Decision Stings Insureds, Though Impact Overstated

Generations of policyholders' coverage lawyers have feasted on the very brief, 4-paragraph 1928 opinion of Judge Augustus Hand in Zeig v. Massachusetts Bonding & Insurance Co., 23 F. 2d 655, which held that an excess insurer must pay once the underlying limits are "exhausted in the payment of claims to the full amount of the expressed limits." The issue is what it takes to trigger the excess policy: Must underlying insurance have been actually expended on the claim up to that policy's limits, or is it sufficient that the amount of money was used up in the matter, even though part of it came from the insured because it settled or because the first level insurer had gone broke?

It has been widely reported that this June the 2nd U.S. Circuit Court of Appeals overruled this hoary bellwether. That turns out to be an overstatement, but the news is not good for policyholders.

The new case, Ali v. Federal Ins. Co., No. 11-5000 (June 4, 2013), does distinguish Zeig on two grounds: different policy language and different type of insurance claim. The different policy language is that in Ali, the excess coverage was triggered "only after ... all Underlying Insurance has been exhausted by payment of claims" and that such exhaustion must occur "solely as a result of payment of losses thereunder." The relevant language in Zeig triggered the excess policy when the underlying coverage was "exhausted in the payment of claims to the full amount of the expressed limits," without a clause requiring the exhaustion to be "solely as the result of payment of losses," as in Ali.

The Ali court found that the language about exhaustion "solely as a result of payment of losses thereunder" precluded a trigger of the excess coverage until the underling insurer had made such actual payments, whereas in Zeig, although the opinion does not expressly so state, it has been understood for nearly a century that, to quote that court, "the defendant had no rational interest in whether the insured collected the full amount of the primary policies, so long as it was only called upon to pay such portion of the loss as was in excess of the limits of those policies," and that "[t]here is no need of interpreting the word 'payment' as only relating to payment in cash. It often is used as meaning the satisfaction of a claim by compromise, or in other ways."

Thus under Zeig, if the insured settled with the underlying insurer for less than the full coverage amount and shelled out the difference, or if the underlying insurer became insolvent and the insured paid the underlying limits on the claim, the excess had to step in. Under Ali's language, the excess can avoid liability completely even though either scenario would meet its economic condition that it would not be called upon until its inception point had actually been reached.

Actually, Judge Hand saw this coming. In Zeig he mentioned that "[i]t is doubtless true that the parties could impose such a condition precedent to liability upon the policy [i.e., actual payment by the primary], if they chose to do so."

The other ground on which Ali distinguished Zeig was that Zeig was a first-party loss while Ali was a third-party claim. It is true that, as Ali noted, a first-party loss is a true loss - although inflated claims happen there as well as in third-party claim situations - whereas third-party claims can be manipulated to make it appear that payment had been made though it hadn't, such as (quoting the district court in Ali), by "structur[ing] inflated settlements with their adversaries."

That second ground is a true concern although it really is not limited to third-party claims. But there is certainly language available that would deny the excess coverage unless real money had been spent by someone to get to the excess carrier's inception point. That seems the limit of an excess carrier's reasonable concern. On the other hand, policyholders' counsel have often made settlements with first or second level carriers that did not exhaust their coverage layers in full, and the insured made up the difference. Where that happened, any reasonable concerns that there might be some gamesmanship to trigger the excess policy before its inception limits had been paid out in hard cash are satisfied; and that is all that the concept of excess insurance should expect. If a primary carrier goes broke, or if its policy presents some knotty coverage problems that are better settled than litigated, what true economic interest does the excess have in that situation, other than to make sure that the money up to its inception point has been actually spent on the claim - whether that is the underlying carrier's money or that of the insured?

Excess insurance is often a necessity; its underwriters should not get this kind of a freebie. And yet, in places like my home in California where policy language must not be approved by an insurance commissioner, there is no law that can force the excess carrier to provide a fair inception point formulation. As Judge Hand said 85 years ago, the parties are free to craft such deceiving language - meaning that the carrier can write it if it will, since the insured is not likely to see the policy until long after it was actually bound. So, insurance buyers should check their excess coverage binders or term sheets to see whether the terms for inception are more generous as in Zeig, or at least discuss the point with their brokers. But realistically, that will be hard to do because as I just said, the buyer won't see the actual policy until long after its coverage began; and binders do not usually deal with policy language in this detail.

I don't like the concept of laws that define how contracts may be written, but there are many such examples on the books. Should this be another one?