Excess Insurer Contract Language Amounts to Free Pass
Excess insurance is essential to businesses of medium or larger size because it provides catastrophe coverage at much lesser rates per dollar of coverage than primary insurance. There are two main reasons for this: The excess insurer is not often called on to defend cases since it need not defend until it is also bound to indemnify, meaning that the loss will exceed the amount of insurance below – also called the "inception point" - and it is likewise not called on to pay losses below its inception point. Thus, the price for this coverage reflects the fact that until the inception point is reached, the excess insurer need not worry about the claim.
But like many insurers, excess insurers have a bag of tricks. One trick concerns the trigger of excess insurance.
Although insurance is looked on as a haven that protects the insured against third-party claims and liabilities, insurance companies love to litigate coverage with their
insureds when claims arise, and it is not at all unusual that such coverage cases settle.
The insured may give up some of his coverage in order to settle the lawsuit, deal with the underlying claims, and get on with life.
But if the insured tries to cut such a settlement with his primary carrier in a situation where the likely losses reach into the excess coverage, he faces an unexpected and unreasonable challenge. The excess carrier may claim that it is entirely off the hook because its coverage does not incept - i.e., begin - until (to quote language found in at least one insurance policy) "(a) all Underlying Insurance carriers have paid in cash the full amount of their respective liabilities, (b) the full amount of the Underlying Insurance policies have been collected by then plaintiffs, the Insureds or the Insureds' counsel, and (c) all Underlying Insurance has been exhausted." That language is a triple trap since all three conditions must be met before the excess carrier must step in to assume its burdens.
There is a degree of reason behind such trigger traps such as these: Because it is to be called on only in the case of major claims, the excess insurer reasonably relies on the condition that a stated sum - the dollars below the inception point - must have been exhausted in dealing with claims. It is also reasonable for the excess carrier to expect that the main burden of the underlying expense must be borne by another insurer, not the insured, because insurers may reasonably believe that members of their industry have a more informed and professional approach to claims than an ordinary business, so that that this condition will assure that the losses incurred beneath their level are genuine.
But this absolutism leaves no room for disagreements and for settlements. Disputes do settle - even insurance coverage disputes - and there is no logical reason why the primary insurer and the insured could not settle a genuine dispute about coverage by dividing the loss. That is commonly done where there is no excess insurance. And before excess insurers began to resort to absolutist language such as that quoted above, insureds and their primary insurers did settle. The insured would pay that portion of the loss below the excess inception point that the primary avoided through a settlement, and the excess would step in at the inception point once the lower level losses had actually been paid by both the primary insurer and the insured itself.
That arrangement has repeatedly been blessed by some courts, commencing with Zeig v. Massachusetts Bonding & Ins. Co., 23 F. 2d 665 (2d Cir. 1928), where Judge Augustus Hand demolished the excess insurer's argument that there can be no settlement with the primary insurer under which the insured pays some of the losses up to the excess inception point:
"The defendant argues that it was necessary for the plaintiff actually to collect the full amount of the policies for $15,000, in order to 'exhaust' that insurance. Such a construction of the policy sued on seems unnecessarily stringent. It is doubtless true that the parties could impose such a condition precedent to liability upon the policy, if they chose to do so. But the defendant had no rational interest in whether the insured collected the full amount of the primary policies, so long as it was only called upon to pay such portion of the loss as was in excess of the limits of those policies. To require an absolute collection of the primary insurance to its full limit would in many, if not most, cases involve delay, promote litigation, and prevent an adjustment of disputes which is both convenient and commendable. A result harmful to the insured, and of no rational advantage to the insurer, ought only to be reached when the terms of the contract demand it."
Notwithstanding Zeig's reasoning, courts have exonerated excess insurers from their obligations where the underlying coverage was not fully exhausted by payment of losses, if the policy language allowed such escape. One case among many exemplifies the issues. In Qualcomm v. Certain Underwriters at Lloyds, London, 161 Cal. App. 4th 184 (2008), the insured settled a claim for directors and officers coverage with the primary carrier by absorbing about 20 percent of the $20 million primary coverage, and then sought to have the excess carrier pick up obligations in excess of the $20 million inception point. The insured argued that "denying excess coverage in the circumstances presented would be contrary to public policy because such denial would work a forfeiture, provide a windfall to the excess carrier, and encourage litigation by discouraging settlements between insureds and their primary carriers," but the court would have none of it. It ruled that the policy language controlled and that there was not (and would never be) coverage for the excess claims because the excess policy required that the primary have "paid" the full amount of its coverage. Public policy could not apply because the policy language was clear.
This is an unfair situation. The excess carrier has every right to make sure that the claims tendered to it have exceeded its inception point, and it also has a reasonable expectation that the primary insurer was firmly involved in the management of the claims up to the inception point level. But a clause that exonerates the excess insurer simply because a dispute between the insured and the primary carrier was settled for a relatively small discount amounts to a free pass.
Since the courts will not declare such clauses void as against public policy, this seems to be a matter for the legislatures. State law commonly requires insurance policies to contain certain terms that the legislature found necessary to foster the public interest in fairness of certain publicly important contracts. The states should require that excess policies must be triggered where the underlying policy limits have been expended by either the primary carrier or the insured or both, provided that the settlement of any dispute at that level was fair and reasonable.