The current worldwide economic downturn has placed insurers in difficult situations where their insureds, due to insolvency or bankruptcy, are unable to fund their financial obligations under their policies. This article examines the impact of an insured's financial difficulties on its insurer, focusing on whether an insurer must "drop down" to fund defense costs and/or settlements when an insured is unable to fund its deductible or self-insured retention, and the impact of bankruptcy on the insurer.
II. Typical Scenario
Insurers increasingly are finding that their insureds are unable (or unwilling) to satisfy their financial obligations under their liability policies due to financial pressure and ultimately a bankruptcy filing. In this connection, insurers are seeking answers regarding how to react when an insured maintains an inability to fund defense costs or settlement otherwise uncovered by the policy, or the bankruptcy court assumes control over the insured's assets. Typically, the scenario involves an insured who is unable to fund amounts within the policy's pay-first provisions (i.e., deductible or self insured retention); however, insurers also address this issue when the insured is unable to fund its portion of a settlement allocated to uncovered allegations, or when the insured has agreed to an allocation of defense costs or is funding independent counsel's defense costs in excess of the insurer's "reasonable, usual, and customary" hourly rates.
A. The Purposes of Co-Insurance
The large-loss principle provides that the primary purpose of insurance is to cover large, catastrophic losses that could financially ruin an individual or business. The purposes of co-insurance are to 1) keep insurance affordable, and 2) encourage insureds to act responsibly to avoid losses. With a pay-first provision, insurers can lower their risk by eliminating small claims, and, consequently, offer insurance at a more affordable price. In this connection, premiums are determined by the amount of co-insurance chosen by the insured; the higher the co-insurance, the lower the premium.1 An insured, independently or working with its broker, can determine acceptable co-insurance thresholds by analyzing the insured's ability to pay and risk tolerance.
Co-insurance also encourages insureds to act responsibly in order to prevent losses. Without "skin in the game", insureds may be nonchalant about losses, doing little to prevent them because their insurer bears the financial risk. Where an insured must fund the initial costs of defense and/or settlement, the insured is more likely to take steps to avoid claims, actively defend claims once they are made, and better appreciate the cost-benefit of early resolution.
B. Pay-First Provisions: Deductible v. Retention
The two predominant pay-first provisions in liability policies are deductibles and retentions. There are a number of traditional distinctions between deductibles and retentions. When dealing with a "deductible," the insurer generally assumes the coverage obligation once a claim is tendered and controls the defense. In this connection, the insurer/insured relationship is said to be governed by general coverage principles that the duty to defend is broader than the duty to indemnify. The deductible is considered to be within the limits of liability, and the insurer is responsible for defense costs and fees, unless there is a "barring limits" provision in the policy which erodes into the indemnification limits.
While a retention is similar to a deductible because it represents a dollar amount not covered by insurance, a retention traditionally must be exhausted through direct payment by the insured to defense counsel (or the claiming third party) before the insurer will respond to the loss. In this connection, the insured with a retention, as opposed to a deductible, usually assumes greater responsibility for the defense and settlement of claims, reporting to the insurer only those claims likely to exceed the retained limit. Further, the retention is not considered to be within the limits of the policy.
Finally, in a deductible situation, the insurer generally can settle the case without the insured's consent, pay the settlement amount and then collect the deductible from the insured. Conversely, it is generally understood that an insured can settle any claim within its retention without consulting the insurer. The reverse proposition (i.e., the insurer settling within the retention without the insured's consent) generally is not allowed.
IV. Confirmation of Financial Impairment
Initially, when faced with pleas of financial hardship by an insured, the insurer should seek objective evidence from the insured regarding its financial condition. Citing, as necessary, the cooperation clause, the insurer should request that the insured provide documentation supporting its alleged financial impairment, including:
- Year-end corporate financial statements (3 years);
- Tax returns (3 years);
- Bank account statements (24 months);
- Details of real property owned (and related mortgages(s));
- An accounting of assets valued in excess of $10,000;
- Any judgments against the Named Insured;
- Any pending litigation involving the Named Insured;
- A list of all property, valued in excess of $10,000, previously owned by the Named Insured which was transferred or disposed of during the previous 60 months;
- Signed affidavits from the CFO and CEO authenticating the above documents and the insured's inability to fund the retention; and
- Any retainer agreements between the insured and entity, including defense attorneys in other cases.
V. Seek Funds From Additional Insureds
In addition to seeking objective evidence of financial impairment, the insurer should consider contacting the named "additional insureds" under the policy, requesting that they fund any shortfall in the retention or for uncovered damages even if no claim has been raised against such other insureds. Although few reported decisions discuss the issue, there is some support for an insurer compelling named additional insureds to make up the retention shortfall even though the "additional insured" is not a defendant or otherwise asserted a claim under the policy.2
VI. Review of Policy Language
Once the insurer is satisfied that the insured is unable to fund the pay first provision, the insurer should review the policy language to determine what, if any, policy provisions address the insolvency of the insured. In this connection, liability policies often contain provisions that specifically address insured insolvency/bankruptcy. Although such provisions can vary greatly from insurer-to-insurer and policy-to-policy, an insurer should pay particularly close attention to provisions entitled Insured Bankruptcy, Financial Impairment, Priority of Payments and/or Conversion to Run-Off.
Certain policy language may be a reaction to legislation enacted by various states requiring insurance policies to include a provision stating that a policyholder's bankruptcy or insolvency will not relieve the insurer of its obligations under the insurance policy.3 In this connection, many insurance policies now contain a Bankruptcy provision such as the following:
Bankruptcy or insolvency of any Insured or the estate of any Insured shall not relieve [the insurer] of its obligation nor deprive the insurer of its rights or defenses of this Policy.
Nevertheless, insurers often argue that the above provision does not specifically address the consequences of a insured's failure or inability to satisfy the pay first provision, noting that their policies also include language such as:
The insurer's liability under this Policy shall apply only to that part of each Loss which is excess of the [Deductible or Retention] set forth in Declarations. Such [Deductible or Retention] shall be borne by the Insured and remain uninsured.
Based upon pay-first provisions similar to the above, insurers have argued that the Bankruptcy provision has no effect on the policyholder's obligation to fund initial losses in accordance with the pay first provision. In this connection, insurers have argued that payment of the retention is an absolute condition precedent to coverage, and that any other interpretation relieving an insured of that obligation and/or requiring an insurer to "drop down" to cover amounts within the pay-first provision would impose additional obligations on the insurer to which it never consented or contemplated when forming the insurance contract.
VII. Drop Down Analysis
The phrase "drop down" refers to the insurer's payment of amounts within the pay-first provision. Below is an analysis of the current state of the law addressing an insurer's obligation to drop down.
A. Traditional Approach (The Minority View)
Courts reviewing the drop down issue under the traditional approach attempt to parse out an insurer's payment obligations by determining whether the policy contained a deductible or retention.
Applying the Traditional Approach
Evaluating the traditional differences noted above, courts have found that where the policyholder is unable to pay the deductible due to insolvency, the insurer must drop down to pay covered losses up to its full policy limits and then seek reimbursement of the deductible amount from the insolvent insured's bankrupt estate. (Emphasis added.) With an retention, however, the insurer typically is not obligated to pay the amount that the insolvent policyholder retained.4 However, courts have been reluctant to support insurers' arguments that a retention constitutes primary insurance for purposes of "Other Insurance" clauses, thereby disallowing insurers to disclaim all coverage pending the insured's payment of the SIR.5
Problems with the Traditional Approach
Notwithstanding the traditional distinctions noted above, the clear line between a deductible and a retention has become blurred. Legal commentators have pointed out that many of the hallmark cases cited under the traditional approach are based upon "traditional" policy wording that cannot be reconciled with the policy terms, phrases, endorsement and exclusions in today's liability policies. In this connection, courts, insureds and even insurers often use the terms deductible, retention and SIR interchangeably, resulting in inconsistent (and inaccurate) legal analysis.6 As a result, at least one California court noted that "?the labels used [by insurers] to define policy terms are not controlling; the terms themselves are."7
B. Drop Down Analysis Under the Modern Approach
Over the past two decades, there has been a shift away from the traditional approach towards the modern approach which attempts to harmonize insurers' contract rights with the insured debtors' rights, all within the guidelines and purposes of the Bankruptcy Code.8 Courts following the modern approach generally do not make a distinction between a deductible or retention.9 Rather, courts note that the insured debtor's payment of the policy premium constitutes substantial compliance with its contractual obligations with the insurer, and, therefore, the insurer should not be allowed to fully disclaim coverage under the policy where the deductible or retention cannot be met by the insured.
Under the modern approach, courts generally require insurers to maintain the defense of an insured where same is otherwise called for under the policy, notwithstanding the insured's failure to satisfy the pay-first provision.10 However, insurers are only required to provide coverage for settlements in excess of the pay-first amount, up to the limits of liability.11 Under the modern approach, an insurer controls settlement and maintains its rights regarding "cooperation" from the insured.
VIII. The Impact of Bankruptcy
The bankruptcy of an insured changes the drop down analysis as the rights and obligations of the parties under the policy are impacted by the Bankruptcy Code.
A. Stay Issues
Where the subject claim is against the named insured entity only, the litigation or proceedings should be automatically stayed under § 362 of the Bankruptcy Code, as actions concerning "property of the estate." However, where the litigation involved insured persons as named defendants, there are additional issues to consider.
The first issue is whether the automatic stay is appropriate where the insured entity is not a party. In making this determination, a court generally will look at the following:
Is the entity a necessary and indispensable party in the litigation?
If so, the individual defendants should argue that the litigation should not be allowed to proceed against them while the entity's bankruptcy is pending.
Does the litigation against the individual defendant(s) arise out of actions taken in their capacities as employees, partners or officers of the entity?
If so, the individual defendants should argue that the litigation should be stayed on the grounds that allowing the litigation to proceed against them would implicate the entity and impair the entity's bankruptcy proceedings.
B. Post-Bankruptcy Action by the Insurer
Once an insured declares bankruptcy, an insurer often is left trying to determine what, if any, action it can take without violating the automatic bankruptcy stay or otherwise unlawfully diminishing the assets of the estate. In particular, the insurer needs to be certain that any payments made to fund will be credited as depleting the policy limits.
Paying Pre-Bankruptcy Defense Costs
Once the bankruptcy has been filed, relief must first be granted from the automatic stay for either the insured or the insurer to make any payments, including payments for defense fees and costs incurred prior to the filing of bankruptcy.
Where the insured is reorganizing, the insured should be encouraged to seek relief to fund pre-bankruptcy defense costs and ongoing costs for "critical vendors", including defense counsel, on an ongoing basis as an administrative expense of the estate. Such action will allow for less disruption with defense counsel and vendors and will encourage the continued efficient handling of open claims by the insurer.
Where the insured is liquidating, the insurer may seek relief to drop down to fund pre-bankruptcy defense costs within the retention. Generally, such relief is in the form of a "comfort" order granted by the bankruptcy court. It is important to remember that if the insurer advances funds without leave of the bankruptcy court, the insurer may face assertions that it is liable for the amount of the advances, either as voided payments or as a sanction imposed under 11 U.S.C. § 362(h).
Funding Ongoing Defense Costs
The issues related to insurer drop down are discussed in greater detail above. However, at this time, it is important to note that where 1) the insured is no longer able to fund defense costs within the retention (i.e., no critical vendor order), 2) the insurer is required to drop down to cover defense costs within the retention, and 3) the insurer has been granted relief to make payments under the policy during an insured's bankruptcy, the insurer should consider filing a request for reimbursement of those amounts as administrative expenses of the estate. Under Bankruptcy Code § 503(b)(1)(A), a creditor may file a request for an administrative expense for the "actual, necessary costs and expenses of preserving the estate." An administrative expense claim generally takes priority over other unsecured claims and will most likely be paid in full.
C. Does the Liability Policy Constitute "Property of the Estate?"
In many situations, there will be a disagreement as to whether insured persons and/or additional insureds will be able to access the proceeds of a bankrupt named insured's liability policies. The courts have adopted divergent approaches when determining whether policy proceeds are property of the bankruptcy estate under § 541(a)(1), and recent decisions evidence that the courts are no closer to establishing a consistent approach. However, there are certain factors which an insurer will want to evaluate when analyzing whether a court may view the policy as property of the estate. First, the insurer should determine whether the bankrupt entity otherwise would have the right to receive and keep the proceeds when the insurer pays on a claim. If so, the proceeds likely are property of the estate.12 On the other hand, where the bankrupt entity has no right to receive or keep the proceeds when the insurer pays on a claim, the policy and proceeds generally are not property of the estate.13
When determining how a court may view a liability policy, the insurer should look at the following:
Is there entity coverage? If so, there is a strong argument that the policy is the property of the estate.
Is there a single limit in the annual aggregate, meaning that once the limit is depleted during the policy period by any insurer, there is no coverage left? If so, courts tend to favor retaining policy benefits as property of the entity and estate.
Are the individuals Named Insureds on the Declarations Page or through Endorsement or are they only covered as "employees" or "Insured Persons" under a specific insuring clause? If coverage is only granted to the individuals as "employees" or "Insured Persons," courts generally will find that the interests of the Named Insured entity takes precedent.
Does the policy have a specific allocation of the proceeds in the event of bankruptcy, including a provision called "Priority of Payments," or "Order of Payments?" These provisions dictate that when a claim involves both the individuals and the corporate entity, the payments are first made on behalf of the individuals. Where the policy proceeds are dedicated first to the individuals, a bankruptcy filing by the corporate entity likely will not prevent the individuals from accessing the policy proceeds for covered claims.
In the alternative, is there any provision discussing a "Conversion to Run-Off?" This provision would state that coverage will continue until the policy's stated expiration, but only for wrongful acts committed prior to the appointment of a bankruptcy trustee (or any change of control). Some policies will stay in full force and include coverage for the bankruptcy trustee as a named insured.
If the policy is property of the estate, the automatic stay under the Bankruptcy Code would prevent anyone, including a creditor litigant, from accessing the policy and its proceeds.
Directors and Officers Liability Policies
Directors and Officers (D&O) liability policies present a difficult issue for insurers because, while they ordinarily benefit third parties harmed by the insured, they also provide coverage for defense costs incurred by the insured entity and/or insured individuals. Traditionally, D&O policies contained only two types of coverage. First, Insuring Agreement A (or Side-A coverage) provided liability coverage payable directly to the directors and officers for claims for wrongful acts when indemnification is not permitted or not available due to insolvency. Second, Insuring Agreement B (or Side-B coverage) reimburses the insured entity for its indemnification payments to officers and directors for such claims. More recently, D&O insurers have offered policies with a third type of coverage, Insuring Agreement C (or entity coverage). This coverage part provides direct coverage to the insured entity for its own wrongful acts. Entity coverage typically is limited to securities claims in policies issued to publicly-traded companies, but it may be broader in other types of policies.
Under a traditional Side-A only D&O policy, directors and officers of a bankrupt insured generally would be able to access the policy proceeds to cover claims against them as well as obtain reimbursement of their defense costs.14 However, some courts have held that the proceeds of D&O policies that provide entity coverage are the property of the bankruptcy estate.15 These courts reason that the addition of direct coverage for the corporate entity insured transforms the policy into a vehicle for both individual and corporate protection. Because the proceeds of the policy are commingled between the individuals and bankrupt corporate entity, one court found that the debtor's interest in the policy proceeds is sufficient to bring all of the policy proceeds into the bankruptcy estate.16 Moreover, because a single aggregate limit of liability generally applies to both the coverage for directors and officers under Side-A and the coverage for the entity under Side-B and the entity coverage, depletion of the aggregate limit by payment to the directors and officers will reduce the coverage available to the debtor and thus to the debtor's estate.17
If the policy is deemed property of the estate, the bankrupt insured would not be able to pay claims against its directors and officers or reimburse them for their defense costs associated with any pending litigation against them without court approval. Further, any distribution by the estate might explicitly exclude the directors and officers, because under Bankruptcy Code § 502(e), indemnification claims may be disallowed entirely, or they may be subordinated under § 510(b) or (c) to the claims of all creditors. Where an insurer finds itself faced with these difficult issues, it would be wise to contact counsel familiar with bankruptcy and coverage so as to address the situation in good faith while not violating the provisions of the Bankruptcy Code.
IX. Conclusion - Practical Considerations Regarding Claims Resolution
The practical implications of resolving a claim within the pay-first provision where an insured is insolvent or bankrupt must be weighed by the insurer on a case-by-case basis against the legal complexities noted above. In this connection, given the possibility that the insured's employees may become less cooperative or unavailable after leaving the insolvent/bankrupt insured, an insurer may choose to accelerate its payment obligations and settle a claim quickly where the litigation can be resolved for a reasonable amount. Further, even where an insurer legally is not obligated to fund a settlement within the pay-first provision, it may still want to consider seeking leave from the bankruptcy court to do so where the claimant remains unaware of certain facts that would increase potential covered liability and/or when defense counsel threatens to withdraw from the case unless the insurer expressly confirms that defense costs will be funded. On the other hand, where potential liability is a fixed amount, an insurer may wish to allow the litigation to remain stayed indefinitely in hopes that the claimant will dismiss the complaint or reduce his demand when faced with a lengthy stay (and pennies on the dollar).
1 However, generally, the amount of co-insurance and the amount of the savings to the insured are not linear. By increasing the size of co-insurance, savings to the insured will be much greater at first, but decline dramatically thereafter.
2 See, e.g., Continental Casualty Co. v. Duckson-Carlson, LLC, 2006 WL 1073075 (Minn. App. 2006); Northbrook Ins. Co. v. Kuljian Corp., 690 F.2d 368, 373 (3d Cir. 1982).
3 See Illinois Insurance Code (215 ILCS 5/388); California Insurance Code Section 11580(b)(1).
4 Patricia A. Bronte, Pay First Provisions and the Insolvent Policyholder, The Insurance Coverage Law Bulletin (June 2004).
5 See Wake County Hospital System, Inc. v. National Casualty Company, 996 F.2d 1213, 1217 (4th Cir. 1993)
6 William T. Barker, Combining Insurance and Self-Insurance: Issues For Handling Insurance and The Decision To Settle, 61 DEF COUNS. J. 352 (1998).
7 Vons Companies v. United States Fire Insurance Company, 78 Cal.App.4th 52 (Cal.App. 2000). See also General Star Indemnity Co. v. Superior Court, 47 Cal.App.4th 1586 (Cal.App. 1996) [Even though the policy was denominated as primary coverage subject to a deductible, it was in fact transmitted into excess coverage subject to a retention based on the policy language.]
8 See, e.g., Albany Ins. Co. v. Bengal Marine, Inc., 857 F.2d 250, 256 (5th Cir. 1998).
10 Bengal Marine at 257.
11 Examples are fire and life insurance policies.
13 An example is third-party automobile insurance.
14 In re Pintlar Corp. (Pintlar Corp. v Fidelity & Cas. Co.), 124 F.3d 1310 (9th Cir. 1997).
15 See Homsy v. Floyd (In re Vitek, Inc.), 51 F.3d 530 (5th Cir. 1995); In re Metropolitan Mortgage & Secs. Co., 325 B.R. 851 (Bankr. E.D. Wash. 2005); In re Eastwind Group, Inc., 303 B.R. 743 (Bankr. E.D. Pa. 2004); Exec. Risk Indem., Inc. v. Boston Reg'l Med. Ctr., Inc. (In re Boston Reg'l Med. Ctr., Inc.), 285 B.R. 87 (Bankr. D. Mass. 2002); In re CyberMedica, Inc., 280 B.R. 12 (Bankr. D. Mass. 2002); In re Sacred Heart Hosp. of Norristown, 182 B.R. 413 (Bankr. E.D. Pa. 1995).
16 In re Vitek, Inc. at 534.
17 Id. See also, Kimberly M. Melvin, D&O Policy Proceeds as Bankruptcy Estate Assets: The Elusive Quest for Clarity, Insurance Coverage Digest Vol. 16, No. 3 (May/June 2006); See Nan Roberts Eitel, Now You Have It, Now You Don't: Directors' and Officers' Insurance After a Corporate Bankruptcy, 46 Loy L Rev 585 (Fall 2000).