In an issue of first impression, the Ninth Circuit was asked to decide whether a second level excess insurer may question the propriety of settlement payments of lower level insurers based on an improper erosion theory. (AXIS Reinsurance Company v. Northrup Grumman Corp. (2020) 975 F. 3d 840.) AXIS Reinsurance Company (“AXIS”) challenged the erosion of primary and first level excess limits through settlement payments for what it alleged was an uncovered disgorgement claim under the Employee Retirement Income Security Act (“ERISA”). The Ninth Circuit Court of Appeals held excess insurers generally may not second guess the payment decisions of underlying insurers absent evidence the payments were motivated by fraud or bad faith or a clear contractual right to do so.
Underlying ERISA Claims
Two separate ERISA actions were brought against the insured Northrop Gruman Corp. (“Northrop”). The Department of Labor (“DOL”) brought the first action following an investigation into the administration of several related employee-savings and pension plans (“the Plans”). The investigation resulted in a lawsuit based on assertions of wrongful activity by Northrop entities and individuals. The Plans brought the second action.
Northrup had a $45 million tower of Employee Benefit Plan Fiduciary Liability Insurance. National Union Fire Insurance (“National Union”) furnished the primary layer, with limits of $15 million. Continental Casualty Company (“CNA”) furnished the first excess layer, with limits of $15 million. AXIS furnished the second excess layer, with limits of $15 million. AXIS was only required to provide coverage when the underlying $30 million limits were exhausted for a covered loss under the National Union and CNA policies.
Both lawsuits were settled out of court, with Northrop referring its settlement payment to its insurers for coverage. The DOL lawsuit settled for the amount of $22,956,237.92, including payment of the $15 million primary limits by National Union and a partial payment by first excess layer CNA in the amount of $7,956,237.92. Accordingly, because CNA’s partial payment did not fully exhaust its limits, AXIS was not called upon to cover any portion of the DOL settlement. Both National Union and CNA determined the DOL settlement was for covered claims, even though there was no allocation of the settlement payment to disgorgement.
The second action settled for the sum of $16,750,000. CNA covered the second settlement as the primary insurer, exhausting the remainder of its limits in the amount of $7,043,762.08 after determining the settlement fell within its scope of coverage. AXIS was then called upon to fund the balance of the settlement in the amount of $9,706,237.92. However, AXIS put Northrop on notice it intended to seek reimbursement of the first DOL settlement, claiming National Union and AXIS improperly settled a loss that was not covered, thereby triggering the AXIS policy.
Lower Court Decision
AXIS filed a complaint in federal district court against Northrop for declaratory relief and damages, alleging the DOL settlement was not a covered loss, resulting in improper erosion of the underlying policy limits and unjustly enriching Northrop by the same amount. Specifically, AXIS argued the DOL settlement constituted disgorgement (return of money improperly gained), which is not insurable under California law and therefore a loss not covered under the primary or excess policies. The district court agreed and granted AXIS’s summary judgment motion, awarding AXIS damages in the amount of its contribution to the second settlement.
The appellate court began its analysis by discussing the improper erosion theory put forth by AXIS. Under the improper erosion theory, the insured who purchases a tower of insurer coverage bears the risk an excess insurer might not pay otherwise valid claims to compensate itself for exposure caused by alleged improper payments by lower level insurers. The court found no circuit precedent adopting the improper erosion theory.
The court agreed with Northrop’s position, which was that AXIS assumed the risk the lower layers might adjust claims in a manner triggering its excess coverage. The court adopted the holding in Costco Wholesale Corp. v. Arrowwood Indem. Co., 387 F. Supp. 3d 1165 (W.D. Wash. 2019) (“Costco”) which held excess insurers generally may not avoid or reduce their own liability by contesting payments by lower levels absent evidence those payments were motivated by fraud or bad faith. The Ninth Circuit’s adoption of the Costco holding was motivated by policy because to adopt the position of AXIS and the district court “would undermine the confidence of insureds and insurers in the dependability of settlements [and eliminate] one of the primary incentives for obtaining insurance in the first place.”
As to the district court’s concern that adopting the Costco rule would render the terms of an excess insurance policy useless without an opportunity to dispute the validity of lower level payments, the appellate court disagreed, pointing out AXIS never disputed the validity of the second settlement to which it was called upon to contribute. Instead, AXIS sought to avoid liability for paying a claim it concedes was covered. The Ninth Circuit explained, under the Costco rule, an excess insurer is not bound by the coverage determinations of lower levels for the same claim. However, absent a valid contractual provision, an excess layer may not second-guess lower level insurers payments of earlier claims without showing those payments were motivated by fraud or bad faith.
Because AXIS had not alleged fraud or bad faith, the appellate court looked to the terms of the AXIS excess policy. The AXIS policy required exhaustion of the underlying limits for a covered loss under those policies. However, the terms of the AXIS excess policy had no language expressly giving AXIS the right to challenge the propriety of the lower level insurers’ payment decisions for unrelated claims. As conceded by AXIS, the covered loss provision was silent on the ability to challenge prior payments for other claims. Thus, the terms of the AXIS excess policy did not provide a basis for AXIS to question the settlement payments made by National Union and CNA for the first DOL claim.
Accordingly, the Ninth Circuit did not have to address the issue of whether the DOL settlement was for disgorgement and therefore improper as a matter of California law. In dicta, the Ninth Circuit suggested the DOL lawsuit likely falls outside California law prohibiting insurance for disgorgement claims. (See California Insurance Code § 533.5 and Bank of the West v. Superior Court (1992) 2 Cal. 4th 1254 [policy prohibiting insurance of disgorgement claims does not apply to lawsuits brought by the federal government].) The Ninth Circuit also noted the DOL action asserted multiple theories of recovery, there was no stipulation or adjudication on the issue of disgorgement, and Northrop made no admission of guilt. Finally, the Ninth Circuit asserted even if the DOL settlement was made in violation of California insurance law, AXIS had no standing to raise the issue of uninsurable disgorgement in relation to the second claim, which AXIS paid and concedes was a covered claim.
There are several takeaways from the Ninth Circuit’s holding. First is the corollary to the holding, which does allow an excess insurer to question the propriety of lower level payment decisions involving the same claim the excess insurer is being asked to pay. The second takeaway, as alluded to by the court, is that excess carriers concerned about improper erosion of underlying limits should reserve a right to challenge the propriety of payments made on other earlier claims in the policy, or build in the cost of the risk of improper erosion to premiums. Otherwise, the only way an excess carrier may challenge earlier payments of other claims by underlying insurers will be through evidence of fraud or bad faith.