I went back and forth on whether to include the Ninth Circuit’s decision, in Scottsdale Insurance Co. v. Certain Underwriters at Lloyds, London, No. 19-55502 (9th Cir. Dec. 18, 2020), as one of the year’s ten most significant coverage decisions.  The case involves a unique issue.  That’s a factor that generally favors a decision making the annual list.  But is the issue too unique?  In other words -- the coverage scenario at hand may not arise very often. That’s often a factor that keeps a decision off the annual coverage hit parade.

I decided to include Scottsdale v. Lloyds for a couple of reasons. First, the case involves a dispute between a primary and excess insurer.  I have always believed that such cases are important.  Second, the court addressed, and distinguished, this year’s decision in Axis Reinsurance Co. v. Northrop Grumman Corp., No. 19-55135 (9th Cir. Sept. 14, 2020), another excess case that received a lot of attention, including from myself. Third, while the specific facts of Scottsdale v. Lloyds may be unique, there is language in the opinion that may give it wider applicability.

[In general, the court in Axis Reinsurance Co. v. Northrop Grumman Corp. held that excess insurers may not contest the soundness of underlying insurers’ payment decisions.  While the case was certainly a win for policyholders, my take is that it has narrow applicability.  It seems to be limited to insureds that have layered insurance programs, with multiple claims, where the insurers in a tower may not agree with the coverage decisions made by insurers, in lower towers, in prior claims.  Because of this disagreement, the higher layer insurers may believe that their policy was prematurely triggered.  Importantly, the court in Northrop Grumman noted that its rule did not apply where there was a dispute between insurers on a specific claim.]

At issue in the brief opinion of Scottsdale v. Lloyds was a dispute between Scottsdale, an excess insurer, and Lloyd’s, a primary insurer, over a settlement of a significant legal malpractice claim. The court refers to it as the “SFA Settlement.” 

The court noted that the SFA settlement addressed two types of claims: “(1) claims against a former Dickstein [Shapiro] partner for malpractice; and (2) claims against Underwriters [Lloyd’s] for bad faith and failing to defend against the malpractice claim. Although the settlement did not allocate between the claims, the Underwriters did, agreeing that approximately $11.74 million would be paid out of the primary policy, $4.50 million would be paid out of the excess policy, and $1.26 million would be paid by the Underwriters as extra-contractual liability.”

Scottsdale brought an action challenging this allocation and seeking a determination that the settlement did not erode the underlying limits. The District Court concluded that “Scottsdale has no independent right to veto a reasonable settlement decision made by the primary insurer.”  The Ninth Circuit disagreed.

As the appeals court saw it, the allocation “appeared to be the product of collusion.” The problem for the appeals court was that Lloyd’s [Underwriters] may have eroded their policy limits based on the payments allocated to settle the bad faith and failure-to-defend claims.

However, as the court noted, “nothing in the insurance policy gives Underwriters the authority to do this.” Rather, the policy provided that Underwriters will “pay on behalf of the Assured, Damages and Claims Expenses which the Assured shall become legally obligated to pay because of any Claim or Claims. . . arising out of any act, error or omission of the Assured.”

Underwriters, the court stated, are not the “Assured,” and the bad faith and failure to defend claims are not claims “arising out of any act, error or omission of the Assured[.]”

Therefore, the court concluded that “any payment to settle the bad faith or failure-to-defend claims should not have been paid out of the policy limits, but rather, as ECO [extra-contractual].”

The court rejected Lloyd’s reliance on this year’s much-discussed decision in Axis Reinsurance Co. v. Northrop Grumman Corp., which Lloyd’s argued stood for the proposition that Scottsdale cannot challenge Lloyd’s payments.  However, the court in Scottsdale v. Lloyds drew a distinction between that case and the matter at hand.

While language in Northrop Grumman “appears to support Underwriters’ and the district court’s conclusion, context is key. In that case, the excess insurer was arguing that the claim against the insured was not a covered loss. Whereas here, Scottsdale is arguing that a claim against the insurer is not a covered loss. This difference limits the AXIS [Northrop Grumman] court’s primary justification for its rule — i.e., protecting the insured’s objectively reasonable expectations.”

Thus, the Scottsdale v. Lloyds court remanded the case to the district court for a determination of the extent to which the SFA settlement erodes the policy limits.  Presumably, this means a determination of how much of the settlement is for the malpractice claim, which erodes the Lloyd’s limits, versus the bad faith and failure-to-defend claims, which do not.

Indeed, the situation here is a little unique – an underlying insurer’s settlement involves both a claim covered under the policy as well as a claim for bad faith and failure to defend.  But it is not so unique. 

The possible takeaways from Scottsdale v. Lloyds, warranting its inclusion as one of the year’s ten most significant coverage cases: Northrop Grumman does not stand for a general proposition that an excess insurer cannot challenge a lower-tier insurer’s coverage decision. Second, bad faith and failure to defend settlements are borne solely by the insurer that committed the wrongful conduct.  Thus, they do not erode the limits of the responsible insurer’s policy.  Third, and perhaps most importantly, presumably excess insurers can challenge other decisions by lower-tier insurers, that do not interfere with coverage provided to the insured.