Chapter 11 Limits Issues

• Library: The Handbook on Additional Insureds (ABA) (2018 Ed.)

CHAPTER 11 Limits Issues

Timothy A. Diemand

Imagine the frustration faced by an additional insured who convinces an insurer that a loss should be covered only to discover that there is little to no real benefit. This section examines some of the myriad ways this situation may arise and advises additional insureds how to identify, avoid, or ameliorate that possibility.

I. Self-Insured Retentions and Deductibles

Many insurance policies include deductibles and/or self-insured retentions (SIRs) that must be paid by an insured in the event of a loss. Where an insured is bankrupt or otherwise insolvent, an insurer may attempt to deny coverage to an additional insured because those obligations have not been met.

Deductibles and SIRs are both designed to allocate a layer of risk to the insured by specifying an amount of an insured claim that the insured is responsible for pay-ing.² However, there are several key distinctions between them. First, an insurer with an SIR pays only defense costs and indemnification in excess of the SIR, whereas an insurer with a deductible defends and indemnifies from the outset of the claim and seeks reimbursement of the deductible from the insured.³ In addition, a deductible generally applies to indemnification but not defense costs, whereas an SIR typically applies to both.⁴ Whether a named insured or additional insured is responsible for paying the deductible and SIR is normally decided by the indemnification and insurance provisions of the contract governing the parties' relationship. The insurer generally does not express a preference so long as someone satisfies the SIR or deductible.⁵

When an insurer knows that a named insured is bankrupt or insolvent, it may argue that satisfaction of the SIR by the named insured alone is a condition precedent to coverage for all insureds, and that satisfaction by the additional insured is insufficient. Some policies expressly provide as much, stating that the named insured must make actual payment of the SIR as a condition precedent to the insurer's liability under the policy, and that payment cannot be made by any other person, insurer or organization for or on behalf of the insured.⁶ Most policies are not nearly so specific and contain only general wording to the effect that the insured is responsible for satisfaction of the SIR and the insurer is only liable for losses in excess of the retention amount.⁷ Regardless of the operative SIR provisions, insurers have cited named insureds' bankruptcies and claimed that their inability to satisfy the SIR forfeited coverage for all insureds. When this defense has been raised, courts have generally rejected it.

When a policy does not expressly require actual payment of the SIR by the named insured as a condition precedent to coverage, courts often hold that the insurer cannot shirk its obligation to pay losses in excess of the SIR merely because the named insured is bankrupt or insolvent. Two approaches have evolved to deal with this situation. Some courts hold that the SIR does not need to be exhausted so long as the insurer's liability is limited to amounts in excess of the SIR.⁸ Other courts enforce the SIR language of the policy but allow the additional insured to make the necessary payment.⁹

Even when a policy expressly requires actual payment of the SIR by the named insured as a condition precedent to coverage, courts often reject insurers' arguments of coverage forfeiture.¹⁰ Rarely, courts have upheld a policy's express requirement that the named insured make actual payment of the SIR as a condition precedent to coverage.¹¹ Forecast Homes, Inc. v. Steadfast Insurance Co. is one example where the court did uphold the policy's requirement that the named insured satisfy the SIR. In Forecast Homes, the court held that the insurer had no obligation to provide coverage to the additional insured in the wake of the named insured's bankruptcy and failure to pay the SIR, even though it was undisputed that the additional insured had incurred defense costs sufficient to satisfy the per-occurrence amounts in the SIR endorsements.¹² The two policies at issue expressly provided that only the named insured could satisfy the SIR. In addition, one of the two policies expressly provided that "[s]atisfaction of the self-insured retention as a condition precedent to our liability applies regardless of insolvency or bankruptcy by you."¹³

In Pak-Mor Manufacturing Co. v. Royal Surplus Lines Insurance Co., the court held that a bankrupt insured's inability to satisfy the SIR precluded coverage under a provision expressly requiring "actual payment" of the SIR by the named insured as a condition precedent to coverage. However, recognizing the obvious inequity, the court explained that the named insured could still "pay the retained limit in any form," including merely a promissory note to the underlying personal injury plaintiff/judgment creditor in the amount of the SIR so long as the note was "not dischargeable in bankruptcy and [was] shown to be a credible obligation of [the insured]."¹⁴

Further limiting an insurer's ability to argue that bankruptcy vitiates its coverage obligations, some states have enacted legislation requiring that policies include a "bankruptcy clause" providing that bankruptcy or insolvency of the insured will not relieve an insurer of its obligations under the policy.¹⁵

Generally, an insurer will not be able to take advantage of a named insured's bankruptcy by claiming that only the named insured may satisfy the SIR as a condition precedent to coverage for all insureds. As discussed, however, the coverage afforded additional insureds is not without limit. First, the amount of coverage is limited by the terms of the policy to losses in excess of the SIR. Second, the court may still require the satisfaction of the SIR, either by the named insured in the form of a note to the injured party, as seen in Pak-Mor, or by the additional insured itself.¹⁶

II. Dilution of Policy Limits

All insureds under one policy share the same per-occurrence and aggregate limits of coverage. As a result, a claim by one insured dilutes policy limits available for all other insureds. Indeed, while a "severability clause" or "separation of insureds clause" generally requires insurers to treat each insured on an individual basis, these same clauses specifically except policy limits, thereby reinforcing the principle that policy limits are applied collectively.

Because policy limits are applicable on a collective basis, the more insureds there are, the higher the probability that coverage will be exhausted. Furthermore, insurance policies typically do not limit the number of additional insureds.¹⁷While an additional insured may ask the named insured whether there are any other additional insureds, there is no customary requirement or practice of informing additional insureds of the total number of additional insureds or the extent, if any, to which policy limits have been diluted by other claims. For a full discussion on how policy proceeds should be allocated among insureds, see Section IV.

Contracts between the named insured and additional insured typically do not address the concern of policy dilution. One potential solution is for the contract to require that the named insured (1) certify in writing the number of additional insureds and the extent, if any, that the policy limits have been diluted; (2) notify the additional insured when the named insured adds any more additional insureds; and (3) provide written notice to the additional insured when a claim for coverage is made, followed by updates concerning the amount of the insured exposure for each claim. This solution, however, is impracticable in many industries—particularly those that frequently make use of subcontractors or where the insurance policy is for a large entity with many subsidiaries.

If there is a concern that the named insured's limit will be diluted because of additional insureds covered under the same policy, then the named insured may mitigate the risk by capping additional insured limits in the underlying contract between the parties and in the policy through a sublimit for additional insured coverage. The additional insured may also attempt to mitigate its risk by including indemnification provisions within the underlying contract, thereby retaining the ability to pursue a claim directly against the named insured. If a contract is large enough, the additional insured should consider requesting that the named insured increase existing policy limits or procure an additional policy that is specific to that contract.

III. Effects of Other Insurance Clauses

The amount of coverage available to an additional insured under a given policy may also be limited when more than one policy covers the loss. Typically, an additional insured maintains its own coverage, a policy on which it is a named insured, as well as additional insured coverage under another entity's or entities' policies. When an insured has more than one policy potentially providing coverage for the same loss,¹⁸ courts first look to the other insurance clauses in each policy to determine the priority and allocation of payments among the insurance carriers. Other insurance clauses were incorporated into insurance policies to prevent a policyholder from recovering from multiple policies for the same loss and to limit the liability of insurance carriers.¹⁹

A. Type of Other Insurance Clauses

Most modern policies contain other insurance clauses that describe how the policy interacts with other insurance policies covering the same loss. There are three basic types of other insurance clauses: a pro-rata clause, an escape clause, and an excess clause.²⁰

1. Pro Rata Clauses

A pro rata other insurance clause provides that the policy will contribute with other policies covering the same loss and explains how the contribution will be calculated. The most common pro rata other insurance clause limits the...