Farella Braun + Martel LLP: Recent Media Coverage Overstates Impact of New Second Circuit Case Regarding “Drop-Down” Issue

Farella Braun + Martel LLP: Recent Media Coverage Overstates Impact of New Second Circuit Case Regarding “Drop-Down” Issue

   By Erica Villanueva, Partner, Farella Braun + Martel LLP

There has been much hand-wringing over the Second Circuit’s decision in Mehdi Ali v. Federal Insurance Co., __ F.2d __ (2d Cir. 2013) [enhanced version available to lexis.com subscribers], in which the court declined to extend the holding of Zeig v. Massachusetts Bonding & Insurance Co. , 23 F.2d 665 (2d Cir. 1928) [enhanced version available to lexis.com subscribers], to the specific facts of the case before it. Commentators are chalking it up as a major victory for insurers, claiming that policyholders have now lost a key precedent, one which had previously allowed them to argue that an excess insurer can be required “drop down” to cover losses below its attachment point.

Not so fast.

As an initial matter, the Zeig case does not stand for the proposition described above. The Zeig case held that an excess insurer could be required to pay losses above its attachment point, if the insured had actually sustained those losses. In Zeig, an insured suffered a property loss which exceeded the limits of his primary policy, but settled with that insurer for less than the full primary policy limits. The Second Circuit reasoned that, because the insured could demonstrate that it had actually suffered property losses in excess of the primary limits, the excess insurer could be required to pay that portion of the loss which exceeded its attachment point.

In Mehdi Ali, the Second Circuit confronted a different factual scenario. There, several layers of D&O coverage were written by insurers that are now insolvent (Reliance and Home). The insureds asked the Second Circuit to rule that the excess insurers whose policies sat above these insolvent layers must begin paying covered loss once the insureds’ “payment obligations” reached those excess insurers’ attachment points – regardless of whether anyone (either the primary insurers, or the insureds themselves) had actually made such payments.

The Second Circuit refused to do so, for two reasons. First, the court explained that the excess policies contained language which expressly prohibited the result sought by the insureds. The excess policies specified that they would attach only after the scheduled underlying insurance was exhausted “as a result of payment of losses thereunder.” The Second Circuit reasoned that this language requires actual payment of the underlying limits, not merely a finding that the insureds had incurred a “payment obligation” equivalent to that amount.

In Mehdi Ali, it appears that nobody – neither the underlying insolvent carriers nor the insureds – had made any payment at all. The Second Circuit therefore affirmed the district court’s finding that, under the policy language at issue, the excess insurers could not be required to pay until their attachment point was reached through actual payment of covered loss. But the Second Circuit went out of its way to explain that the district court had not decided the separate issue of what would have happened if the insureds had actually paid an amount equivalent to the underlying limits before requesting that the excess insurers begin paying.

For the same reason, the Second Circuit also ruled that Zeig did not apply. The Second Circuit explained that, because Zeig was a first-party property case, the insured had “actually paid” (i.e. , had actually sustained) losses in excess of the primary limits. The insured was therefore entitled to recover from the excess insurer that portion of the loss which exceeded the excess layer attachment point. In contrast, the Mehdi Ali insureds had paid nothing, and therefore had not yet sustained – through actual payment, as the excess policy language required – losses equivalent to the scheduled underlying limits.

Following Mehdi Ali, Zeig still remains good law. Moreover, the Second Circuit strongly implied that, if the Mehdi Ali insureds had actually paid covered loss in an amount equivalent to the underlying limits, it would have ruled that the excess insurers had a present payment obligation. Thus, Mehdi Ali continues to permit insureds to do what they’ve been long been citing Zeig for: to settle with a D&O liability insurer for less than its full limits, make up the gap between that layer and the next layer themselves, and then ask the next layer to pick up its payment obligations at its usual attachment point.

Finally, there is another important reason why the Mehdi Ali ruling isn’t as devastating as some commentators claim. The decision is firmly grounded in the specific language of the excess policies at issue in the case – policy language which is now obsolete. The excess policies at issue in Mehdi Ali were issued in the early 1990s and provided that they would attach only after the scheduled underlying insurance was exhausted “as a result of payment of losses thereunder.” Over the last ten years, this policy language has evolved. Newer policies frequently say that payment can be made by underlying insurers or insureds or a drop-down of excess Side A/DIC coverage. Some policies even say payment can be made by underlying insurers or “any other source” (to cover situations where a third-party indemnitor pays part of the loss). This more liberal policy language is now widely available and, as the Mehdi Ali case demonstrates, is well worth purchasing.

Read additional articles on legal developments that affect policyholders at the Policyholder Perspective blog.

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