I am pleased to reproduce below the latest guest post submission. This post has been submitted by John Iole, a partner in the Pittsburgh office of the Jones Day law firm. In submitted this post, John emphasized that "comments expressed are those of the author and do not necessarily represent the views of Jones Day or its clients." In addition, John has expressly retained the copyright to the content. John previous guest post submission to this blog can be found here.
I would like to thank John for his willingness to post his submission on this site. The D&O Diary welcomes guest submissions from responsible persons on differnent points of view. Readers who may be interested in submitting a guest post should please feel free to contact me. John's guest post follows below:
Large insureds often purchase substantial D&O coverage limits in layers that comprise a tower, with each D&O insurer occupying one or more layers and attachment points.[1] The excess policies commonly contain provisions that dictate how the overall program will respond to claims that implicate multiple layers. Ideally, the policy responses will be harmonious, because all participants are interested in efficiency of administration as well as a satisfactory level of coverage predictability. This guest post addresses the “narrowing clause” found in many such excess D&O policies, and how this feature can raise extremely difficult issues of policy interpretation and coverage that are not always obvious -- or even knowable -- at the time of policy placement.
Assume that each excess policy in a layered program contains a “follow form” endorsement providing that the excess policy will follow the terms, conditions and exclusions of a designated underlying policy. A standard explanation of a follow form policy is that it provides coverage that is neither more broad nor more narrow than the followed policy.[2]
If all of the policies in a tower are written on a “pure” follow form basis, then it is likely (but not inevitable) that coverage issues will be determined in essentially the same way at each layer of coverage. However, many D&O excess policies are not pure follow form, but instead contain terms and conditions specific to particular insurers. This is where the “no broader than underlying” provision (called a “narrowing clause” for the purposes of this post) comes in.
A sample narrowing clause from an “Underlying Insurance” section in a Bermuda D&O excess form provides:
In no event shall this policy grant broader coverage than would be provided by any of the Underlying Policies.[3]
This provision clarifies that the excess policy does not to provide coverage if the underlying policies do not provide coverage.[4] The excess policy might impose additional restrictions on coverage, but it is a one-way ratchet. Coverage can only get more narrow as a claim rides up the coverage tower.[5] The following sections discuss the potential coverage impact presented by narrowing clauses.
What Are The Mechanics Of Applying A Narrowing Clause?
In the most basic situation, a narrowing clause can be interpreted to allow an excess insurer to incorporate a selected, “more narrow” provision from an underlying policy. In many cases, the effect of incorporation will be to erase a contrary term that otherwise would be applicable through the followed policy, or to erase such a term in the (incorporating) excess policy itself. As a consequence, the upper-level policy might, in operation, provide drastically different coverage than is implied by the direct terms of the upper-level policy (but for the narrowing clause).
Narrowing clauses do not actually provide that they permit “incorporation” of provisions in underlying policies, nor do they provide any guidance on how incorporation is to be achieved. Nevertheless, it is likely that courts will permit incorporation as the method for executing such a clause. A good example of this in the D&O context is Fed. Ins. Co. v. Raytheon Co., 426 F.3d 491 (1st Cir. 2005). In Raytheon, the court held that a prior and pending litigation exclusion in the primary policy negated coverage under the excess policy, even though the excess policy had its own, differently-worded PPL exclusion that might not have excluded the claim.[6] The narrowing clause therefore deleted the excess policy’s stated PPL provision.
Assuming that the narrowing clause permits incorporation by reference, a more difficult question is how much leeway it gives the excess insurer to pick and choose amongst underlying provisions. For example, assume that two excess policies each have an arbitration clause. Further assume that each clause has two provisions, one that deals with selection of arbitrators, and another that deals with the conduct of the arbitration itself. Further assume that the lower-layer policy is more limited in respect of arbitrator selection, and the upper-layer policy is more limited in respect of the arbitration proceedings. Can the upper-layer excess insurer invoke the narrowing clause to incorporate the selection provision from the lower-layer policy, but retain the proceedings provision from the upper-layer policy, thereby stitching together the most narrow, combined arbitration clause applicable to the upper-layer policy? If this is possible in practice, then a high-level excess insurer would be able to pick and choose from amongst numerous underlying provisions. One can easily envision a situation in which this exercise could lead to a bewildering patchwork of coverage arguments in a multi-issue case.[7]
One can say with almost certain confidence that an “unlimited incorporation” approach, resulting in a hodgepodge policy, is likely to be rejected as unfair. Accordingly, it is likely that an insurer will have to incorporate underlying provisions in full (“jot for jot”), or not at all. Even this rule of thumb could be difficult to apply in practice. If the upper- and lower-layer policies are structured in ways that do not allow provisions to be easily matched up (or are endorsed so as to make a match-up confusing), then an incorporation exercise can lead to difficult questions about the scope of coverage.
Can A Narrowing Clause Be Applied To All Underlying Provisions?
Again assuming that a narrowing clause permits incorporation of underlying policy provisions, one must ask whether all underlying provisions are candidates for incorporation. A policyholder would contend that the excess policy is not restricted in all instances to what is provided by the underlying insurance. A trivial example is the limit of liability provision of the excess policy, which is unaffected by “narrower” underlying provisions.
Another seemingly obvious example is the notice provision. That is, if an underlying policy requires notice “immediately” and the excess policy requires notice “as soon as practicable”, it would seem to be absurd to import the more rigid standard into the excess policy, even if doing so would potentially affect the timeliness of a claim under the excess policy. Nevertheless, it is perhaps not completely free from doubt as to whether incorporation in this setting would be refused by a court.
There are additional provisions that, one could argue, are not candidates for incorporation because they do not directly pertain to coverage, such as forum selection, choice of law, and claims participation clauses. However, these provisions can have an important impact on the effective coverage available, and therefore an insurer might well contend that they are subject to incorporation as “more narrow” provisions. An insurer would likely contend that the purpose of the narrowing clause is to limit the net effective coverage under the excess policy to what is available from the underlying coverage. Therefore, it would contend, any term in the underlying coverage that has the practical effect of limiting coverage also should apply to the excess policy. These arguments are left to the courts or other tribunals to determine without guidance from the narrowing clause itself.[8]
If Incorporated, Should Policy Provisions Be Interpreted Uniformly?
Once the incorporation of underlying text is settled, there is another problem awaiting the parties – interpretation of the text. Is the text to be incorporated “bag and baggage”, such that a 2nd-layer excess insurer is bound by a reading of the text that satisfies the 1st-layer excess insurer? The answer to this is perhaps “No”, at least in those jurisdictions that follow reasoning similar to the Supreme Judicial Court of Massachusetts in the Allmerica case.[9] If the policyholder and the 1st-layer excess insurer obtain a court or arbitral declaration on the meaning of the text, does this bind the 2nd-layer excess insurer in its own use of the text? The answer here is “Yes, perhaps,” but I am not aware of any authority for this outcome.[10]
A related question can arise in the case of policy mistakes. It is not unknown for a mistake to be made in an insurance policy, perhaps through misunderstanding or inattention on the part of the underwriter, broker or policyholder. Assume that an underlying policy is reformed on the basis of mistake, where does that leave the excess policy? An excess insurer can probably make a strong case for leaving the underlying policy intact (as to the excess insurer) insofar as the unreformed policy provides narrower coverage than the as-reformed policy. The excess insurer probably would contend that its excess policy was placed in actual or presumed reliance on the terms of underlying coverage, and therefore no change via reformation is effective as to the excess policy.[11] Moreover, if reformation of the underlying policy has the opposite effect – i.e., reformation results in a narrowing of coverage, that change might well trickle up to the excess policies, narrowing them as well. These dynamics greatly magnify the potential consequences of any mistake that occurs at the time of placement.
What Does it Mean to be “Broader Than” Underlying Coverage?
The previous three issues are somewhat mechanical. A more fundamental question provoked by narrowing clauses is what it means to be “broader than” the underlying coverage. In some respects, such a characterization is not far different from asking whether one restaurant is “better than” another – the distinction works perfectly well for extreme (or at least reasonably clear) examples, but breaks down when a more precise differentiation is required.
An example helps to illustrate the problem. Let’s assume that a 1st-layer excess policy in a coverage tower selects New York substantive law for all matters of policy interpretation, including insurability of punitive damages, and that such damages are uninsurable as a matter of New York law. Then assume that the 2nd-layer excess policy specifically selects Wisconsin law, under which punitive damages are insurable. Is coverage afforded by the 1st-layer policy “less broad” than that afforded by the 2nd-layer policy? If the answer to that question is “Yes”, is the New York choice of law swept into the 2nd-layer excess policy so as to supplant Wisconsin law? The 2nd-layer (and above) excess insurers might well contend that this is what should happen.
Well, if the 2nd-layer excess insurer is correct (New York law supplants Wisconsin for purposes of punitive damages), then what happens if the dispute involves multiple issues? Let’s assume in our same example that the parties also dispute how a prior and pending litigation exclusion in the excess policy should be interpreted. In our hypothetical, let’s say that Wisconsin has a much more expansive (favoring insurers) application of PPL exclusions, which has the ultimate affect of narrowing coverage. Does Wisconsin law retain its place in the dispute for this purpose, via some type of party-dictated depecage (New York law applies so as to preclude coverage for punitive damages and Wisconsin law applies so as to favor application of the PPL exclusion)?[12] The excess insurer(s) might again say that this is an available outcome.
When Is The True Scope Of Excess Coverage “Knowable”?
There is a major consequence of the “no broader than underlying” exercise that should be apparent from the foregoing discussion. If one stops to think about it, the implications of a narrowing clause are potentially ominous. The content, meaning and coverage of the excess policies – as determined only after the incorporated provisions have been selected – cannot be known until the point of a claim, or even a good bit thereafter. It is impossible to say, on an a priori or categorical basis, whether a lower-level policy is more or less broad than an upper-level policy. First, one needs to know: (a) exactly the claim for which coverage is being requested and, potentially, (b) how the claim has been resolved in each of the underlying layers. Although a party and its counsel can hypothesize examples and anticipate how the coverage would respond, it is not possible to know exactly what issues the next claim will bring. This raises the prospect of inefficient and contentious claims resolution.
One might counter that all insurance policies are somewhat indeterminate until a claim has crystallized to the point at which coverage can be analyzed, rendering trivial this observation. In a standard insurance situation, however, the wording is static, and all that is left to do is apply the policy wording to the claim as presented. The major difference with “no broader than underlying” provisions is that the actual wording of the policy is not fixed until a claim is asserted. The excess policy is “inchoate” until the point of a claim and the wording floats and metamorphoses until determinations are made under each of the underlying layers. The text of the excess policy cannot truly be determined until each of the underlying policies has responded.
Potential Solutions to Ponder
Perhaps the most simple and comprehensive solution to the “problem” of narrowing clauses is to negotiate “pure” follow-form coverage if possible. This solves the problem through identity of wording and avoids the prospect of vertical discontinuity. Obviously, this alternative will not always be available. Another potential solution is to implement quota-share insurance.[13] In that event, the problem of layered coverage is eliminated through a change in program structure. Again, however, knowledgeable observers have identified problems with this approach, including the difficulty in arranging for claims control, and the potential for losing horizontal continuity on a long-standing program. Notwithstanding these potential solutions, it appears likely that layered, non-uniform programs are going to continue into the foreseeable future. Therefore, a solution that directly meets the terms of narrowing clauses could be useful.
When seeking to determine the field over which a narrowing clause operates, and the clause states that the excess policy provides coverage no broader than underlying, it is reasonable to interpret the provision as applying to the coverage grant, and terms that specifically pertain to the scope of coverage. Under this interpretation, the narrowing clause would not incorporate “non-coverage” elements of the underlying policies, perhaps those dealing with notice, choice of law, forum selection or cooperation and settlement.[14] In the context of reservation of rights letters, and for the purpose of crafting rules dealing with waiver of defenses and avoiding “coverage by estoppel”, some courts already distinguish between “coverage defenses” and “policy defenses” available under the policies at issue.
Under these cases, a “coverage defense” is one asserting that a claim simply does not fall within the scope of insurance for which a premium was charged. For example, a claim seeking coverage under a D&O policy when no “wrongful act” has been alleged, or seeking Side-C coverage for something other than a securities claim, would be deemed to fall outside the scope of coverage, and therefore would be subject to a coverage defense.
A “policy defense” is one in which the insurer acknowledges that the claim comes within the scope of coverage, but contests the claim based on the policyholder’s failure to comply with some other provision in the policy, such as a requirement of cooperation. See, e.g., Ideal Mut. Ins. Co. v. Myers, 789 F.2d 1196 (5th Cir. 1986) (Texas law); Continental Ins. Co. v. Bayless & Roberts, 608 P.2d 281 (Alaska 1980).
This distinction obviously cannot be applied woodenly, and it is beyond the scope of this post to engage in a full-blown discussion of the merits, deficiencies and complexities it poses in a particular situation. Nevertheless, there is no simple way to craft a rule that can be applied in all instances, and this approach can form a basis for striking a fair balance between the interests of insurers and policyholders.
[1]The use of pure follow-form and/or quota share insurance to ameliorate the problems addressed herein is mentioned briefly below, but this post assumes a continuation of the practice of placing layered coverage with less than full vertical continuity.
[2] E.g., Travelers Cas. & Sur. Co. v. Constitution Reinsurance Corp., 2004 U.S. Dist. LEXIS 21829 (E.D. Mich. Aug. 16, 2004) ("A typical 'follow the form' provision 'expressly limits the reinsurance to the terms and conditions of the underlying policy and provides that the reinsurance certificate will cover only the kinds of liability covered in the original policy issued to the insured.' . . . [A] 'follow the form' emphasizes ab initio that the scope of the reinsurer's undertaking is not broader (or narrower) than that of the ceding insurer.") (quoting 14 Appleman on Insurance Law & Practice § 106.2 (2d ed. 2004)).
[3] Some other formulations of this concept are as follows:
“Provided always that this policy shall, in no event and notwithstanding any other provision, provide coverage broader than that provided by the Followed Policy unless such broader coverage is specifically agreed to by the Insurer in a written endorsement attached hereto.”
"In no event shall this Policy grant broader coverage than would be provided by the most restrictive policy constituting part of the applicable Underlying Insurance."
“The Insurer shall pay the Insured . . . in accordance with the terms and conditions of the Followed Form . . . as amended by any more restrictive terms, conditions and limitations of any other Underlying Policies excess of the Followed Form . . . .”
[4]Simply because an insurer occupies an excess position above more narrowly-drawn underlying policies does not preordain that its coverage is limited to the scope of underlying coverage. E.g., Smith v. Hughes Aircraft Co., 783 F. Supp. 1222 (D. Ariz. 1991) (in a CGL context, court held that follow form excess policy covered pollution loss whereas underlying policy did not, based on difference in relevant endorsements, and the presence of phrase “except as otherwise provided herein”).
[5]This post does not address the separate question of whether an excess policy should pay if the claim is “covered” but one or more of the underlying policies has not fully paid its limits. In those cases, an “exhaustion of underlying insurance” provision might provide that the excess policy will pay if – and only if – the underlying insurance pays in full. This is a different method for achieving essentially the same result as the narrowing clause. Although outcomes differ depending on jurisdiction and policy wording, recent cases have resulted in particularly strict applications of such exhaustion requirements. E.g., Great American Ins. Co. v. Bally Total Fitness Holding Corp., 2010 U.S. Dist. LEXIS 61553 (N.D. Ill., June 22, 2010)(less than limits settlement with primary and first- and second-layer excess carriers means that third- and fourth-layer excess policies are not liable);Citigroup, Inc. v. National Union Fire Ins. Co., 2010 WL 2179710 (S.D. Tex., May 28, 2010)(settlement with primary insurer for less than full limits means that excess policies are not liable). A reasonable (although perhaps not always feasible) solution to this problem is to settle on a global or top-down basis as opposed to a bottom-up basis. Because of their potentially chilling effect on settlements, one might conclude that these provisions are even less favorable to policyholders than narrowing clauses. Practically speaking, both provisions are apt to appear in the excess policies.
[6] See also HLTH Corp. v. Clarendon Nat'l Ins. Co., 2009 Del. Super. LEXIS 437 (Del. Super. Ct., July 15, 2009), in which a D&O excess insurer at the $10mm xs of $90mm layer effectively incorporated a run-off endorsement from the $10mm xs of $80mm policy instead of a provision in the “followed” primary policy.
[7] As another (more substantive) example, can an upper-level policy incorporate a “more narrow” PPL date from below, but retain its own “more narrow” PPL trigger wording?
[8] When policy language does not provide clear guidance for incorporation, courts sometimes can reach results that are quite different from what the parties appear to have intended. For an example of incorporation by reference of a defense obligation into an excess follow form policy in the CGL context, see Johnson Controls Inc. v. London Market, 325 Wis.2d 176, 784 N.W.2d 579 (2010).
[9] Allmerica Fin. Corp. v. Certain Underwriters at Lloyd's, 449 Mass. 621, 871 N.E.2d 418 (Mass. 2007)(excess insurer who issued follow-form policy was not bound by settlement entered into by primary insurer). It is important not to overstate the holding of Allmerica. That was a case in which the primary carrier paid its full limits, but did so by way of a “no admission of coverage” settlement on a claim as to which it had already raised coverage questions. The primary insurer also expressly provided that the settlement had no effect on excess coverage.
[10]Assuming that at least one of the policies involved has a private arbitration provision, there is no functional way in which all of the parties can be haled into a court or arbitral forum for the purpose of forcing a declaration that is binding on them all. The most logical solution, however, is to bind any higher-layer excess insurer to an interpretation of lower-level policies so long as it was reached in an arms-length proceeding otherwise worthy of recognition. Some insurers may be more likely agree to be informally bound by underlying determinations than others, and the assistance of a knowledgeable broker can be extremely important.
[11] The excess follow-form insurer made this argument, unsuccessfully, in L.E. Myers Co. v. Harbor Ins. Co., 77 Ill. 2d 4, 394 N.E.2d 1200, 31 Ill. Dec. 823 (1979). In that case, however, the evidence showed that the excess insurer did not bother to review the underlying policy before issuing its excess policy.
[12] The concept of depecage (French for “dismemberment”) allows a court to apply different states’ laws to different parts of a single contract. Schwartz v. Twin City Fire Ins. Co., 492 F. Supp. 2d 308 (S.D.N.Y. 2007) (applying law of two states to D&O policy interpretation and to handling of claim under policy), aff’d, 539 F.3d 135 (2d Cir. 2008). Although not really an issue of depecage so much as party choice, a policy can specify the application of more than one state’s law. The Bermuda form choice of law clauses are a familiar example of this in D&O policies, in that they apply a modified version of New York law in some circumstances, and potentially call for the application of other law (such as the law of England and Wales) in other circumstances, which easily can result in the application of both.
[13]Some participants in the Bermuda market have been particularly active in advocating a simplification of coverage terms and basic vertical continuity, although others remain uncertain. E.g., P&C National Underwriter, Top Bermuda Players Split Over Wisdom Of Adopting Single Excess Policy Form (June 16, 2008); see also Insurance Journal, Aon: Bermuda Markets Introduce Single Excess Follow Form (October 13, 2008). Other commentators have advocated the quota-share solution. For example, in 2008 and again this past August, Joseph Monteleone pointed out the inefficiencies of multiple wordings in the same tower, suggesting that quota share insurance might be the best response. E.g., J. Monteleone, D&O E&O Monitor, Quota Share Insurance - An Idea Whose Time Has Come Again (Aug. 18, 2010).
[14]However, as can be seen by the third example in note 4, supra, not all narrowing clauses will specifically reference “coverage”, but might limit themselves to the “most restrictive” terms in the underlying policies. Moreover, some provisions that might be identified as “non-coverage” are nevertheless classified as conditions precedent to coverage in some wordings.
In a case involving multiple ghosts of long lost companies, a judge in federal court in Manhattan has held that excess D&O insurers do not have a duty to “drop down” to fill the gaps in coverage caused by the insolvency of underlying insurers. The court also held, based on the language of the excess policies at issue, that the excess insurers’ coverage obligations were not triggered merely because the insureds’ losses exceeded the amount of the underlying insurance, where the underlying insurance has not been exhausted by actual payment.
In an opinion that provides an interesting glimpse of a complex D&O insurance program, on August 24, 2011, Central District of California Judge 
As reflected in detail below, noted D&O maven 
One of the recurring D&O insurance coverage issues is the question of excess D&O insurers’ obligations when the underlying insurers have paid less than their full policy limits as a result of a compromise between the underlying insurers and the policyholder.
