Drop Down Drop Dead Excess Insurers Not Required to Provide Primary Coverage in Lieu of an Insolvent Insurer

Drop Down Drop Dead Excess Insurers Not Required to Provide Primary Coverage in Lieu of an Insolvent Insurer

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Courts have consistently ruled that excess insurers are not required to provide "drop-down" coverage to pay for losses sustained by policyholders in cases where (a) the primary underlying insurer is insolvent and unable to pay or (b) the policyholder itself is in bankruptcy and is unable or unwilling to pay the deductible or self-insured retention amount. Why do so many insured parties seem to have missed the message and still seek to have their excess carriers provide drop-down coverage? This article will examine the issue by looking at several recent cases.1

Excess insurance has several forms, but the purpose is the same. Companies may purchase direct primary insurance that has a "retained limit" or threshold loss amount that must be reached by the policyholder before the excess insurance coverage comes into effect. Conversely, companies will either pay a deductible or agree to a "self-insured retention" (SIR) up to a specific amount of loss. Under a typical excess insurance contract, the excess-policy carrier will only be liable for coverage once the retention limit (the threshold amount) has been reached. In a hypothetical case, the insured entity may have a SIR of $300,000 per covered event, after which the excess carrier will provide coverage up to a maximum amount, if any, set forth in the policy. With larger entities and greater risk, there are often multiple carriers and overlapping contracts for primary and excess coverage. In such cases, an excess insurance carrier may be second or third in line behind primary and other insurers. Figuring out who is responsible for coverage—and for how much—can keep many lawyers busy, depending on the complexity of the situation and the size of the loss.

What happens when a primary insurer (or another excess carrier) is insolvent and unable to meet the retention limit? The default position is that the contract between the parties governs. A recent example is the case of Premcor USA Inc. v. American Home Assur. Co., 2004 WL 1152847 (N.D. Ill. May 21, 2004), aff'd., 400 F.3d 523 (7th Cir. 2005). In that case, two Premcor employees were fatally injured on the job and their estates filed wrongful-death claims. Premcor was covered by several insurance policies. The initial layer was a $2 million general liability policy from Reliance National Indemnity Co., under which Reliance also agreed to pay unlimited defense costs for any actions covered by its policy. In addition, Premcor had an umbrella policy from American Home Assurance Co. to provide up to $10 million in excess coverage for liabilities not covered by its existing policies. One part of the AHA contract specified that it would cover losses "in excess of the amount recoverable under the underlying insurance [the $2 million Reliance policy]." However, another part of the policy stated that AHA "shall not be liable for expenses as aforesaid when such are covered by underlying policies of insurance whether collectible or not." 400 F.3d at 525.

After Reliance became insolvent and was unable to pay its loss coverage obligations, Premcor sued AHA seeking coverage for the costs of defending the wrongful-death actions. Premcor focused on the policy language that specified AHA's obligations "in excess of the amount recoverable" and sought to interpret the AHA policy in such a way as to make AHA a primary insurer for any gaps in its insurance coverage—based on what was "recoverable" from the primary insurer, rather than on the basis of what the various layers of insurance policies provided at the time the AHA policy was signed. The district court granted summary judgment for AHA, and on appeal, the Seventh Circuit agreed. Interpreting the contract as a whole, the appeals court ruled that the policy provided for "excess coverage only after the underlying insurance has been paid to the policy limits." Id. at 529. The failure of the primary insurer to meet its obligations did not alter the terms of the umbrella policy, which specified that the coverage limits were irrespective of whether the underlying insurance was paid or not.

The insolvency of a self-insured policyholder is treated similarly. In In re Amatex Corp., 107 B.R. 856 (E.D. Pa. 1989), the debtor was unable to pay the $25,000 self-insured retention amount and, inter alia, moved to require the insurer, Stonewall Insurance, to pay the entire amount of its maximum limit. Since payment of the SIR constituted a post-petition breach of the pre-petition insurance contract, Stonewall would be relegated to the status of an unsecured creditor for the $25,000 self-insured retention amount. The court denied the debtor's motion, quoting Black's Law Dictionary for a simple definition of "self-insurance" as "setting aside a fund to meet losses instead of insuring against such through insurance." 107 B.R. at 871. The excess insurer was not required to provide coverage until the SIR was exhausted and was not required to "drop down" and pay the SIR amount.

What if an insolvent insured refuses to expend its SIR defense costs and simply waits for the threshold amount to be reached? This is not uncommon. In Eastern Retailers Serv. Corp. v. Argonaut Ins. Co. (In re Ames Department Stores Inc.), 1995 WL 311764 at *2 (S.D.N.Y. 1995), the insured, Ames, was contractually obligated to defend and administer claims within a $50,000 deductible. When it refused to do so, its insurance carrier, Argonaut, sought to compel Ames to defend the case on the basis that if Ames did not defend the claim, a readily manageable claim within the deductible amount would readily magnify into a much-larger claim. The court denied Argonaut's request, holding that, at most, Argonaut had an unsecured claim for post-petition breach of the pre-petition contract, and that if it wanted the claim defended, it would have to undertake the defense itself. 1995 WL 311764 at **2-3.

Similarly, the court in In re Vanderveer Estates Holding LLC, 328 B.R. 18 (Bankr. E.D.N.Y. 2005), held that the debtor's insurer, American Safety Indemnity Co. (ASIC), could not compel the debtor to meet its pre-petition obligation to spend the first $25,000 per occurrence to defend claims as required under the insurance policy. The debtor's payment of the deductible amount was not a pre-condition to ASIC's performance. Any claim for nonperformance of the contract would only give rise to an unsecured claim by the insurer. 328 B.R. at 24. The policy was not an "executory contract" under §365 of the Bankruptcy Code because the premiums had been paid and the policy period had run. "The failure of the insured to perform these continuing obligations [SIR payments] would not excuse the insurer from being required to perform...." Id. at 26. In addition, because the insurance contract was a pre-petition contract and not a contract between ASIC and a debtor-in-possession (DIP), it did not qualify as an administrative claim. Id. at 27.

As these recent cases show, courts take a consistent approach in considering whether an excess insurer must provide "drop-down" coverage. Usually, the answer is "no." Policyholders considering whether to sue their excess insurer should review the entire insurance policy in light of these cases. To balance the scales of justice, excess insurers cannot compel a DIP policyholder to provide coverage within its SIR or deductible amount. At best, insurers may have a pre-petition claim if the policy calls for the insured to provide defense or indemnity up to a retention amount. All this calls for careful draftsmanship of insurance contracts providing absolutely clear expectations in the event of insolvency by a policyholder or underlying insurer. Do it right, and courts will uphold the insurance policies as written.


Footnotes

1 This article does not deal with workers' compensation coverage, for which excess insurers are generally required to provide drop-down coverage in the event of insolvency by the primary carrier. Return to article

Journal Date: 
Tuesday, November 1, 2005