Recent Bankruptcy Opinion Reiterates that Excess Policies Require Actual Payment of Underlying Limits Before Coverage Is Triggered

Defense Digest, Vol. 22, No. 4, December 2016

By Stephen M. Wagner, Esq.*

In the Chapter 11 case of In re Rapid-American Corp., 2016 Bankr. LEXIS 2224 (Bankr. S.D.N.Y. June 7, 2016), the court has ruled that excess directors’ and officers’ liability insurance cannot be triggered without actual payment of the underlying policies’ limits of liability. The court’s ruling effectively clarifies that Zeig v. Mass. Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928) is no longer controlling law in light of the Second Circuit’s more recent decision in Ali v. Fed. Ins. Co., 719 F.3d 83 (2d Cir. 2013). Zeig had long stood for the proposition in the Second Circuit that exhaustion language in insurance policies should not be read literally, but, rather, exhaustion language was satisfied so long as the insured settled with and released the underlying insurers, potentially even if those insurers did not pay the full policy limits.

In 1974, claimants began suing Rapid-American in asbestos-related personal injury actions. Many of the claims were settled, but, by March 2013, there were approximately 275,000 asbestos-related personal injury claims pending. Rapid owned several primary and excess liability insurance policies during the relevant periods. Beginning in 1998, Rapid reached settlements with nearly all of its insurers. However, a number of the insurers that issued policies to Rapid became insolvent and were unable to pay the full limits of their policies.

Rapid filed a declaratory judgment action seeking to clarify that coverage under its policies would attach upon the lifting of the automatic stay. Rapid argued that Zeig was still controlling and mandated that exhaustion language is satisfied if the insured settles with and releases the underlying insurer, even if that insurer did not pay full policy limits. Travelers Casualty and National Union argued that their policies expressly required exhaustion of underlying insurance by actual payment before any excess coverage could be triggered.

The court held that Zeig’s “continuing vitality” was open to question following the Second Circuit’s decision in Ali. In Ali, the plaintiff insurers sought declaratory relief, claiming that their excess directors’ and officers’ liability insurance policies did not attach until actual payment of the full amount of the underlying insurance was made. The defendant directors argued, as Rapid did, that coverage attached once their obligations exceeded the underlying insurance even if it remained unpaid. Ali held that excess insurance coverage does not attach until the underlying insurance has been exhausted. To that end, the court stated, “[t]he very nature of excess insurance coverage is such that a predetermined amount of underlying primary coverage must be paid before the excess coverage is activated.” This business model, of course, makes excess insurance available at a lower cost.

The court aptly recognized that cases like Zeig involve first-party property insurance where an insured suffers a fixed out-of-pocket loss for which he seeks indemnification. In contrast, in cases like Ali, the requested relief focuses on the insured’s obligations to pay third parties. Practically speaking, the excess insurers bargained for actual payment before their coverage liability attached. Thus, if insureds could trigger the excess policies based on their aggregated, unpaid losses, they might be tempted to structure inflated settlements, which would have the same effect of requiring excess insurers to “drop down” and assume coverage in place of insolvent carriers.

The bankruptcy court’s opinion confirms the new principle in the Second Circuit that requires exhaustion of underlying limits by actual payment before excess insurance policies can be triggered. This decision, coupled with Ali, makes it abundantly clear that Zeig is no longer applicable precedent in the Second Circuit. Thus, excess insurers cannot be forced to “drop down” unless and until primary insurance has been exhausted by actual payment.

Given the clarification from these decisions, insurers and insureds should be cognizant of the coverage they have in place to protect directors, officers or members in situations where those key individuals may be relying on a directors’ and officers’ policy of insurance that is not designed to protect them against the risk of insolvency or bankruptcy of underlying insurers. Policyholders may protect themselves against the risk of an insurer’s insolvency by purchasing what is commonly referred to as a “Side A” policy. Specifically, an organization should seek to purchase, from a different insurer, excess coverage through a difference in conditions (DIC) Side A policy.

Purchasing Side A coverage is practical for any organization. Acquiring this coverage provides assurance to directors and officers that the organization is serious about indemnifying them should litigation take a turn for the worst. To make certain that adequate coverage is in place in case of an underlying insurer’s insolvency, an organization should consult with a knowledgeable broker to ensure that the Side A coverage being purchased matches the coverage that would have been provided by the underlying policy.

*Stephen is an associate in our Cincinnati, Ohio office who can be reached at 513.372.6816 or smwagner@mdwcg.com.

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_{Defense Digest, Vol. 22, No. 4, December 2016. Defense Digest is prepared by Marshall Dennehey Warner Coleman & Goggin to provide information on recent legal developments of interest to our readers. This publication is not intended to provide legal advice for a specific situation or to create an attorney-client relationship. ATTORNEY ADVERTISING pursuant to New York RPC 7.1. © 2016 Marshall Dennehey Warner Coleman & Goggin. All Rights Reserved. This article may not be reprinted without the express written permission of our firm. For reprints, contact tamontemuro@mdwcg.com.}