This week, in AXIS Reinsurance Co. v. Northrop Grumman Corp., ____ F.3d ____, 2020 WL 5509743 (9th Cir. Sept. 14, 2020), the Ninth Circuit addressed an important question of first impression: When can an excess insurer second-guess an underlying insurer’s decision to pay a claim? Prior to AXIS Reinsurance, there had been no California or the Ninth Circuit case discussing an excess insurer’s right to make a covered-claims challenge to the exhaustion of underlying insurance, even though policyholders frequently encounter such arguments.
The policyholder in AXIS Reinsurance carried three layers of liability insurance. The primary insurer and first-layer excess insurer paid to settle a lawsuit. Settlement exhausted the primary policy and eroded the first-layer excess policy. The policyholder was later sued in a second lawsuit. The policyholder asked AXIS, the second-layer excess insurer, to drop down and contribute to settlement. Although AXIS did not challenge coverage for the second lawsuit, it nonetheless argued that payments by the underlying insurers to settle the first lawsuit should not erode their limits because the first lawsuit was not covered by the underlying policies. AXIS paid to settle the second lawsuit and sued, arguing the policyholder must reimburse AXIS’ settlement costs because the underlying insurers had improperly exhausted their policy limits, and AXIS owed no duty to cover the second lawsuit. The district court found in AXIS’ favor.
The Ninth Circuit reversed. The Ninth Circuit held that an excess insurer may not challenge exhaustion by second-guessing an underlying insurer’s prior payments, unless the excess insurer proves the underlying insurer was motivated by “fraud” or “bad faith,” or there is specific policy language that expressly grants the excess insurer this right. The Ninth Circuit reasoned that while an excess insurer is free to decide whether a specific claim is covered by its own policy even if the underlying insurer reaches a different conclusion, an excess insurer may not force a policyholder to prove that every dollar paid by an underlying insurer was covered before agreeing to drop down. The Ninth Circuit explained that AXIS did not allege fraud or bad faith by the underlying insurers, and AXIS’ policy contained no language allowing it to challenge exhaustion by second-guessing coverage for prior payments made by underlying insurers.
Moving forward, AXIS Reinsurance should limit challenges by excess insurers to the exhaustion of underlying insurance. However, we expect excess insurers to begin arguing that underlying insurers were acting fraudulently or in bad faith when paying money to exhaust their limits. Excess insurers often contend that underlying insurers exhaust to avoid paying defense fees or make business-guided decisions to pay uncovered claims. Whether true or not, policyholders should be ready to face such arguments. In the meantime, policyholders should review their existing excess policies to determine whether the language is susceptible to a covered-claims exhaustion challenge. Policyholders should carefully review exhaustion provisions when purchasing or renewing excess insurance to avoid a scenario like AXIS Reinsurance, where an insurer refused to pay a claim that it freely admitted was covered by arguing that underlying insurance paid out bad claims and did not properly exhaust.