UNDERWRITING RESPONSES TO ALLOCATION
The July 1995 edition of The ACE Report discussed the recent Ninth Circuit ruling in Nordstrom, Inc. v. Chubb &. Son Inc. with respect to allocation under a D&O insurance policy. Since then, two additional circuit court opinions, one entitled Caterpillar Inc. v. Great American Ins. Co. in the Seventh Circuit and the other entitled Safeway Stores, Inc. v. National Union Fire Ins. Co. again in the Ninth Circuit, further addressed allocation issues under different facts. All three cases adopted some version of the "larger settlement rule" as the proper method for allocating loss between a corporation and its directors and officers when both are named as defendants in a claim. That rule allocates loss to the corporation only if and to the extent the loss is larger because of claims against the company or because of the acts of non-defendant directors, officers, employees or agents of the company.
As a result of these cases, there is now an unprecedented level of awareness and discussion by insureds and brokers regarding allocation under the D&O insurance policy and how allocation disputes can be avoided. Because this high level of interest exists at a time when the D&O insurance market is quite soft, insureds have a number of options available to address allocation within the policy.
The four primary underwriting responses now available in the market with respect to the allocation issue are briefly summarized and discussed below.
1. Entity Coverage for Securities Claims. In May 1995, National Union introduced a creative new D&O policy form which not only provides traditional D&O insurance coverage, but also provides coverage for securities claims against the corporation whether or not D&Os are co-defendants at any time during that claim. Thus, the policy eliminates the need to allocate loss between covered securities claims against D&Os and uncovered securities claims against the corporation. The policy creates a secondary benefit by eliminating the need for D&Os to be defendants in the securities claim in order to trigger insurance coverage, thereby ostensibly reducing the incentive for plaintiffs to name D&Os and increasing the incentive defendants to seek dismissal of D&Os at an early stage of the litigation. In reality, though, it is doubtful that the existence of entity coverage will materially change the litigation strategies of either plaintiffs or defendants in securities claims.
This entity coverage policy does not eliminate the need to allocate loss between the corporation and defendant D&Os in a non-securities claim. In that context, the policy attempts to reject the "larger settlement rule" articulated in the recent case law and instead requires allocation based upon the relative legal and financial exposures and other benefits of each party. That alternative method of allocation will likely result in a significantly lower allocation to the D&O insurer than under the "larger settlement rule."
2. Predetermined Allocation of Securities Claims. The October 1994 edition of The ACE Report described several carriers that offer a D&O insurance policy with an endorsement which predetermines a specific allocation for all securities claims covered at least in part by the policy, regardless of the specific facts of each claim. Depending upon the insurer, these endorsements may predetermine only the allocation between D&Os and the company, or also predetermine the allocation between insured and uninsured allegations against the defendant D&Os. The additional premium charged for the endorsement typically varies depending upon the predetermined percentage selected by the insureds.
When evaluating the worth and wisdom of a particular predetermined allocation arrangement in light of the recent circuit court decisions, insureds should not only consider what allocation the insureds would likely attain in the absence of the endorsement (in light of the federal circuit in which the securities claim is likely to be filed and other facts which arguably distinguish a future claim from the recent circuit court decisions), but also the benefits from avoiding the uncertainty and a potential disagreement with the insurer regarding allocation. Although under certain circumstances, insureds have and will probably continue to obtain an allocation up to 100% of the loss, such a result is likely to be obtainable only with expensive, protracted and contentious litigation. Such an experience is quite costly not only in light of the resources and time which insureds must invest, but also because an important relationship with its D&O insurer may be destroyed. Accordingly, a predetermined allocation somewhat less than the amount which insureds believe they could obtain in light of the recent case law may be justified.
3. Direct D&O Coverage Only. A D&O policy which insures only the directors and officers for non-indemnifiable claims is an alternative approach to eliminating disputes involving allocation of loss between the D&Os and the corporation. This type of policy, which has been primarily offered by CODA since 1986, responds typically to derivative suits and litigation where the corporation is insolvent. In both instances, the corporation is not a collectible co-defendant and therefore allocation between the defendant D&Os and the corporation is not an issue. Thus, this approach assures full coverage to directors and officers without the risk of allocation disputes and is available for reasonable modest premiums since the corporation self-insures its indemnification liability risks.
4. Ad Hoc Allocation. D&O policies which do not include one of the three allocation alternatives listed above generally contain an allocation provision which either commits the parties to perform their best efforts to reach a fair and appropriated allocation or which defines the methodology for determining a fair allocation. The recent circuit court decisions strongly indicate that courts should and will follow express insurance policy language in determining the proper allocation. Therefore, there is little doubt that a policy provision which either adopts or rejects the "larger settlement rule," the relative exposure test or another methodology would be enforceable.
Although it is still too early to fully assess the effect of the recent circuit court decisions, preliminary indications suggest that the effect will not be dramatic. Contrary to some initial predictions that the decisions would further polarize insureds and insurers in negotiating an acceptable allocation, some recent experience suggests that these decisions ironically may be facilitating early agreement by the parties on an acceptable allocation. Insureds and their counsel generally do not appear to be insisting upon a 90% or 100% allocation as a result of these recent opinions and insurers are not insisting on 50% or 60% allocations. Therefore, for some insureds, it may be appropriate to continue the historic practice of negotiating a specific allocation with the insurer in each case based upon the unique facts and circumstances of that case.
Conclusions
When evaluating the preferred underwriting approach to the allocation issue, insureds should consider both their long-term and short-term interests. Although some insurers are offering extremely attractive terms and pricing for either entity coverage or a predetermined allocation, these proposals are obviously a product of the current soft insurance marketplace. Simple arithmetic suggests that extremely high allocations cannot be funded by insurers long-term without significant additional premium. For example, the Wyatt Company's D&O surveys have concluded the average allocation to be approximately 65%. If insurers now agree to a 90% to 100% allocation, the insurers may be effectively agreeing to a 30% to 40% increase in loss payments for securities claims, which is the largest class of claims for D&O insurers. This large additional payout of loss must eventually be funded either out of insurer profits or additional premium. This simplistic analysis strongly suggests that the D&O insurance market cannot continue long-term to offer high allocation products for little or no additional premium. Accordingly, it is prudent for insureds to make current insurance purchasing decisions with the goal of creating a stable and predictable insurance product and insurer relationship.
ARBITARATION OF COVERAGE DISPUTES: QUESTIONS AND ANSWERS
D&O insurance policies now frequently include some form of arbitration provision which permits or requires the insureds to resolve coverage disputes with the insurers through some form of arbitration. The Bermuda-based D&O insurers, including ACE and CODA, have included such a provision in their policy forms since their inception. Now, many of the U.S. domestic insurers are recognizing the benefits of arbitration through various forms of arbitration policy provisions or endorsements. In addition, even in the absence of a policy provision, insureds and insurers are more frequently utilizing arbitration and other forms of alternative dispute resolution to resolve their disagreements.
As a result, many insureds and brokers are now evaluating the wisdom and effect of arbitrating coverage disputes. The following briefly summarizes some answers to the most commonly asked questions regarding arbitration of insurance issues.
What are the likely benefits for insureds?
The three benefits traditionally associated with arbitrating a dispute are speed, lower costs and fair resolution.
Speed. Most courts are inundated with cases, resulting in delays of several years or more before a case can be adjudicated. This is due both to unprecedented levels of new case filings and constitutionally mandated preference by courts to dispose promptly of criminal proceedings at the expense of delaying civil proceedings. In contrast, the life span of an arbitration proceedings is typically measured in terms of months, not years.
Costs. The traditional notion that arbitration proceedings are less costly than litigation is generally attributable to the expectation that formal discovery will be less and the presentation of evidence at "trial" will be shorter. In large disputes, these expectations may be only partially realized since the cost of arbitrating the dispute may not be substantially less than the cost of litigating. For example, it is not unusual for one party in a large insurance arbitration to incur legal fees and expenses in the mid six-figure to seven-figure range.
Fair Resolution. Particularly in specialized areas such as insurance, many believe that qualified arbitrators with some knowledge regarding the industry and its unique practices and issues can reach a fairer resolution of the dispute than a judge with little prior exposure to the relevant issues. The extent of this benefit is obviously dependent upon the quality of the judge (and the judge's clerks) who would rule on the case if litigated and the qualification of the arbitrators if arbitrated.
In the insurance context, a fourth benefit to arbitrating frequently exists. Unlike litigation, which is a public proceeding, arbitration is private both as to its proceedings and result. Thus, arbitration permits the parties to avoid publicity, public disclosure of confidential or sensitive information, and the creation of adverse precedent. These benefits can be particularly important if the coverage dispute is being resolved while the underlying liability claim remains pending.
What are the possible disadvantages to an insured?
The most commonly cited disadvantage to insureds if a coverage dispute is arbitrated relates to the perception that judges and juries are more likely than arbitrators to be inherently antagonistic toward an insurance company and thus insureds are more likely to prevail in litigation. That perception may be true and relevant in disputes between an individual with limited resources and a "deep pocket" insurance company. However, that perception has less relevance in disputes between large corporations and their insurance companies. In any event, arbitrators may be more likely to render a fair decision based only on the relevant law and facts, which should be the goal of all parties to the dispute.
Other possible disadvantages arise out of the fact that the procedures relating to how the arbitration proceedings is to be conducted are typically not identified in detail in advance. Instead, those procedures are determined in each proceeding by the arbitrators for that proceeding. Thus, the parties may not know in advance the extent and availability of, for example, formal discovery, motion practice and presentation of various forms of evidence. In addition, the parties typically have limited rights of appeal following an arbitration award. Fraud or other misconduct in connection with the arbitration proceeding is often the only permitted basis for the losing party to seek an appeal. These potential disadvantages though, are equally applicable to both insureds and insurers.
Also, in some jurisdictions, arbitrators, unlike the courts, may not be authorized to award punitive or exemplary damages.
Are mandatory arbitration clauses enforceable?
Both U.S. and foreign courts consistently enforce mandatory arbitration clauses. This deference to arbitration agreements is based upon the importance of enforcing a contract as written and recognizes the value of resolving disputes privately and efficiently without judicial intervention.
What qualifications should the selected arbitrator(s) have?
Some arbitration provisions define certain minimum qualifications, which all arbitrators must have. Although general qualifications such as prior knowledge or experience relating to insurance matters, may be appropriate to assure that the parties realize some of the intended benefits from the arbitration, more detailed qualifications which would likely benefit one party at the expense of the other should be avoided. For example, a requirement that all arbitrators be current executives of an insurance company might be perceived as creating a bias in factor of the insurer at the expense of the insureds and therefore should be avoided.
Most arbitrations are conducted with a panel of three arbitrators. Each party selects one arbitrator and those two arbitrators select a third "umpire" or "neutral" arbitrator. Under that format, the arbitrator selected by each party should be both knowledgeable about the general issues in dispute and should be capable of being an effective and persuasive advocate. The decision of the "umpire" arbitrator is typically the decisive vote and therefore the ability of each "party" arbitrator to persuade the "umpire" can become critical.
What procedures are followed throughout the arbitration?
Usually, arbitration provisions do not define the detailed procedures to be followed throughout the course of the arbitration. Reference to rules of the American Arbitration Association or other similar association generally define only preliminary procedures concerning the selection of arbitrators and similar administrative issues. The exact procedures relating to discovery, admissibility of evidence and other important issues are typically established by the arbitrators in conjunction with the parties on an ad hoc basis.
Usually, these ad hoc rules do not permit as broad discovery rights as permitted in litigation and do not incorporate the detailed and somewhat restrictive litigation rules of evidence. As a result, arbitration proceedings frequently involve somewhat less pretrial discovery and motion practice and more informal presentation of evidence to the arbitration panel. Evidence that would not otherwise be admissible in litigation may be introduced and considered in arbitration. Although this more "casual" type of proceeding can create a "trial by ambush" if both parties are not careful, it can also result in a more efficient and expedited dispute resolution process.
In order to avoid inappropriate or abusive practice in this type of proceeding, it is highly desirable for both parties to select experienced arbitrators who can implement and oversee practical and efficient procedures. Similarly, each party should use competent legal counsel experienced in arbitration matters to assure the maximum benefit of the arbitration process is realized.
Conclusions
Experience indicates that most parties who participate in an arbitration generally have recognized the value of that type of dispute resolution and remain willing to use arbitration in the future. Although many insureds are instinctively reluctant to arbitrate coverage disputes with their insurer, further analysis should be make to evaluate objectively the desirability of arbitration. Invariably, arbitration proceedings are conducted with at least as much integrity and fairness as judicial litigation, but frequently with greater speed and somewhat lower cost.