Objectively Reasonable Expectations of the Insured Prevails – Improper Erosion Theory Rejected

Primary and excess insurers periodically clash over whether the underlying claim should have been paid by the primary insurer. But it is pretty unusual for an excess insurer to argue that the underlying claim payment made by other insurers improperly eroded the excess insurer’s attachment point and prematurely triggered the excess coverage for a subsequent claim. The Ninth Circuit Court of Appeals recently addressed the question of whether an excess insurer challenge an underlying insurer’s payment decision.

In Axis Reinsurance Co. v. Northrup Grumman Corp., No. 19-55135 (9th Cir. Sept. 14, 2020), in a case of first impression, two underlying ERISA lawsuits were settled by the insured, which then sought coverage for the settlements from its insurers. The insured had a tower of insurance. The primary and first excess insurer agreed to pay the first settlement. That settlement exhausted the primary layer and required the first excess insurer to drop down and pay the remainder of the settlement.

On the second settlement, the first excess insurer dropped down and paid its remaining limits, leaving the second excess insurer to pay the remainder of the settlement. The second excess insurer did not contest the validity of the second settlement, but advised the insured that it was going to seek reimbursement from the insured on the first settlement, which the second excess insurer claimed was not for a covered loss.

The second excess insurer brought this case for declaratory relief and damages, arguing that payment of the first claim by the underlying insurers was an improper erosion of the limits of liability of the underlying policies, which caused the drop down on the second settlement and unjustly enriched the insured. The district court agreed with the second excess insurer. The Ninth Circuit reversed and held that no authority supported the improper erosion theory.

In reversing, the circuit court found that there was no precedent that adopted the improper erosion theory, which, the court described, shifted the risk to the insured that an excess insurer might disagree with the underlying payment decisions. The court agreed with the insured that the second excess insurer assumed the risk that the underlying insurers might trigger the excess coverage based on their claim decisions.

The court noted that its view was consistent with the limited caselaw presented, which held that excess insurers generally may not avoid or reduce their own liability by contesting payments made at prior levels of insurance, unless there is an indication that the payments were motivated by fraud or bad faith. While accepting that this general proposition may be changed by contract, the court found no indication that the policy did so here.

Another concern expressed by the court was that the improper erosion theory would undermine the confidence of insurers and insureds on the dependability of settlements. The court stated that the improper erosion theory would introduce a host of inefficiencies into the insurance industry with no countervailing benefits for insurers or policyholders.

The court rejected the notion that the second excess insurer could reduce its liability for a concededly valid claim by contesting the validity of another claim. It held that excess insurers remain free to contest claims submitted to them, but absent a specific contractual provision, excess insurers cannot second-guess other insurers’ payments of earlier claims without a showing of fraud or bad faith.

The court concluded that no reasonable insured in the insured’s position would understand that it might have to justify its underlying insurers’ payment decisions as a prerequisite to obtaining excess coverage from the second excess insurer.