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Ninth Circuit Rejects “Improper Erosion” Argument, Rejects Excess Carrier’s Refusal to Acknowledge Exhaustion of Underlying Policies

GettyImages-173203881-gavel-300x200Last month, the U.S. Court of Appeals for the Ninth Circuit awarded Pillsbury client Northrop Grumman a significant appellate victory, reversing an adverse decision from the U.S. District Court for the Central District of California on a question of first impression within the circuit. The court’s decision in AXIS Reinsurance Company v. Northrop Grumman Corporation not only restores Northrop Grumman’s access to millions of dollars in insurance coverage; it provides stability and predictability in insurance law by rejecting an excess insurer’s assertion of wide-ranging authority to “second-guess” coverage decisions made by underlying insurers.

The case arose in the wake of two separate lawsuits brought against Northrop Grumman alleging violations of the Employee Retirement Income Security Act of 1974. The first suit, which the Department of Labor brought after investigation the administration of the Northrop Grumman Savings Plan, was settled in December 2016. Under the terms of the DOL settlement, Northrop Grumman agreed to pay certain amounts to the savings plan and the DOL, in exchange for a full release of from further liability. The second lawsuit—technically, a consolidation of two related actions—involved various allegations of breach of fiduciary duty in the management of the Northrop Grumman Savings Plan and another Northrop-related savings program. Collectively referred to as the Grabek litigation, this suit was settled in June 2017, after the DOL settlement was finalized. The terms of the Grabek settlement required Northrop Grumman to pay a further sum of nearly $17 million.

Both the DOL and Grabek settlements were allocated to Northrop Grumman’s 2006 – 2007 policy year. During this period, Northrop Grumman held primary coverage pursuant to a policy sold by National Union Fire Insurance Company with a limit of $15 million, excess of certain applicable retentions. Northrop Grumman also held a first-layer excess policy sold by Continental Casualty Company, providing another $15 million in excess of the National Union policy limit and retentions, and a second-layer excess policy from AXIS Reinsurance Company, applying in excess of retentions and the combined underlying policy limits of $30 million. The AXIS policy also provided that, after the underlying insurance was exhausted, the AXIS policy would apply as primary insurance.

National Union determined that the DOL settlement fell within its primary policy and contributed to its payment—in the process, exhausting the $15 million limits of the National Union policy. Continental also agreed that the DOL settlement fell within the scope of coverage and “dropped down” to pay the remainder of the settlement amount, partially exhausting the limits of the Continental policy. AXIS was not required to cover any portion of the DOL settlement, and neither the National Union nor the Continental policy required AXIS’s consent prior to contributing to the DOL settlement.

With National Union’s limits exhausted by the DOL settlement, Continental covered the Grabek settlement as primary insurer and exhausted the remainder of its policy limits. AXIS was called upon to cover the remainder of the Grabek settlement—nearly $10 million. AXIS did not contest that the Grabek settlement was covered under the terms of the AXIS policy and, therefore, covered its portion of the settlement. But AXIS also filed a complaint for declaratory relief and damages against Northrop Grumman, challenging the propriety of National Union and Continental’s payment of the separate DOL settlement. According to AXIS, because the DOL settlement did not actually fall within the coverage provided by National Union and Continental, the limits underlying the AXIS policy should not have been exhausted prior to the Grabek settlement, entitling AXIS to reimbursement for its excess coverage. The district court agreed with AXIS and granted summary judgment against Northrop Grumman, which appealed to the Ninth Circuit.

Rejecting the Concept of “Improper Erosion”
On appeal, the Ninth Circuit zeroed in on a critical question: whether AXIS was even permitted to challenge National Union and Continental’s decision to provide coverage for the DOL settlement.

Precedent generally recognized that an excess insurer was not bound by a lower carrier’s coverage decisions within the context of a single claim: the fact that an underlying carrier determined that its policy provided coverage does not deprive an excess carrier of its right to challenge its own portion of the claim. But AXIS was not challenging any coverage decisions made regarding the Grabek settlement; rather, AXIS was challenging the underlying carriers’ prior decision to provide coverage for the DOL settlement, which served to exhaust all of National Union’s limits and much of Continental’s. AXIS contended that payment of the DOL settlement “improperly eroded” the limits of coverage underlying AXIS’s policy; in other words, had National Union rejected coverage over the DOL settlement, as AXIS believed the policy required, then underlying coverage for the Grabek settlement would still exist and the AXIS policy would not be triggered.

AXIS insisted that a right to challenge the DOL settlement coverage decision was inherent in the terms of its policy, which provided that AXIS would provide drop-down coverage only when the underlying limits were exhausted for “covered loss” under those policies. But the Ninth Circuit disagreed. The appellate court held that the policy language did not clearly indicate that AXIS reserved a right to second-guess coverage decisions made by the underlying insurers. (Without a clear and unambiguous reservation of rights, any ambiguity that existed had to be resolved in favor of Northrop Grumman, the insured.) Nor had AXIS alleged that the underlying carriers’ decisions to provide coverage for the DOL settlement were the result of fraud or bad faith, which the court might have permitted to serve as the basis for a challenge even without specific authorization from policy language.

Thus, the Ninth Circuit held that AXIS had no legal basis to challenge the DOL settlement’s exhaustion of the policy limits underlying AXIS’s coverage. The law provided no general rule supporting AXIS’s “improper erosion” claim, and the AXIS policy did not include such a mechanism.

Potential Ramifications
The Ninth Circuit’s decision provides needed stability and certainty for insurance holders. Had the district court’s rule prevailed, excess insurers would have had free rein to challenge the soundness of all underlying insurers’ coverage decisions, which “would introduce a host of inefficiencies into the insurance industry, with no obvious countervailing benefits to insurers or policyholders,” as the Ninth Circuit observed. Instead, insureds can take comfort in the finality of prior coverage decisions, including those arising out of settlements, without concern that future clams will provide a basis to revisit the past under the guise of challenging “exhaustion.”

More broadly, the Ninth Circuit’s logic also has important implications for the interaction between excess and underlying carriers when addressing a single claim. Northrop Grumman left intact a general rule that “an excess insurer remains free to contest claims submitted to it during the claims adjustment process, even when an underlying insurer has already determined that the same claim falls within the scope of coverage.” But the Ninth Circuit’s logic invites a distinction between an excess carrier’s right to make its own coverage decisions and an excess carrier’s lack of right to challenge the underlying carrier’s coverage decisions. In other words, although excess carriers remain free to make their own determinations regarding coverage, they should not be permitted to use exhaustion principles as a basis to challenge the underlying carrier’s decisions—even with respect to the same claim. Accordingly, policyholders should pay close attention to potential disagreements within their towers of coverage. When a higher-level carrier is expected to contest a portion of a claim, allocating that portion to a lower-level carrier may maximize an insured’s potential recovery.

But these observations come with a critical caveat: like so many matters of insurance coverage, the Ninth Circuit’s decision hinges on the language of the specific policies involved in the case. Excess carriers may seek to blunt the future impact of the Northrop Grumman decision by adding new language to future policies, granting themselves a contractual right to make the same “improper exhaustion” arguments the Ninth Circuit refused to imply into the policies as a matter of law. Conversely, insureds with excess coverage that is triggered upon an underlying carrier’s payment of “loss”—rather than “covered loss,” the term relied upon by AXIS to support its arguments—will have even more protection against efforts to deny coverage by contesting the coverage decision of underlying insurers. Policyholders should consult coverage counsel to evaluate their current policies and ensure their interests are adequately protected, both now and into the future.