Excess Insurers' Duty to Defend: Time for a New Rule
The Wisconsin Supreme Court's recent decision in Johnson Controls, Inc. v. London Market, et al.(Johnson Controls IV) held that an excess carrier (London Market) had to “drop down” and assume the defense obligation for its insured, Johnson Controls, because the primary insurer, Travelers Insurance Company (Travelers), refused to defend. The second and more problematic question in that case was when London Market's duty to defend began. Johnson Controls IV held that London Market’s duty to defend began when Travelers refused to defend. The dissent contended Travelers’ policy had to be exhausted before London Market had to defend.
This article only addresses when the duty to defend should begin for an excess carrier. The debate in Johnson Controls IV was between the date of denial of coverage by Travelers versus the exhaustion of Travelers’ coverage limits. However, both triggers (denial and exhaustion) hold out the specter of expensive and time-consuming litigation over the measure of London Market’s duty to defend. Johnson Controls IV overlooked a third trigger of coverage for London Market. There was a settlement between Johnson Controls and Travelers that covered Travelers’ duty to indemnify and defend. The date of that settlement should have been the trigger of the duty to defend for London Market because it would have been fair to all parties, would have reduced litigation, and is consistent with Wisconsin law and the law of other jurisdictions.
II. Johnson Controls IV
The history of Johnson Controls IV starts with City of Edgerton v. General Casualty Co., which held, among other things, that a letter to a potentially responsible party (PRP) from a state or federal environmental agency was not a “suit” and therefore did not trigger the duty to defend. Johnson Controls, Inc. v. Employers Ins. of Wausau (Johnson Controls III) reversed City of Edgerton. The Johnson Controls III court held that the cost of restoring and remediating damaged property was covered by CGL policies, and a PRP letter was the equivalent of a “suit” that triggered the duty to defend.
After Johnson Controls III was decided, Johnson Controls settled with several of its primary insurers, including Travelers, the underlying insurer for the London Market excess policy. Johnson Controls then filed a declaratory judgment action against London Market, claiming it had breached its defense obligation. The circuit court held that London Market’s “following form” provision incorporated the duty to defend that was in the Travelers’ policy. On appeal, the court of appeals certified two questions to the supreme court: (1) Was the duty to defend provision in the underlying policy imported into the excess policy; and (2) Did the excess insurer’s duty to defend require exhaustion of the underlying policy limits before the excess policy would apply?
London Market’s policy made no specific reference to a defense obligation, but the policy did state that it was subject to “the same terms, definitions, exclusions and conditions (except as regards to the premium, the amount of limits of liability and except as provided herein) as are contained in or as may be added to the (underlying policy) prior to the happening of an occurrence.” The majority held that London Market was required to drop down and provide a defense because the duty to defend of the Travelers’ policy was incorporated into the excess policy of London Market by virtue of this language. Justice Ziegler dissented, joined by Justices Roggensack and Gableman, contending London Market’s policy language was insufficient to support a duty to defend. The key fact for the dissent was the lack of any specific reference in the London Market policy to the duty to defend. The Johnson Control IV majority read a duty to defend into the policy. The dissent did not.
Johnson Controls IV also concluded London Market’s duty to defend was triggered when Travelers denied liability. The dissent contended London Market’s duty to defend did not start until Travelers’ policy limits were exhausted.
Johnson Controls IV then remanded the case for “further proceedings.” Litigation will now focus on the amount of Travelers’ settlement, the reasonableness of defense costs, the basis for any allocation for defense costs verses indemnity payments, whether Johnson Controls settled too cheaply, and whether payment by London Market resulted in double recovery for Johnson Controls. In short, Johnson Controls IV set the stage for Johnson Controls V. However, most, if not all, of this litigation could have been avoided by using another trigger for London Market’s duty to defend, a trigger which is preferable to either denial or exhaustion—the date of Johnson Controls’ settlement with Travelers.
III. Travelers' Settlement
A. Denial of Coverage Recanted
When Johnson Controls settled with Travelers, the dynamics between Travelers, London Market, and Johnson Controls changed dramatically. First, Travelers recanted its denial of coverage and paid indemnity and defense costs. Thus, Johnson Controls IV is premised on a denial of coverage that Travelers did not really mean. Second, Travelers was released and out of the case. Third, London Market could not recoup from Travelers any money it paid to Johnson Controls because Travelers had been released by Johnson Controls. Fourth, new major issues were created, including the extent and effect of Johnson Controls’ settlement with Travelers and the impact of that settlement on London Market.
B. Settlements and Unpaid AmountsMost courts have adopted the analysis of the Second Circuit in Zeig v. Massachusetts Bonding Insurance Co., which holds that, in the event of settlement between the policyholder and primary insurer, the policyholder is lia
ble for any gap in coverage below the policy limits. The excess insurer’s policy is triggered, but only for amounts in excess of the primary limits. Zeig noted that requiring collection of the “gap” in funds would only delay cases and promote litigation.
Attorney John F. O’Conner has published a law review article summarizing the rationale of Zeig and subsequent cases:
[C]ourts generally have held that one insurer’s settlement cannot increase the ultimate coverage obligations of a nonsettling insurer, and that the policyholder must pay any gaps in coverage caused by its below-limits settlement of triggered policies. By placing the risk of a below-limits settlement on the policyholder, courts allow settling insurers to obtain the finality for which they bargained, while preventing the policyholder’s decision to settle with certain of its insurers from negatively affecting the coverage obligations of nonsettling insurers.
For example, in Westinghouse Electric Corp. v. American Home Assurance Co., the Superior Court of New Jersey stated as follows:
When an insurer settles with an insured, the non-settling insurers lose their right to pursue contribution actions against settling insurers. Non-settling insurers are entitled to a credit or set-off from the insured to account for the settling insurer’s liability. This prevents double recovery by the insured, which is prohibited under fundamental principles of insurance law.
In Westinghouse Electric Corp., the insured settled with some of the underlying primary insurers, and some of the excess insurers refused to defend arguing the underlying limits were not exhausted. The Superior Court of New Jersey held the settlement had triggered the excess insurers' duty to defend. Even if the insured did not receive the policy limits from the underlying carriers, the excess insurers had no stake in that issue when the excess insurers were only obligated for sums in excess of the policy limits of the primary insurers.
In Stargatt v. Fidelity & Cas. Co. of New York, the Delaware federal district court also held the excess insurer was liable only for covered losses in excess of the primary limit where the primary insurer settled for less than its limits. The Stargatt court held that Zeig was correct and determined that Delaware courts would have reached the same result.
In HLTH Corporation v. Agricultural Excess & Surplus Insurance Co., the Superior Court of Delaware noted it would be “unfair” to allow any excess carrier to avoid payment of defense costs because of a settlement between the insured and an underlying insurer.
Settlements avoid costly and needless delays and are desirable alternatives to litigation where both parties can agree to payment and leave other separately underwritten risks unchanged. The Court sees unfairness in allowing the excess insurance companies in the instant case to avoid payment on an otherwise undisputedly legitimate claim. Therefore, to the extent that Plaintiff’s defense costs exceed any loss they may have imposed on themselves by accepting settlements with underlying insurers for less than the policy limit, the Court holds that those underlying policies have been exhausted as a matter of law.
Most of the above cases dealt with the duty to indemnify, not the duty to defend. Policy language often refers to “policy limits”—that is, the obligation to indemnify. For example, in Johnson Controls IV, the London Market policy stated: “Liability shall attach to (London Market) only after the Underlying Umbrellas Insurers have paid or have been held to pay their policy limits.” However, this language does not preclude application of Zeig. On the contrary, settlement by Travelers with credit given to the limits of Travelers’ policy comes within the policy language “or have been held to pay their policy limits.” Issues surrounding when an excess insurer’s duty to indemnify is triggered are beyond the scope of this article. However, the rationale of cases which key on a date of settlement is particularly suited to an excess insurer’s duty to defend.
Indemnification limits are stated on the declaration page. Defense costs are a different matter. There are no policy limits for defense costs, yet a liability insurer’s defense obligation is well established in Wisconsin. An insurer is obligated to defend until a final judgment terminating the defense obligation, the insurer tenders its policy limits into court, or the primary insurer settles with the plaintiff and the insured is protected by a covenant not to sue. In Johnson Controls IV, Travelers’ defense obligation continued until Johnson Controls released Travelers pursuant to their settlement agreement.
Limiting an excess insurer’s defense obligation to costs and expenses incurred after an insured’s settlement with a primary insurer is consistent with the Wisconsin Supreme Court's decision in Teigen v. Jelco of Wisconsin, Inc., which involved a true excess carrier and a primary insurer. The defense obligation, unlike indemnity, is geared to the status of the case. In Wisconsin, the duty to defend can be terminated by a final judgment, a tender of policy limits into court, or a settlement that includes the primary insurer.
Tiegen mirrors the rationale of Zeig and its progeny. The excess carrier in Loy v. Bunderson had no obligation to pay defense costs and the gap in indemnification between the settlement and primary limits was absorbed by the plaintiff. The supreme court firmly established the Loy release in Teigen, which involved a true excess carrier:
If the issue of the existence of a true primary/excess insurance situation had been fundamental to our reasoning behind the Loy principle, then our holding in Loy would not control in the present suit. However, that is not the case. The rationale behind our affirmance of the “LoyRelease/Covenant Not To Sue” is not anchored to the issue of whether a true primary/excess insurance situation exists. The desirability of Loy-type agreements lies in the encouragement of partial settlements in future cases, thereby fostering effective and expeditious resolution of lawsuits. Partial settlements not only benefit the parties involved, but the justice system as a whole.
This reasoning applies with equal vigor to the duty to defend of an excess carrier when there is a settlement between an insured and its primary insurer. The primary insurer (and the insured) are obligated for defense costs only up to the date of settlement.
C. Subrogation and Double Recovery
An excess insurer has the right to bring suit against a primary insurer based on equitable subrogation. Assuming for the moment that Travelers and Johnson Controls did not reach a settlement and the trigger of coverage for London Market was Travelers’ denial of coverage, two alternative claims would be available to London Market in its litigation with Johnson Controls. First, it could argue the Johnson Controls' action is a contract claim with London Market entitled to a setoff for amounts due and owing by Travelers, and adding Travelers as a third-party defendant. In the alternative, London Market could pay Johnson Controls and then bring a subrogation action against Travelers. Either way, Johnson Controls would only recover its actual defense costs with no risk of a double recovery by the insured. This, however, cannot happen on remand of Johnson Controls IV. When Johnson Controls settled with Travelers, any potential right of subrogation by London Market against Travelers was extinguished. This, in turn, opened up the possibility that Johnson Controls could have a double recovery by payment of defense costs from both Travelers and London Market.
One of the main purposes of subrogation is to prevent double recovery. If the trigger of an excess insurer's duty to defend is the date of settlement by a primary insurer, then subrogation and the risk of double recovery are non-issues. The excess insurer's duty to defend does not begin until settlement by the primary insurer. The primary and excess insurers' duties to defend do not overlap, and there is no risk of double recovery by the insured, and no basis for a subrogation claim by an excess carrier against the settling primary insurer.
The proper trigger of the duty to defend in Johnson Controls IV was not the denial of coverage or exhaustion of limits, but the Johnson Controls-Travelers settlement. Using the date of this settlement as the trigger of London Market’s duty to defend would give Johnson Controls what it bargained for without negatively affecting the rights and obligations of the non-settling excess carrier, London Market.Using the settlement date as the trigger of the duty to defend for an excess insurer would also foster “effective and expeditious resolution of lawsuits.”
 2010 WI 52, 325 Wis. 2d 176, 784 N.W.2d 579.
 184 Wis. 2d 250, 517 N.W.2d 463 (1994).
 2003 WI 108, 264 Wis. 2d 60, 665 N.W.2d 257.
 Johnson Controls IV, 2010 WI 52, ¶ 18.
 Id., ¶ 34.
 Id., ¶ 54.
 Id., ¶ 89.
 Id., ¶ 88.
 Id., ¶ 121.
 Id., ¶ 88.
 23 F.2d 665 (2d Cir. 1928).
 John F. O’Conner, Insurance Coverage Settlements and The Rights of Excess Insurers, 62 Md. L. Rev. 30, 34 n.26 (2003) (internal citations omitted).
 2004 WL 1878764 (N.J. Super. Law Div. July 8, 2004) (unpublished) (internal citations omitted).
 67 F. R. D. 689 (D. Del. 1975), aff’d, 578 F.R.D 1375 (3d Cir. 1978).
 2008 WL 3413327 (Del. Super. Ct. July 31, 2008) (unpublished).
 Id.; see also Koppers Co. v. Aetna Casualty & Surety Co., 98 F.3d 1440, 1454 (3d Cir. 1996) (holding that a policy may be “functionally exhausted” by a settlement). For two cases that adhered to the language in the policies before them and did not follow the Zeig analysis, see Qualcomm, Inc. v. Certain Underwriters at Lloyd’s of London, 161 Cal. App. 4th 184 (2008) and Comerica, Inc. v. Zurich American Insurance Co., 498 F. Supp. 2d 1019 (E.D. Mich. 2007). See also Schmitz v. Great American, 2010 WL 2160748 (Mo. App. 2010) (unpublished); Great American Insurance Co. v. Bally Total Fitness Holding Corp., 2010 WL 2542191 (N.D. Ill. 2010) (unpublished); Citigroup, Inc. v. National Union Fire Insurance Co., 2010 WL 2179710 (S.D. Tex. 2010) (unpublished).
 Newhouse v. Citizens Sec. Mut. Ins. Co., 176 Wis. 2d 824, 501 N.W.2d 1 (1993).
 Gross v. Lloyds of London Insurance Co., 121 Wis. 2d 78, 358 N.W.2d 266 (1984).
 Loy v. Bunderson, 107 Wis. 2d 400, 320 N.W.2d 175 (1982); Teigen v. Jelco of Wisconsin, Inc., 124 Wis. 2d 1, 367 N.W.2d 806 (1985).
Teigen, 124 Wis. 2d at 7 (emphasis added).
 Evanston Ins. Co. v. Stonewall Surplus Lines Ins. Co., 111 F.3d 852 (11th Cir. 1997); Douglas R. Richmond, Rights and Responsibilities of Excess Insurers, 78 Denver U. L. Rev. 29, 72 (2000).
 Calbow v. Midwest Sec. Ins. Co., 217 Wis. 2d 675, 579 N.W.2d 264 (Ct. App. 1998); see also State Farm Mutual Automobile Ins. Co. v. Bailey, 2007 WI 90, 302 Wis. 2d 409, 734 N.W.2d 386 (holding that a first party UIM claim—like first party defense costs—requires that an insurer pay for uncompensated damages in order to prevent a windfall to the insured).
 O'Connor, supra note 12, at 34 n.26.
 Teigen, 124 Wis. 2d at 7.