Structuring Your Excess Insurance Program: Don't Be Pound Wise and Penny Foolish
In the course of counseling a client about insurance coverage matters, one of our recurring conversations is about the difficulty of deciding what amount of excess insurance is "just right" and is neither too little, too much nor too costly. Once the discussion moves from the subject of the expense of building a robust coverage program, the conversation generally moves to assessing and evaluating the client's risk profile, potential liability exposures, what the client perceives as its "worst-case" liability scenario and its appetite for risk.
Different constituencies within a corporation will often have different views about how much coverage is enough (for example, it is not unusual for management and outside directors to have different opinions). To provide some guidance for its placement decision, the client frequently will turn to analytical tools such as benchmarks that compare the limits of its insurance program to those of its peers, or models of the client's potential exposure to certain types of claims. These considerations are useful in evaluating coverage needs, making risk management decisions, and structuring a coverage "tower" (i.e., the aggregate layers of coverage, beginning with primary insurance, above which there are one or more layers of umbrella or excess coverage, and perhaps concluding with some form of specialty excess coverage).
Clients often think that the discussion about what makes for adequate excess insurance ends here. But this is really the starting point of the discussion. If the coverage "tower" is not structured in an effective manner, it does not matter how many dollars in limits, or how many layers of excess coverage, that an insured purchases. For a directors & officers (D&O) insurance program, for example, the following are some of the basic building blocks that should be used to build an effective excess program:
- Excess policies should be at least as broad as, if not broader than, the terms and conditions of the primary policy;
- Excess policies should provide for the common situation in which due to a disputed claim, an underlying insurer pays less than its policy limits;
- Excess policies should provide sufficient safeguards in the event of the insolvency of an underlying insurer;
- If the insured buys specialized high-level excess insurance, such as "difference in conditions" (DIC) coverage, such policies should contain adequate "drop down" provisions and underlying policies should recognize payment by a DIC insurer; and
- The insurers in the tower should be suitable and sufficiently secure so that the insured can be reasonably confident that the insurer will be able to pay claims.
These factors are not exhaustive, nor do they guarantee that the insured's expectations will always be met; but they are at least as important as deciding what the total limits of an excess tower will be. As the following scenarios demonstrate, if an insurance tower is not structured correctly, it may make no difference as to how much in limits of coverage is purchased.
Scenario one: Do your "follow form" policies really follow form?
Spacely Sprockets, a fictitious company, was found liable in a shareholder lawsuit for an amount that exceeded the limits of its primary and first layer excess D&O insurance after it was discovered that for several years its president and chief financial officer had conspired to inflate its sales. No other directors or officers were involved and the scheme went undetected for several years.
Fortunately for the company and its officers and directors, the primary D&O policy provided that the fraudulent or criminal conduct of any insured person could not be imputed to the company or any other insured person for the purposes of the application of the crime/fraud exclusion. The first layer excess policy was a "follow form" policy, which means that its terms are supposed to track the terms of the primary policy. But this policy was follow form except where the excess policy expressly contained different terms.
Unfortunately, that little "except" made a big difference in this case. The excess policy stated that for the purposes of the crime/fraud exclusion, the conduct of any insured person would not be imputed to the company or any other insured person, except where the person who had signed the application for the excess policy had engaged in excluded conduct. The president of Spacely was the person who had signed the application. So much for "follow form."
Scenario two: Do you really know when your excess insurance attaches?
After the first layer excess insurer filed a lawsuit against Spacely Sprockets seeking a declaration that it had no coverage obligation because of the application of the conduct exclusion, Spacely entered into a settlement in which the excess insurer agreed to pay $500,000 toward the liability of Spacely and its directors.
The limits of the excess policy were $2,500,000. Spacely made up the difference between what the excess insurer paid and the policy limits and requested that its second layer excess insurer, Cogsworth Worldwide, indemnify it for the balance of its liability. Cogsworth denied coverage because under the terms of its insuring agreement, its obligation to pay for Spacely's losses attached only after the underlying insurers had exhausted their limits of liability.
The Cogsworth policy did not provide that Cogsworth would recognize payments by Spacely to make up the difference between what was paid by the underlying insurers and the limits of the underlying insurance. More litigation followed.
Scenario three: Do other insurers acknowledge drop-down coverage?
As a result of the accounting scandal, Spacely entered bankruptcy and was unable to indemnify its directors in the shareholder litigation. Before the scandal, Spacely's directors had the foresight to insist that Spacely's third layer excess coverage provide coverage only for non-indemnified directors and officers and fill any gaps in case any of the underlying insurers denied coverage. This type of coverage is what is commonly referred to as Side-A difference in conditions or DIC coverage. When Spacely's first layer excess insurer denied coverage and filed a declaratory judgment action, the DIC coverage filled the first layer excess insurer's place on behalf of the individual insured persons.
Unfortunately for Spacely's directors and officers, however, the Cogsworth policy did not state anything about DIC insurers filling the role of the underlying insurers. As a result, Cogsworth denied coverage and commenced litigation seeking a declaration that its policy does not recognize payments by DIC insurers.
What we can learn from Spacely Sprockets?
In each of these scenarios, paying attention to the effective structure of the excess tower would have identified the problematic policy terms. But the worst time to discover potential problems is when there is a claim the insured expects will trigger coverage. By then it is too late to seek alternative coverage options and the only hope for the insured is that it will prevail in litigation against its insurers.
In each scenario, however, Spacely could have sought alternative policy terms or purchased different coverage –- if only Spacely had paid attention to the factors necessary for effectively structuring an excess insurance tower.