An Issue of First Impression
On September 14, 2020, the United States Court of Appeals for the Ninth Circuit limited an excess insurers’ ability to second-guess lower-level carriers’ coverage payment decisions, absent evidence of fraud, bad faith, or a contractual provision reserving the right to challenge such decisions. This matter was an issue of first impression for the Ninth Circuit panel.
In AXIS Reinsurance Company v. Northrop Grumman Corporation, 975 F.3d 840 (9th Cir. 2020), AXIS Reinsurance Company (“AXIS”) argued it had overpaid in the settlement of a class action suit because the other insurers had prematurely exhausted their policies. The U.S. Court of Appeals rejected AXIS’ argument of “improper erosion” and reversed the district court’s decision, allowing AXIS to recoup a portion of the $9.7 million AXIS paid towards Northrop Grumman Corporation’s (“Northrop”) $16.75 million settlement of an Employment Retirement Income Security Act (“ERISA”) class action litigation.
Northrop, the employer-defendant, possessed three layers of coverage under an employee benefit plan fiduciary liability insurance program. The coverage consisted of a $15 million primary insurance layer, a $15 million first-tier excess policy, and a $15 million second-tier excess policy. AXIS was the second-tier excess insurer. In 2016 and 2017, Northrop settled two matters involving allegations of ERISA violations: (1) a U.S. Department of Labor (“DOL”) investigation; and (2) a class action litigation. Because of the lower-level carriers’ funding of the DOL settlement, there remained only $7 million available of the first-excess layer of coverage to cover the class action litigation settlement, triggering AXIS’s second-excess layer of coverage to fund the remainder. AXIS did not contest the validity of the class action litigation settlement.
The trial judge held the DOL settlement was not insurable under California law. Accordingly, the district court held AXIS overpaid in the settlement of the class action litigation because Northrop’s lower-level carriers had improperly exhausted their coverage layers by funding settlement in the DOL investigation. The district court agreed with AXIS that Northrop alone should have paid for the DOL settlement, which would have left the lower-level carriers with sufficient funds to pay for the entire class-action settlement.
The Ninth Circuit disagreed, finding even if the lower-level carriers were not obligated to cover the DOL settlement, AXIS still was not legally entitled to question the other insurers’ payment decision. The panel reasoned AXIS assumed the risk of faulty claims adjustment by the primary and first-level excess insurers. Based on the foregoing, the Ninth Circuit held an excess insurer could not challenge an underlying insurer’s payment decisions to argue the excess coverage layer has not been reached.
The panel noted an excess insurer remains free to contest claims submitted to it during the claims adjustment process, even when an underlying insurer has already determined the same claim falls within the scope of coverage. U.S. Circuit Judge Consuelo Callahan’s written decision for the panel stated, “[a]bsent a specific contractual provision, [an excess insurer] may not second-guess other insurers’ payments of earlier claims without first showing those payments were motivated by fraud or bad faith.” The panel further noted accepting AXIS’s argument “’would undermine the confidence of both insureds and insurers in the dependability of settlements,’ eliminating one of the primary incentives for obtaining insurance in the first place.”
Impact in New York
AXIS did not assert a claim for bad faith or fraud in the Northrop case, and it did not challenge the coverage decision of the lower-level carriers regarding the class action litigation, which triggers AXIS’s layer of coverage. Instead, AXIS argued it had a right to challenge the lower-level carriers’ coverage of the DOL settlement pursuant to the terms of its policy, which stated AXIS would provide drop-down coverage only when the underlying limits were exhausted for “covered loss” under those policies. The Ninth Circuit rejected AXIS’s argument. The appellate court held the policy language did not clearly and unambiguously indicate AXIS reserved a right to second-guess coverage decisions made by the underlying insurers. The court determined any ambiguity that existed in the policy language had to be resolved in favor of Northrop, the insured.
It appears the issue raised in Northrop remains unaddressed by the New York courts, to date. Unlike California, it is well established under New York law a primary insurer owes a duty of good faith to its excess insurer, specifically when deciding whether to settle a claim. However, this principle applies solely in the context of a single claim, which could or would affect primary and excess layers of coverage.
The language of the governing insurance policies will most likely determine whether a New York court would issue a decision similar or contrary to the Ninth Circuit. Like the Ninth Circuit, a New York court faced with the same legal arguments, where no claims of bad faith or fraud were asserted, would need to determine whether the governing policy language clearly and unambiguously allows the excess insurer to evaluate coverage decisions of underlying insurers.
In order to avoid any such issues, excess carriers could include specific language in future policies to create a contractual right to assert “improper exhaustion” as a basis for failure to trigger excess coverage. Alternatively, an excess carrier could strengthen the policy language stating only a “covered loss” triggers excess coverage. Although AXIS raised the latter argument in Northrop, the Ninth Circuit found the policy language too ambiguous.
The Ninth Circuit’s decision in Northrop raises a novel issue concerning the potential for improper erosion of underlying coverage limits for excess carriers. Excess carriers concerned with reserving the right to challenge the propriety of payments made by underlying carriers in earlier claims should take note of the decision and how to transfer the potential risks of such an occurrence.
 See Pavia v. State Farm Mut. Auto. Ins. Co., 82 N.Y.2d 445, 452 (1993); St. Paul Fire & Marine Ins. Co. v. U.S. Fid. & Guar. Co., 43 N.Y.2d 977, 978 (1978).