Layers of Liability

Verdict amounts across the country are on the rise, due in part to the phenomenon of social inflation and the success of reptile theory-style arguments. An insurer’s potential extra-contractual liability for these verdicts and related damages continues to substantially increase a carrier’s exposure in litigation.

However, the potential for extra-contractual liability does not lie solely in the insured/claimant versus carrier context. In some circumstances, a primary liability insurer may owe duties to an excess or umbrella carrier giving rise to potential extra-contractual claims between carriers. Let’s explore the interplay between carriers issuing layers of insurance covering the same liability or loss, as well as the manner in which their duties to one another may lead to extra-contractual liability for bad faith.

Primary insurance refers to the first layer of coverage that applies when a covered liability or loss takes place. More than one primary insurance policy may apply to a covered liability or loss. The priority of coverage between multiple policies applying on the same layer is typically determined by an analysis of the “Other Insurance” provision in each policy. Confusion often arises because a primary policy may dictate that it applies to a loss on a primary, excess, or super excess basis in relation to other primary insurance covering the same liability or loss. The policy nonetheless remains a primary liability policy.

A second layer of coverage also may be available under an umbrella or excess policy. Although the terms “excess” and “umbrella” are often used interchangeably, in actuality they refer to two different types of coverage. Coverage under an excess liability policy—in contrast to a primary liability policy applying on an excess basis—is typically triggered after the limits of the primary policy are exhausted. Per the decision of Granger v. Auto-Owners Ins.: “Umbrella policies are different from standard excess insurance policies, since they provide both excess coverage (vertical coverage) and primary coverage (horizontal coverage)…. The vertical coverage provides additional coverage above the limits of the insured’s underlying primary insurance, whereas the horizontal coverage is said to drop down to provide primary coverage for situations where the underlying insurance provides no coverage at all.”

Therefore, insureds purchasing such insurance must understand the difference between an excess policy and an umbrella policy to ensure that they are purchasing the coverage they intend and seek. 

Generally, a carrier affording excess insurance for a loss or liability may, under the terms of its policy, elect to participate in the insured’s defense. Most states addressing the issue have held that the excess carrier’s duty to defend is not triggered until the primary carrier’s limit is exhausted by settlement or tender of payment, even if the claim for damages exceeds the limit and the excess coverage is necessarily implicated in the action. In contrast, a minority of states have held that the excess carrier’s duty to defend is triggered once the excess carrier becomes aware that the claim for damages will exceed the primary carrier’s policy limit.

The issue of bad faith most often arises in this context when an excess carrier contends that the primary carrier committed bad faith by refusing to settle within the primary insurance layer. However, carriers managing claims in jurisdictions in which the minority position is followed should be aware of the potential extra-contractual exposure for an excess carrier’s refusal to become involved in the underlying claim or suit once it becomes clear that the claimed damages will exceed the available primary coverage.

It is axiomatic that a carrier owes its insured a duty to act in good faith and to put the insured’s interests ahead of its own. The duty generally derives from the exclusive control an insurer exercises on behalf of its insured in controlling the defense and from the insurer’s right to settle, thereby imparting on the carrier the duty to act in the insured’s best interests.

Courts in some jurisdictions have extended similar duties to the primary carrier in favor of the excess carrier due to the inherent conflict between the primary insurer’s desire to settle the claim for as little as possible and the excess insurer’s desire to avoid a judgment exceeding the primary policy limit. A primary insurer typically discharges its duty of good faith to an excess carrier by giving as much consideration to the excess carrier’s interests as it does to its own. The substantive bad-faith laws of the jurisdiction in which the action is pending typically will determine whether a cause of action sounding in bad faith or extra-contractual liability exists. Courts recognize these causes of action in many jurisdictions when a judgment exceeding the primary policy limit occurs. They also may recognize them when a settlement is reached and the benefits are assigned, so long as bad faith occurred during the primary liability carrier’s refusal to settle within its limits.

There is a belief that carriers issuing primary liability policies will have less incentive to settle within the primary policy limit when an excess or umbrella policy layer applies above the primary liability carrier’s exposure. In this situation, some contend that a primary liability carrier may take a riskier position on settlement when it knows the exposure of an excess verdict will fall to an excess or umbrella carrier rather than the insured.

Courts that recognize an excess or umbrella carrier’s bad-faith cause of action against a primary liability carrier reason that doing so will encourage settlements that are in the insured’s best interests. They also reason that a bad-faith cause of action will discourage insurance companies from refusing to settle as a matter of policy or taking risks that they otherwise would avoid in the absence of an excess or umbrella policy. Courts in these jurisdictions believe that enforcing these principles will help prevent increasing insurance and litigation costs and will encourage settlements to avoid unnecessary exposures as a matter of equity and fairness.

Primary, excess, and umbrella carriers should consider these duties and potential extra-contractual liabilities as they defend and settle claims with multiple levels of liability insurance.