Self-Insurance, Primary Insurance, and Excess Insurance: Adventures in Contract Interpretation

February 2002

Litigation is increasingly used to resolve ambiguities and fill the gaps in risk financing documentation, and here Ken Wollner examines a recent decision by the Ninth Circuit Court of Appeals.

by Kenneth S. Wollner
Casualty Risk Consultants, LLC

A risk financing program may involve many forms of self-insurance and intricate layers of primary and excess insurance covering the self-insured/policyholder and other persons or entities. Drafting insurance policies and other contracts that accurately and clearly express the intended relationships is a difficult and time-consuming task. If the controlling documentation is not adequate, a great deal and time and money may be spent arguing about such matters as who has the duty to defend, the right to select defense counsel, and the right to settle a claim. Moreover, once the underlying claim is adjudicated or settled, more resources may be devoted to deciding who pays for defense and indemnity, and in what amounts.

Litigation is increasingly used to resolve ambiguities and fill the gaps in risk financing documentation. While nominally applying the same general principles of insurance contract interpretation, the courts have reached disparate and often contrary results. Some follow a doctrinaire approach based on their understanding (or misunderstanding) of risk financing program structures. Others focus on a literal interpretation of such fine print provisions as the "other insurance" clause. A few simply reject the contract language in favor of pro-ration or other extra-textual remedy. In most cases, the likely result of litigation is an unpleasant surprise for one or more of the parties.

AmHS Insurance Company Risk Retention Group v Mutual Insurance Company of Arizona, No. 99-15703 (Filed July 30, 2001), provides an illustration of the vagaries of litigation. The core issue was straightforward: How much should each of two insurance companies contribute to payment of a judgment? The resolution of this issue by the Nine Circuit Court of Appeals, however, presented as many twists and turns as a long drive through the San Francisco street system.

The case arose out of a malpractice claim against Dr. Romberger. Three insurance companies insured Dr. Romberger:

1. An affiliate of Samaritan Health Systems covered the hospital and, as a "physician Insured," Dr. Romberger. This policy provided first-dollar defense and indemnity insurance subject to coverage limits of $1 million per occurrence and $12 million in the aggregate.
2. The Mutual Insurance Company of Arizona (MICA) also provided first-dollar defense and indemnity insurance, subject to coverage limits of $1 million each occurrence and $1 million in the aggregate.
3. AmHS Insurance Company (RRG) underwrote three layers of coverage.

1. The first layer was specific excess over the Samaritan policy: $1 million per occurrence and no aggregate in excess of $1million per occurrence.
2. The second layer was umbrella insurance: $10 million in "excess of Underlying," including the Samaritan and the first excess layer RRG policies.
3. The third layer was "Excess Umbrella:" $5 million in excess of $10 million. (However, this layer of coverage was not applicable to the claim against Dr. Romberger.)

MICA contributed 10 percent of the cost of defending Dr. Romberger, while Samaritan contributed 90 percent. The trial went badly for the defense. Samaritan tendered its $1 million policy limit and RRG satisfied the balance of the $7,897,543.18 judgment against Dr. Romberger. RRG subsequently sued MICA for contribution.

Excess Insurance May Not Be "True" Excess Insurance

Under Arizona law, primary insurance policies must pay before excess insurance policies. The majority opinion properly began the analysis by classifying the policies as primary or excess. The Samaritan and MICA policies provided primary coverage. The RRG policies were excess (specific, umbrella, and excess umbrella). However, the court held that the first and second layer RRG policies applied as excess insurance only with respect to the Samaritan policy, not the MICA policy. The court based its holding on postulation of two characteristics of a "true" excess policy:

1. A true excess policy covers the same insured for the same risk as the underlying policy or policies. The court noted the differences between the RRG and MICA policies in the designation of the insured, the types of liability covered (the second excess layer RRG policy provided broader coverage, including, but not limited to, medical malpractice), and the policy periods.
2. A true excess policy "gives due consideration to known existing and underlying primary policies." While acknowledging that the MICA policy provided primary coverage, the court found significance in the fact that the RRG policy did not schedule the MICA policy as underlying insurance. This implied that RRG did not consider the MICA policy to be underlying insurance.

The first test is a misconception. The court is describing the most basic type of excess policy—concurrent specific excess. However, an excess insurance policy does not have to contain terms and conditions exactly like the underlying policies or policies. The essential attributes are (1) the excess and underlying policies must cover the same insured (Dr. Romberger) (2) for the same risk (medical malpractice liability). The fact that an excess policy also covers another insured for other risks or has an only partially overlapping policy period may affect the amount of the excess insurer's coverage obligations. But any such difference in relation to the underlying insurance does not change the inherent nature of excess insurance.

The rationale for the second criterion is an excess insurer underwrites and prices only the risk that a claim would exceed the "known" underlying insurance, i.e., the Samaritan policy. To require exhaustion of the MICA policy limit before triggering coverage under the RRG policy would provide RRG with a windfall because RRG presumptively did not take into consideration that Dr. Romberger had other insurance.

The court noted that RRG could have ascertained that Dr. Romberger purchased coverage from MICA and could have amended its policy to provide that the RRG coverage was excess insurance specific to both the Samaritan and MICA policies. In this way, RRG could have avoided the dispute. The court stated that RRG's failure to clarify its relationship to other insurance covering Dr. Romberger was a factor weighing against an interpretation in favor of RRG.

The "due diligence" argument, of course, cuts both ways—against both RRG and MICA. MICA, since it was closer to the common insured, had more access to information about other insurance covering Dr. Romberger. In fact, a standard insurance application inquires about such matters.

Taken to its logical conclusion, the majority opinion stands this proposition:

Excess insurance does not apply in excess of coverage not specifically identified in the excess insurance policy if such unidentified other insurance contains an excess or escape other insurance clause.

This holding should send a shiver up the spine of any excess insurance underwriter. Identifying all potentially relevant primary insurance available to named insured is difficult enough. To require identification of all relevant insurance available to any other insured imposes an essentially impossible burden on the excess insurance underwriter.

The court's statement of facts regarding the underlying claim is brief. We are told that Dr. Romberger delivered and subsequently treated a "bad baby" and that Dr. Romberger was sued for allegedly negligent failure to detect and diagnose the baby's heart defect. The court does not provide information about the hospital's legal liability, either directly or derivatively, for liability arising out of the alleged negligence of Dr. Romberger. Nor do we know whether the hospital was obligated to indemnify Dr. Romberger for service performed for the hospital in connection with care of the baby. It may well be that under the actual circumstances of this case, that most of the liability should be assigned to the hospital and, in turn, the hospital's insurers. If so, we end up with roughly the right result for the wrong reasons.

On the other hand, looking at the circumstances of the case from the standpoint of the hospital, MICA probably certified a full $1 million of primary coverage in satisfaction of a medical staff credentialing requirement of Dr. Romberger. If, as is typically the case, there was no disclosure of the unusual other insurance clause in the MICA policy (discussed below), one can make the case that to recognize the clause is to encourage a misleading representation. The main reason for the general rule—that primary insurance pays before excess insurance, regardless of other insurance clauses—is to deny an insurer the benefit of fine print conditions that conflict with the understanding of the parties.

Nowhere in the opinion of the majority is attention given to the understanding of the parties, including the understanding of the program structure based on custom and practice or other circumstances bearing on the intent of the parties. In this respect, the opinion is not different from most judicial opinions interpreting insurance coverage. As such, the AmHS result is another example of why careful attention to contract wording is crucial.

Other Insurance Clauses

Having decided that the RRG policy did not qualify as "true excess" with respect to the MICA policy, the court then proceeded to analyze the clauses pertaining to other insurance. The RRG policies contained standard wording. Coverage attached only "after making deductions for all other recoveries, salvages or other insurance." However, the Samaritan and MICA policies did not conform to industry conventions for primary insurance.

The Samaritan policy stipulated that the insurance afforded by its policy is not reduced by any other insurance covering Dr. Romberger or other "physician Insured"—a so-called super-primary clause. MICA's other insurance clause appropriated excess insurance wording as follows:

This insurance shall not apply unless and until the limits of all other sources of funds have been exhausted. Such sources shall include:

(a) Other insurance;

(b) An insurance plan of a health care institution; and

(c) Any similar source of payment.

How do courts interpret incompatible other insurance clauses? If two policies covering the same layer contain identical other insurance clauses, the general rule is that liability will be apportioned on a pro-rata basis. If one policy contains a primary other insurance clause and another policy contains an excess or escape other insurance clause,¹ the later policy either pays only in excess of the first policy or not at all.

Problems arise in the case of other combinations, such as an excess clause in one policy and an escape clause in another. The rules used by courts in resolving conflicts between other insurance clauses include:

1. The insurance company with the most specific clause relating to the characteristics of the loss is primarily liable. For example, in Caribou Four Corners, Inc. v Truck Ins. Exchange, 443 F2d 796 (10th Cir 1971) (applying Utah law), the injury took place while pipe was being unloaded from a truck the insured was driving. Two policies provided coverage, one of which contained an express provision insuring loading and unloading. The court held that the policy containing the specific provision relating to loading and unloading was primary.
2. If the primary tortfeasor is a named insured under one policy and an additional insured under another policy, the former policy is controlling.²
3. The insurer of the automobile is primary and the insurer of the driver is secondarily liable.³ This rule is the reverse of the rule just discussed.
4. The insurer whose policy was first issued is the primary insurer.⁴
5. The other insurance clause that is more restrictive is given effect. For example, if one policy says coverage applies in excess of other insurance and another says it does not contribute with other insurance, the later language controls.⁵
6. The policy that more befits the type of loss in question is primary. For example, where one policy contains an excess clause applicable only when the insured is using a substitute vehicle and another policy contains a general excess clause, the later controls.⁶
7. The intent of the parties is inferred from the structure of the insurance program. For example, in Liberty Mut. Ins. Co. v. United States Fire Ins. Co., 590 SW2d 783 (Tex Civ App 1979), two policies contained essentially identical other insurance clauses. The court held that the automobile policy was primary and the "personal catastrophe liability" policy was excess regarding coverage for liability of an insured involving a non-owned vehicle.⁷
8. If there is a conflict between the clauses, liability is apportioned pro-rata without regard to the wording of the two clauses.⁸

Under the Insuring Agreement section of the RRG policies, RRG agreed to pay for "ultimate net loss." "Ultimate net loss" was defined as the insured's legal liability "after making deductions for all other recoveries, salvages or other insurance." The majority rejected RRG's argument that this clause should prevail because the clause was in the insuring agreement rather than, like MICA, in the policy conditions. The court did not address the following arguments:

1. The RRG provision was a condition qualifying RRG's promise to pay. Since failure to satisfy such a condition normally operates to discharge the promisee's obligations, RRG had the more restrictive provision.⁹
2. If fairness is the primary consideration, one can argue that insertion of a nonstandard other insurance clause in the fine print conditions conflicted with the reasonable expectations of the parties.
3. The MICA policy contained primary insurance policy provisions except for the other insurance clause. This inconsistency gives rise to a contextual ambiguity that should be construed against the drafter (MICA).

Splitting the Baby

The majority in AmHS Insurance Company Risk Retention Group applied the rule that mutually repugnant other insurance clauses are void. The leading case for this rule is Lamb-Weston, Inc. v Oregon Automobile Ins. Co.¹⁰ In Lamb-Weston, the Oregon Supreme Court noted that incompatible other insurance clauses generated coverage litigation and delayed payment of a claim. However, in AmHS, two insurance companies (Samaritan and MICA) provided claim defense, and the other insurance company (AmHS) promptly satisfied the judgment. Consequently, the rationale for the Lamb-Weston rule is not pertinent to the facts of the AmHS case.

What happens when other insurance clauses cancel out each other? The Ninth Circuit prorated coverage between RRG and MICA according to policy limits: $1 million for MICA and $11 million for RRG. Consequently, MICA was required to contribute 1/12 of the total judgment paid.¹¹ In so holding, the Ninth Circuit rejected the maximum loss rule under which, according to the court, the denominator in the formula is reduced to amount of the judgment.

The AmHS holding presents some interesting possibilities for a primary insurer that does not conform to industry standard other insurance clause wording. How may an excess insurer protect itself? There are many possibilities. Probably the safest approach under the circumstances of this case is to cut off direct coverage for claims against additional insureds. If the captive and commercial insurance companies provide coverage for liability assumed by contract ("contractual liability"), the self-insured/policyholder is in a position to control protection afforded to non-employed physicians.

Conclusion

Sophisticated risk financing programs can be cost effective. A trade-off is heightened risk of misinterpretation of insurance policies and other contracts by courts. This risk can be controlled only if the self-insured/policyholder and the commercial insurers ascertain the interrelationships between the affected parties (including additional insureds) and pay careful attention to contract language.

¹The four most common types of other insurance clauses are:

• Primary: The insurer pays loss in excess of the deductible or self-insured retention up to the applicable coverage limit of liability, regardless of the existence of other insurance.

• Pro-Rata: As its name indicates, a pro-rata other insurance clause attempts to limit an insurer's liability to its pro-rata share of a loss. The percentage paid may be based on the total coverage amount, the total premiums, or the total number of insurers affording coverage.

• Excess: By its terms, an excess clause positions the policy to provide only secondary coverage, while other policies would furnish primary coverage. A policy containing an excess other insurance clause would pay, if the clause is enforceable, only the difference between the coverage of the "primary" policies and the covered loss.

• Escape: If there is other insurance, no coverage is provided under the policy containing the escape clause.

²See, e.g., Hartford Acc. & Indem. Co. v Kellman, 375 S2d 26 (Fla Dist App 1979).

³See, e.g., Continental Cas. Co. v Aetna Cas. & Sur. Co., 823 F2d 711 (2nd Cir 1987) (applying Connecticut law.)

⁴See, e.g., Automobile Ins. Co. v Springfield Dyeing Co., 109 F2d 533 (2nd Cir 1940) (applying Pennsylvania law).

⁵See, e.g., Aetna Cas. & Sur. Co. v Beane, 385 S2d 1987 (Fla Dist App 1980).

⁶See, e.g., Prudential Property & Cas. Ins. Co. v New Hampshire Ins. Co., 164 NJ Super 184, 395 A2d 923 (Law Div 1978).

⁷There, the court said:

Where there is apparent conflict between clauses of applicable insurance policies, courts should look to the overall pattern of insurance coverage to resolve disputes among the carriers …

It is true that each of the policies has an "other insurance" clause that apparently limits coverage in the fortuitous circumstance of the presence of other validly subsisting coverage, but an examination of the purpose of the policies dictates resolution of this dispute. Liberty Mutual's policy generally affords primary coverage; its coverage becomes excess only because of the presence of a non-owned vehicle. United States Fire's policy remains excess in all events. Thus it is apparent that the intent of all of the parties to the policies is for United States Fire's policy to remain an umbrella policy, and Liberty Mutual's coverage to underlie it. [Id. at 785.]

⁸Lamb-Weston, Inc. v Oregon Auto Ins. Co., 219 Or 110 (Or S Ct 1959).

⁹See, Wollner, Kenneth S., How to Draft and Interpret Insurance Policies, pp. 183-188.

¹⁰219 Or 110, modified and rehearing denied, 219 Or 129 (1959) ("when any [other insurance clause is] in conflict with the other insurance clause of another insurer, regardless of the nature of the clause, they are in conflict and should be rejected en toto")

¹¹Interestingly, the court did not consider $1 million Samaritan primary insurance policy limit in its calculation.

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