Businesses buy insurance coverage to protect them from liability for various insured risks, and in many cases to shift to the insurer the burden of defending lawsuits.
An insurer providing primary liability coverage generally requires the payment of relatively high premiums to compensate it for assuming a duty to defend the insured against lawsuits that potentially implicate coverage. In contrast, an excess/umbrella insurer usually charges lower premiums than the primary insurer since its duty to defend is much narrower.
Coverage under a typical excess/umbrella insurance policy is divided into two parts: Coverage A and Coverage B.
Coverage A provides excess coverage (also known as vertical coverage) that follows form to the underlying primary policy, and is generally not triggered until the policy limits and defense obligations of the underlying primary policy are exhausted. On the other hand, Coverage B is commonly referred to as "stand alone" coverage (also known as horizontal coverage), designed to provide primary coverage in many situations where the underlying primary policy does not.
In order to prevent overlap between Coverage B and the underlying primary policy, Coverage B explicitly excludes coverage for risks that are covered by the underlying primary policy. Thus, by definition, Coverage B is potentially implicated only if the underlying primary policy does not provide coverage.
Courts have sometimes addressed an interesting question arising from this relationship: What is the duty of the excess/umbrella insurer when the primary insurer wrongfully denies coverage and breaches its duty to defend the insured?
In such a situation, Coverage A has no defense obligation because the limits of the primary policy have not yet been exhausted, while Coverage B has no defense obligation because it does not apply to risks falling within the coverage of the primary policy.
When the primary insurer wrongfully refuses to defend a suit that falls potentially within coverage, the umbrella insurer must decide whether to refuse to defend because coverage does, in fact, exist under the primary policy, or agree to defend despite arguably having no contractual obligation to do so.
The risks of making the wrong decision are serious, as the umbrella insurer faces the possibility of suit by the insured for unfair claim practices, breach of the duty of good faith, or arguments of estoppel barring the umbrella insurer from later asserting coverage defenses.
Although courts are split, many courts have required the excess/umbrella insurer to drop down and provide the insured with a defense when the primary insurer denies coverage, regardless of whether the primary insurer's denial is proper.
Such rulings are often based on the general rule that an insurer has a broad duty to defend whenever a claim is arguably within the scope of coverage, which is broader in many respects under an umbrella policy than it is under a primary policy.
For example, in Hocker v. New Hampshire Ins. Co. (922 F.2d 1476, 1482), the United States Court of Appeals for the Tenth Circuit, applying Wyoming law in 1991, considered whether an umbrella insurer was obligated to drop down and defend its insured automatically upon the primary insurer's denial of coverage. The Hocker court recognized that the primary insurer had breached its duty to defend, but nonetheless noted that the umbrella insurer was broadly obligated to defend the insured against suits that were "not covered, as warranted" by the primary insurance.
The court noted that this "as warranted" language "explicitly addresse[d] the possibility that the primary insurer will wrongfully deny coverage for occurrences that it had warranted would be covered by its primary policy." Accordingly, the court held that the "as warranted" language broadly obligated the umbrella insurer to defend the insured against lawsuits that are, in fact, covered by the underlying primary insurance, despite the fact the primary insurer breached its own contract and wrongfully denied its own duty to defend.
It is clear there is a certain element of pro-insured public policy involved in such decisions, as courts often make extra efforts to ensure that an insured is provided coverage first, leaving the insurance companies to separately deal with their own disputes. However, in recognizing that the umbrella insurer is being inequitably forced to provide coverage not required by its policy, many of these jurisdictions allow the umbrella insurer to seek recovery from the breaching primary insurer of all defense costs and expenses, under the theory of equitable subrogation.
It is important to note that this is not an automatic right, as some courts have rejected umbrella insurers' attempts to recover defense payments from the breaching primary insurer.
On the other hand, an emerging trend in the law, led by the Seventh Circuit Court of Appeals, holds that such defense obligations are simply not provided under the terms of the umbrella policy and, therefore, the umbrella insurer does not have a duty to drop down and defend the insured merely because a primary insurer wrongfully denies coverage.
A recent Seventh Circuit case in this group is Castronovo v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., decided on July 6, 2009. Under the Castronovo court's reasoning, when evaluating an umbrella insurer's defense obligation, the determining question is simply "whether any underlying insurance applies to the risk or occurrence alleged." If the answer is yes, then Coverage B of the excess/umbrella policy is not implicated and the excess/umbrella insurer does not have a duty to defend.
The reasoning of the courts following this trend is sound. The fact that a primary insurer breaches its own obligation should not serve to expand the coverage provided by the umbrella insurer.
Requiring the contrary would force the umbrella insurer to provide coverage for a risk that it could not possibly foresee and underwrite–the risk of the primary insurer breaching its duty to defend–thereby making insurance contracts less predictable and raising insurance premiums.
Todd S. Schenk is a partner in the Chicago office of Tressler LLP. He may be reached at tschenk@tsmp.com Nicolas C. Mesco, an associate in the same location, may be reached at nmesco@tsmp.com
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