess carrier, which believed certain exclusions barred coverage under its follow-form policy, was not bound by coverage decisions by a primary carrier that did not invoke the same exclusions.

Mr. LaCroix, who moderated the PLUS session, said the reason an insured purchases an excess policy with follow-form language is because it wants to have “coverage for the same set of potential losses.”

Having to engage in separate fights with each carrier isn't just burdensome for the insureds. Such battles also threaten to create coverage gaps like those that let excess carriers off the hook in Comerica and Qualcomm, he said.

In a recent interview, Mr. LaCroix conceded that a strict technical reading of the policies in the cases supports the rulings. Taking a more practical view, however, he said, “It seems like a result that courts shouldn't reach because it gives a path to the excess carriers” to deny claims when “they really haven't suffered any detriment.”

“They undertook to provide insurance attaching at a certain level, and if the amount underneath was paid solely by insurance or by a combination of insured and insurer, [then] what difference should it make to the excess carrier?”

“The amount below was paid. Who cares where the money came from? Why should they be able to walk away free?” he asked.

David Bell, senior vice president for Bermuda-based Allied World Assurance Company, gave an answer at the PLUS session and during a recent interview. He explained that money coming from the insured in many workout deals is for “uncovered losses,” and that excess carriers sign on to attach at a certain level of “covered losses.”

Referring to the example accompanying this article in which an insured with $50 million settlement has a $50 million tower of D&O coverage (split into five $10 million layers), he noted that if both the primary carrier and insured realize there are “uncovered matters” included in the $50 million, the primary insurer might propose that the insured contribute 20 percent of the settlement, or $10 million.

(Click on related link at the end of this article for a detailed illustration of this shaved-limits deal.)

In this example, negotiations to divvy up the $10 million benefit to a tower of insurers wound up with the primary paying 9.5 million, and excess carriers paying $8.75 million, $8 million, $7.25 million and $6.5 million of covered losses. The total covered loss of the first four layers–$33.5 million–falls below the $40 million attachment of the fifth-level excess carrier.

Although the compromise deal is usually structured so that each excess carrier gets more of a benefit or “shave” than the carrier below, the fact that the highest level carrier is paying out anything this settlement–even if it's only $6.5 million of its $10 million limit–is wholly unreasonable, Mr. Bell said. That excess carrier signed on to attach at $40 million of covered losses, which have not been reached–and it collected discounted premiums consistent with that level of attachment.

Collapsing the tower to illustrate the “covered losses” being paid by each carrier (shown at the right of the accompanying diagram), he revealed that this high-level carrier had to pay up even though “covered losses” have only reached $33.5 million. Adding insult to injury, it paid 68 percent of the loss amount shelled out by the primary carrier, after collecting only 31 percent of bottom-layer premium upfront.

From Mr. LaCroix's perspective, however, the result is undesirable to the insured who also didn't expect to pay anything and is forking over $10 million.

“Before insureds and carriers entrench themselves in their respective camps and count points on who's winning and losing, it's important to realize that either everyone wins or everyone loses,” Mr. Bell told NU.

“If carriers are forced to pay uncovered claims, the whole process is undermined [because] they lose the ability to quantify the risks being passed to them,” he said. “By the same token, if the carriers don't pay covered claims, the process becomes undermined just the same because there's an expectation that when the risk is transferred, the carriers will be there” to pay claims.

Mr. LaCroix said at PLUS, “What we're selling [our customers] is the experience that they're going to have with a claim.”

The experience “is going to be like a roller coaster,” Mr. Kuhn said, agreeing that the situation is undesirable for all parties.

Mr. LaCroix believes that a greater number of coverage battles being waged by excess carriers today are the result of soaring average severities, which together with smaller primary layers of coverage are pushing losses into excess layers not reached in past years.

Another factor is a real divergence of interests in asserting coverage defenses for primary and excess carriers, experts say.

A primary insurer may have a coverage defense that only applies to settlement or judgment payments, but not to defense expenses, said Joseph Monteleone, a partner with Tressler, Soderstrom, Maloney & Priess in New York.

For example, he said, if the primary limit is $10 million, and $8 million is already used up in defense expenses, the primary insurer has very little incentive to fight. “Your attitude is that even a very modest settlement is going to exhaust your layer,” Mr. Monteleone said, suggesting that the primary would see no benefit in raising coverage defenses to lower its payout on the settlement cost.

Michael Smith, president of AIG Executive Liability in New York, which is typically a primary writer on D&O programs, noted that coverage issues in the D&O world often are not black and white.

“Rather than litigate, which…doesn't work for us or for the insured, we often will find a way to reach some sort of agreement that works for both sides of the equation,” he said. He cited legal costs related to an entity's investigation by the Securities & Exchange Commission as a potential gray area of coverage.

Those are not covered under most D&O policies, but if the SEC investigation turns up facts that later fuel a shareholder class action, the class action will meet the definition of claim under the D&O policy.

At that point, the insured could certainly argue that “some of those [investigation] costs may have been required anyway”–that the carrier ought to recognize that the costs relate to the shareholder action even though there was no claim covered under the policy at the time they were incurred.

The answer, he said, “isn't yes, it's all covered, or no, it's not covered. You have to find some way to work through that” on a case-by-case basis.

“It doesn't sound like a lot, [but] the expense amounts in these cases are huge,” he added. They can be entire policy limits for the primary layer and the one after that.”

John McCarrick, a partner with Edwards Angell Palmer & Dodge in New York, highlighted the skyrocketing costs of special litigation committees of boards set up to look into the decisions of board members or management.

In the wake of the investigations led by former N.Y. Attorney General Eliot Spitzer and regulators in recent years, such committees are now regularly set up, and many of the outside law firms doing the work for committees “have really run amok,” he said.

Noting that his firm is currently involved in more than 30 stock-option backdating cases on behalf of insurer clients, he said “we're routinely seeing coverage reimbursement requests for $5 million, $8 million, even $10 million in legal fees associated with these investigations,” compared to historic costs of $1-to-$2 million.

He attributed much of the increase to the fact that outside law firms effectively decide themselves what the scope of the investigation should be. “They decide what they want to look at and how to staff these investigations, [and] they're apparently throwing every warm body resource they've got into these engagements.”

Illustrating the jump in costs associated with shareholder derivative suits in just a few years, he said, three years ago, a typical derivative case would have likely settled for some nonmonetary corporate governance changes, defense costs of around $500,000, and plaintiffs' lawyers' fees of $500,000 to $2 million.

Now insurers routinely see defense costs of $5-to-$7 million, proposed plaintiffs' lawyer fee awards of are $5-to-$15 million, and to make matters worse, insureds are trying to “shoehorn all kinds of other uncovered expenses”–auditor restatement costs, pre-claim SEC investigation expenses and these special litigation committee costs–onto insurers, arguing they “reasonably relate to the defense” of the case.

A primary insurer providing $10 million in coverage might now be looking at a pile of legal bills far exceeding $10 million, “a lot of which are not covered, but the insurer would have to spend hundreds of thousands of dollars to vet them,” he said. Even if they can reduce them, the effort might not achieve any savings off the primary limit.

So they're telling the excess insurers that unless they're given some kind of break off the primary limit, they won't bother vetting the legal bills. “Make it worth our while by letting us have a discount off our limit, or we're just going to pay our limit and move on,” the primary insurers demand, according to Mr. McCarrick.

Mr. McCarrick also worries that insureds that try to get at insurance proceeds to cover special litigation committee legal costs are engaging in a dangerous maneuver from a legal perspective. If the plaintiffs' bar ever became aware that a company was characterizing such costs as part of a D&O defense effort, “and not as an objective, neutral investigation, then that would be a basis for the plaintiffs' bar to disqualify” the committee report and its findings.

In other words, the plaintiffs' lawyers could say “it was a setup from the start. The special litigation committee was always intended to be a measure to benefit the directors and officers; it was never meant to be an objective investigation.”

Turning to a different set of questionable motivations, Mr. Bell said primary insurers sometimes ignore legitimate coverage defenses to lower their D&O claim payments because they want to maintain relationships with insureds that buy other policies from their companies.

“That's more common than people realize,” Mr. Bell told NU.

“We're not bound to follow their interpretation of language, but we do take it into consideration.” Follow form, however, “does not mean we follow the fortunes of the primary carrier,” he said, noting that motivations for coverage decisions unrelated to policy language “are far from transparent to excess insurers.”

Mr. Monteleone said he has personally witnessed past situations where primary insurers paid portions of a potentially uncovered claims, while saying “we want to be able to renew your policy at above-market rates.”

Such hidden deals weren't offered to excess carriers. “I'm not suggesting this still takes place to a great extent, but I have my suspicions that it did at one time,” he said.

Speaking at the PLUS meeting, Mr. Kuhn also suggested differing motives for primary and excess carriers. Excess carriers look at the damage analysis when assessing their coverage positions, he said. “You're not going to take into account that the primary just threw in its limits because of a phone call between the CEO [of the insured] and the CEO” of the carrier.

“That's an interesting argument,” said AIG's Mr. Smith. “So excess carriers are [accusing] primary carriers of overpaying on claims to make their insureds happy?”

“I think it's a little bit of an excuse rather than a reason,” he said. “I can assure you that anytime AIG Executive Liability pays a claim, there's coverage there.”

“Certainly you look at the relationship with the insured,” and a 15-year insured is one “you make sure that you're careful to be fair to,” he said. “You recognize the relationship, but that doesn't mean you overpay,” he said.

“I think that's where [the excess insurers' theory] gets a little off track, because I can assure if you get five lawyers in a room as to what the right number is to settle a case, you get five different answers.”

“It's not like there's a right answer and you're either above or below that number.”

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D&O 'Workouts' Leave Insureds Fighting Their Way Up Towers Of Coverage

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