When Insurers Collide: Can Exhaustion Turn into Improper Erosion?

The Ninth Circuit Court of Appeals has had two occasions to face the legal complexities surrounding what is called “improper erosion”: the situation where an insurer is alleged to have wrongly paid a claim on a policy, the result of which was to use up (or exhaust) an underlying layer of coverage, thereby exposing to potential claims a reinsurer providing a higher layer of coverage. Most recently, in a unanimous panel opinion issued in September 2020, the Court put the question this way: “[W]hen, if ever, may an excess insurer challenge an underlying insurer’s payment decision as outside the scope of coverage?” AXIS Reinsurance Co. v. Northrup Grumman Corp., 975 F.3d 840 (9th Cir. 2020). The Court’s answer? Not here, but in rare cases, perhaps.

In this article, we examine the AXIS case and discuss opportunities that may present themselves for excess carriers to challenge payments by underlying insurers. Drafting reinsurance contracts to provide a procedure for such a challenge is one option, but not the only one. The Ninth Circuit rule as stated can open up fact-based claim challenges without using the forbidden phrase “improper erosion.”

AXIS Reinsurance Co. v. Northrup Grumman Corp.
Insurance Policies
The facts before the Ninth Circuit are more completely set forth in the District Court’s redacted order on summary judgment. No. 2:17-CV-8660-AB(JCx), 2018 WL 6431874 (C.D. Cal. Nov. 21, 2018). In short, Northrup’s insurance “tower” consisted of three policies covering employee benefit plan claims. The first layer was from National Union Fire Insurance Co., the second from Continental Casualty Co. (CNA), and the third from AXIS, the plaintiff in the case. AXIS’s policy is follow-form (or following-form) with regard to coverage: “This policy does not provide coverage for any Claim not covered by the Underlying Insurance.” If a claim is not covered under the underlying, lower layers of policy coverage, it is not a covered claim for AXIS’s purposes. No more, no less.

As is virtually always the case when dealing with multiple layers of coverage, the AXIS policy further provides that coverage only “drops down” to the extent payment is not made under a lower layer of insurance by reason of exhaustion of the underlying policies. Put differently, without exhaustion of the underlying layers, there is no basis for coverage under the AXIS policy.

First Underlying Lawsuit
Northrup was hit in short order with two separate lawsuits charging violation of the Employment Retirement Income Security Act (ERISA). First, the U.S. Department of Labor (DOL) filed suit at the end of its broad investigation into the administration of the Northrup Grumman Savings Plan (“the Plan”). Northrup entered into a confidential settlement with the DOL in December 2016, consenting to pay certain amounts of money and receiving a release from the Department in return. Northrup did not admit or deny the lawsuit’s allegations. Because the parties settled out of court, there were no judicial findings or factual stipulations about the proportion of the settlement payments (if any) that constituted disgorgement of funds.

National Union and CNA each agreed that the DOL settlement fell within the coverage of the underlying policy. Paying the Department’s claim exhausted National Union’s primary coverage. CNA paid the excess, but the CNA policy’s liability limit was not reached. Because the second layer was not exhausted, AXIS was not called upon to contribute to the settlement.

Before settlement, Northrup was apparently told by counsel for another involved insurance company (Arch Insurance) that the primary policies would not cover the amount sought by the DOL. Arch communicated with counsel for the insurers in September 2016, including AXIS’s counsel, who advised that settlement of the government’s investigation did not contemplate any money from AXIS and that AXIS agreed to not raise failure to obtain consent to the settlement as a bar to coverage with respect to the settlement, but that AXIS reserved all other rights.

Second Underlying Lawsuit
The second lawsuit was brought on behalf of the Plan and another Northrup savings program. Northrup settled this second suit in June 2017, almost exactly six months after the DOL settlement. AXIS did not contest coverage of the second settlement and covered its portion. At the same time, AXIS informed Northrup that it would seek reimbursement of the DOL settlement amount, which (AXIS argued) was not a covered loss. In AXIS’s view, the DOL settlement represented uninsurable disgorgement under California law.

Coverage Case
AXIS filed suit to recover the payment of the DOL settlement, alleging that the money Northrup received from the first two insurers was not for a covered loss and therefore resulted in improper erosion of the liability limits of the underlying policies, causing Northrup to be unjustly enriched and resulting in greater exposure to AXIS, and a lower threshold for payment, on the second suit.

The District Court agreed that AXIS’s theory of improper erosion gave it the right to claim that original payments by the insurers were not for a valid claim under the policies. The trial court reasoned that a follow-form insurer denied the opportunity to dispute the validity of a primary insurer’s payment “could be liable to cover payments totally outside of its excess coverage policy.” The District Court then analyzed the DOL settlement, finding that it constituted disgorgement: the return of ill-gotten gains. The Court noted that, even though the DOL settlement did not use the word “disgorgement,” the DOL “specifically instructed Northrup to restore all payments or reimbursements made in violation of ERISA.” Summary judgment was entered for AXIS.

Ninth Circuit Appeal
The Ninth Circuit panel, noting that the case was a matter of first impression, reversed. The appellate court agreed with Northrup that the trial court’s rule allowing AXIS to challenge the legitimacy of the underlying insurers’ payment decisions would “undermine the confidence of both insureds and insurers in the dependability of settlements,” eliminating one of the primary reasons to obtain insurance in the first place. The Ninth Circuit further stated that the District Court’s rule “would introduce a host of inefficiencies into the insurance industry, with no obvious countervailing benefits to insurers or policyholders.” The panel then announced its own rule: “Absent a specific contractual provision, [an excess insurer] may not second-guess other insurers’ payments of earlier claims without first showing that those payments were motivated by fraud or bad faith” (emphasis added). The Court appeared buttressed in its decision by the unlikelihood that an insurer acting in good faith would pay claims that it is not obligated to pay. If business reasons might encourage such payments, the Court reasoned, that could be handled in policy negotiations by setting higher premiums or putting in specific contract language reserving rights to contest improper erosion.

By “specific contractual provision,” the Ninth Circuit means that the excess policy must “clearly and unambiguously reserve for” the excess carrier’s right to second-guess lower-tier insurers’ coverage decisions. Follow-form provisions alone do not cut it, as with the AXIS policy requiring exhaustion of underlying limits “for covered loss” under those policies, which the Court found insufficient. Finally, while carefully couching its comments as not deciding the substantive issues of whether the payments agreed to in the DOL settlement constituted disgorgement or whether disgorgement by settlement (instead of by court order) was against California public policy and therefore uninsurable, the Ninth Circuit panel cast serious doubt on both propositions, most certainly to the relief of National Union and CNA—and their claims adjusters.

But is that all? Should we leave this as nothing more than a case note of an important, if somewhat complex, case? No, and not just because we promised a discussion of two Ninth Circuit cases.

Shy v. Insurance Co. of the State of Pa.
In AXIS, the lower court relied on, and the appellate court distinguished, an earlier (unpublished and non-precedential) Ninth Circuit decision: Shy v. Insurance Co. of the State of Pa. (“ISOP”), 528 Fed. App’x 752 (9th Cir. 2013). Shy also involved an underlying and excess carrier. The excess carrier’s policy, like in AXIS, was follow-form. The underlying policy limit was $2 million, the excess limit was $10 million. An insured presented a claim for reimbursement of an arbitration award entered against it for $14 million. After the primary insurer paid its $2 million limit, the excess carrier, ISOP, refused to pay anything. The Ninth Circuit ruled that nothing in the excess policy bound ISOP to the primary insurer’s coverage decision: “We conclude,” the Court stated, “that ISOP is bound by the terms of [the underlying insurer’s] policy but not [its] coverage decision.”

The appellate court further affirmed the trial court’s finding that only about $1.4 million of the arbitration award was for covered losses: The underlying insurer overpaid by $600,000. ISOP was in the clear because it was “not obligated to pay unless covered damages exceed $2 million.” They didn’t. While the trial court in AXIS relied on Shy, the Ninth Circuit distinguished it, stating that Shy was simply about a single claim being presented to two carriers, who disagreed about coverage. One paid its own portion while the other challenged what it was asked to pay.

But what if we take Shy and meld it with the circumstances in AXIS? Although several of the key communications among counsel in AXIS are redacted, and some relevant dates are absent from both courts’ recitation of facts, it appears that both litigations may have been pending at the same time and that before settling the DOL case, Northrup received warning that a claim on payments in the DOL litigation might be rejected. With that information in hand, Northrup settled the DOL lawsuit. The claim submitted for the DOL settlement was first in time and it survived adjustment by National Union and CNA. The claim in the other lawsuit, brought by private parties, was settled just six months later and, because it was later in time, AXIS (as second-in-line excess carrier) was barred from challenging the first payment made by the primaries on the DOL case.

Had the settlements been in reverse order, under Shy and the panel’s decision in AXIS, the DOL settlement payment could have been challenged by AXIS as a matter of right. Perhaps the unexplored details of the timing and decision-making processes of Northrup in managing the two apparently-simultaneous litigations and eventual settlements would have revealed nothing more than an ordinary course of action, without consideration of the impact on insurance coverage. Perhaps not. But the order of the settlements made all the difference for the Ninth Circuit.

Excess carriers facing this issue in the future should consider making a deep dive into all the facts surrounding the claims and exploring the ways that the ordering rule can be used to favor a review of the coverage of all claims against the liability limits. For example, can the excess carrier, evaluating two claims, present them as coincident in time? That is, regardless of when the claims were submitted, were the underlying facts and circumstances simultaneous enough that the claims can be fairly considered as having arisen at the same time, with neither later nor earlier than the other? Excess carriers might also look to the players involved (the counsel and party representatives) and the facts gathered in discovery to argue claim simultaneity. If both claims were demonstrably made at the same time, there would be no “payments of earlier claims.” At least from the facts shared in the two AXIS opinions, a finding of claim coincidence may have been a just result that would have allowed AXIS to challenge the DOL settlement as disgorgement. The discovery of facts that permit an inference that the insured staged the timing of the claims to give itself an advantage in dealing with the carriers might also allow an excess carrier to fall within the bad faith exception to the Ninth Circuit’s rule that prohibits second-guessing lower-tier payments.

Opportunities for creativity in these cases abound. The Ninth Circuit opinion in AXIS is just the beginning: for insureds, insurers, and, especially, for excess carriers. Let the games begin.

Arthur F. Fergenson is a Senior Counsel in our Maryland office.
Ryan R. Corkery is a Partner in our Philadelphia office.
Heather L. Williams is a Partner in our Maryland office.