The United States Court of Appeals for the Ninth Circuit, applying California law, has held that an excess insurer could not second-guess the payment decisions of underlying insurers absent a showing of fraud or bad faith, or a policy provision expressly granting the insurer such rights.  Axis Reinsurance Co. v. Northrop Grumman Corp., 2020 WL 5509743 (9th Cir. Sept. 14, 2020).

The insured, a defense technology company, carried three layers of fiduciary liability insurance.  Each layer had a $15 million limit of liability.  In 2016, the company settled a lawsuit with the Department of Labor (DOL) for alleged ERISA violations.  The primary insurer determined that the DOL settlement was covered under its policy and it contributed its entire $15 million limit toward the settlement.  The first-layer excess insurer similarly concluded that the DOL settlement fell within the scope of coverage of its policy, and it paid the balance of the settlement amount remaining after the primary insurer’s contribution.

Six months later, the company settled a separate suit involving similar allegations for nearly $17 million.  The first-layer excess insurer concluded that the settlement was covered, and it paid the remainder of its limit.  The second-layer excess insurer agreed to pay the remaining portion of the settlement, but it subsequently filed a coverage action against the company seeking reimbursement.  Specifically, the second-layer excess insurer argued that the payments made by the underlying carriers toward the DOL settlement were for uninsurable losses, and therefore prematurely triggered its excess policy.  The district court agreed, granting judgment in favor of the second-layer excess insurer.

On appeal, the court pointed out that no circuit court precedent adopted the second-layer excess carrier’s so-called “improper erosion” theory of recovery, and the court rejected the carrier’s position.  The court sided with the company, relying on limited case law holding 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.”  The court explained that, if excess insurers could contest the soundness of underlying insurers’ payment decisions, as the district court suggested, it would “undermine the confidence of both insurers and insurers in the dependability of settlements” and eliminate a fundamental incentive for having insurance in the first place.

Finally, the court held that, because the second-layer excess insurer had not alleged fraud or bad faith, and because there were no terms in its policy that entitled it to challenge decisions made by underlying insurers, it was required to resolve any ambiguity that may have existed in the policy in favor of the company’s “objectively reasonable expectations of coverage.”  In reversing the district court’s decision, the court stated that no reasonable insured would understand that it might have to justify its underlying insurers’ payment decision in order to obtain coverage from its excess carriers.