While most individuals probably think their insurance covers them for every conceivable occurrence, many policies have numerous gaps in coverage. Excess liability coverage can close these gaps, but even these policies contain traps for the unwary. The authors examine the complex issues surrounding excess liability insurance, outlining several pitfalls that, if ignored, could leave individuals dangerously uninsured.
* * *
Many of the financial planning services being offered by CPAs, such as retirement, estate, and investment planning, involve significant risk management, including making certain that clients are adequately insured. This article identifies individuals for whom one type of insurance—excess liability insurance—could be essential rather than excessive. In addition, it identifies some of the complexities involved in determining the adequacy of protection offered by these types of policies.
What Is Excess Liability?
Most individuals and businesses need multiple layers of liability insurance. Related layers combine to form a block of protection that, if properly constructed, leaves policyholders insulated from losses from which they cannot recover. The first layer of liability insurance is typically referred to as “primary” or “underlying” insurance. Additional layers of protection—the “excess liability” insurance—are only triggered by claims that exceed the benefit limits of the primary layer or are not covered by it at all.
Excess insurance usually takes one of two basic forms. First, there are “follow-form” policies, which typically provide excess coverage under the same conditions detailed in a designated underlying policy, also called “vertical coverage;” Exhibit 1 shows an example of such a policy. Second, there are “umbrella” policies, which provide vertical coverage, but also expand liability protection to include events not covered by the underlying policies. For example, an umbrella policy might include liability coverage for operators of watercraft where the underlying auto liability policy does not; this is called horizontal coverage, demonstrated in Exhibit 2. In practice, there can be considerable overlap between these two forms of policies, which often results in “excess liability” and “umbrella” being used interchangeably. Accordingly, this article uses “excess liability” to describe both follow-form and umbrella policies.
Who Needs Excess Liability Insurance?
A simple cost/benefit analysis would likely indicate that all individuals and businesses should have excess liability protection. The benefit limits of these policies are often larger than those of primary policies—$1 million, $5 million, or much more. While this may sound expensive, excess liability is typically very affordable because it only comes into play for claims large enough to exhaust the benefits of underlying insurance. When necessary, strategies can often be found for making excess insurance even more affordable. For example, one may be able to raise the property damage deductibles of underlying policies and use the savings to cover the cost of excess liability policies.
All individuals with a net worth in excess of their liability insurance are underinsured, but they may also be underinsured even when liability protection exceeds net worth. Legal judgments can force a client to pay damages not only from existing net assets, but from future earnings as well. Anyone with significant time remaining before retirement and annual earnings of $100,000 or more should probably have more than $1 million in liability insurance protection, regardless of current net worth.
Soft data should also be considered when determining adequate liability protection. For example, individuals who own rental property, second homes, or boats could need substantially more protection than those without such assets, and individuals in the public eye often need more coverage for libel or slander than typically provided by primary polices. Additional factors that increase exposure to liability claims include dog ownership, swimming pools, teenage drivers, frequent entertaining, and serving on not-for-profit boards. For example, a Home Owners’ Association (HOA) board member could be sued for damages relating to a decision made by the board. Standard homeowners insurance often does not provide liability coverage for activities in service to an HOA, but many umbrella policies do.
Like personal umbrella policies, commercial umbrella policies usually provide coverage in excess of multiple underlying policies. For example, a single commercial umbrella policy might provide liability coverage in excess of a commercial general liability policy (CGL), a business auto liability policy, and an employer’s liability policy. Commercial excess policies are essential for businesses with considerable assets and those in industries with a greater risk of litigation. Additional care should be taken to protect a business owner’s personal assets against commercial liability claims.
Complexities in Assessing the Adequacy of Liability Protection
Although the insurance industry has produced widely used, standardized forms for many types of primary insurance, the same cannot be said for excess insurance. This complicates risk assessment and necessitates a careful reading of the policy when looking for coverage gaps. When looking for loss potential in a multilayered block of liability insurance, five areas deserve special attention: exclusions, defense obligations, exhaustion of coverage, drop-down provisions, and financial strength ratings.
While it is possible for excess liability policies to contain endorsements guaranteeing coverage “at least as broad” as the underlying insurance, it is rare. Liability coverage in both underlying and excess policies is limited by policy exclusions, and policyholders may face substantial risk when unaware of inconsistencies in policy language. For example, an umbrella policy may define property damage more restrictively than an underlying CGL policy, exposing the insured to potential losses.
Even when exclusions are similar, coverage gaps can occur if the events triggering indemnity are not congruent across policy layers. For example, a product liability claim might trigger a CGL when a consumer’s injury occurs, but excess liability coverage might be triggered when the defective product was manufactured. If no excess policy was in place at the time of manufacture, the insured could be vulnerable to unexpected losses.
Imagine a business owner purchases a $2 million umbrella policy with drop-down coverage to provide vertical protection in excess of both a CGL policy and a business auto policy, each with a $1 million benefit limit. Although the policyholder owns a 38-foot boat, the business auto policy completely excludes watercraft protection, the CGL policy provides watercraft protection only on vessels less than 26 feet and not owned by the policyholder, and the umbrella policy provides liability coverage on any vessel less than 50 feet. In addition, the CGL provides liability protection for bodily injury and cleanup related to some pollution incidents, while the umbrella policy only covers bodily injury. Lastly, both the CGL and business auto policies cover punitive damages, while the umbrella policy does not. Ignoring deductibles, Exhibit 3 maps gaps in the coverage described above.
While it is true that primary insurers typically have an obligation to defend the policyholder, this obligation may not extend beyond the benefit limits of the policy, and while some excess liability policies come with their own defense benefits, others do not. It is also important to note that most excess policies will include a “right” or “option” to participate in the policyholder’s defense, rather than an obligation. These provisions are intended to protect the insurer—not the policyholder. The excess insurer will not have a duty to defend when the excess policy does not explicitly require it.
Sometimes the defense benefit in excess liability policies is not an obligation to defend, but simply reimbursement of defense costs, which could create significant cash flow burdens for a policy-holder. Furthermore, obligations to reimburse defense costs and obligations to defend are not equivalent, since reimbursement will likely occur only if the liability is deemed to stem from an event covered by the policy.
Self-insured retentions in umbrella policies can create another source of risk. In claims covered by an umbrella policy but not the underlying policy, a self-insured retention (similar to a deductible) typically applies. In most cases, the retention amount does not apply to defense costs. When defense costs are borne by the policyholder until retentions are met, multiple claims can rapidly multiply losses.
Finally, defense costs can affect benefit limits. Policy language will dictate whether the defense obligations of primary and excess insurers are “within” limits or “in addition” to limits. When defense costs count against benefit limits, the true level of liability protection may create more exposure than the policy-holder realizes.
Exhaustion of coverage.
Generally, the indemnity obligations of excess liability insurers begin only after the obligations of the underlying insurer have been exhausted. Nevertheless, it can be important to determine exactly how exhaustion of coverage is defined by an excess policy. For example, Allen has $500,000 in primary liability coverage and $1 million in excess liability coverage. Allen causes an accident that results in an $800,000 judgment against him. Due to some ambiguity in the extent to which the accident is covered by the primary policy, he plans to meet his $800,000 obligation by settling with the primary insurer for $450,000, paying an additional $50,000 out-of-pocket, and collecting the remaining $300,000 from his excess insurer. On the surface, it would seem that Allen is entitled to this amount because his total liability exceeds the maximum benefit of the primary insurance. But was the primary insurance benefit exhausted, given that it was not paid to Allen?
Since 1928 [Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 665 (2d Cir. 1928)], most courts have held that actual payment of underlying policy benefits is not a prerequisite for determining the indemnity obligations of excess insurers. More recent decisions, however [Comerica, Inc., v. Zurich American Insurance Co., 498 F.Supp.2d 1019 (2007); Qualcomm, Inc., v. Certain Underwriters at Lloyd’s, 161 Cal. App. 4th 184 (2008)] have held that language in an excess policy can be constructed to explicitly prohibit claim coverage if the policyholder settles with the primary insurer for less than the underlying policy’s benefit limit. Even the Zeig court noted that the excess insurer in that case could have written the policy with this binding contractual provision if it had wanted to.
Exhaustion can also be complicated by policy periods. If the policyholder fails to maintain underlying and excess policies with the same inception and expiration dates, exhaustion of coverage may be viewed differently by the underlying and excess insurers, creating the potential for another gap in coverage. Consequently, each comprehensive risk assessment for clients with excess liability policies should include making certain that concurrent policy periods have been maintained despite any other insurance changes that might have occurred.
For example, imagine that Aaron has underlying and excess policies with policy years ending June 30. The aggregate limits of the underlying and excess policies are $1 million and $10 million, respectively. The excess policy provides drop-down coverage (see below) if the $1 million aggregate limit of the underlying insurance is exhausted during a policy year. On January 1, Aaron makes changes to his primary insurance, which results in a new policy year ending December 31. In a subsequent year, Aaron has two claims of $700,000 each, one in May and the other in August. In May, the primary insurer pays the entire $700,000. In August, the primary insurer only pays $300,000 because of exhausting the aggregate limit of the policy period ending December 31. The excess insurer, however, pays nothing because from its policy year perspective (July 1–June 30), Aaron has not exhausted $1 million of primary insurance benefits. Aaron is left with a $400,000 out-of-pocket liability.
In addition to providing coverage after per-occurrence limits of underlying policies have been exhausted, excess policies often “drop down” to replace underlying insurance coverage when the aggregate limits have been exhausted. For example, Beverly has a primary CGL policy with a $750,000 per-occurrence limit and a $1 million aggregate limit. She also has a $5 million excess liability policy with drop-down coverage and no deductible for claims also covered by the primary insurance. Beverly has two $800,000 claims in the same policy year. The primary insurer pays $750,000 of the first claim, and the excess insurer pays the $50,000 in excess of the per-occurrence limit of the primary insurance. Despite the $750,000 per-occurrence limit of the primary policy, the primary insurer only pays $250,000 of the second claim because it reaches the primary policy’s $1 million aggregate limit ($750,000 + $250,000). The excess insurer will drop down to replace the primary coverage and pay the entire $550,000 portion of the claim in excess of the primary insurance’s aggregate limit.
Some excess policies, however, contain endorsements excluding drop-down obligations and potentially obscuring the true liability exposure of policyholders. It is important to review excess policies for these potential gaps in coverage. For example, Kevin has a primary CGL policy with a $500,000 per-occurrence limit and a $750,000 aggregate limit. He also has a $5 million excess liability policy, which excludes drop-down coverage by stating that coverage only applies to liability claims in excess of $500,000. Kevin has two $600,000 claims in the same policy year. The primary insurer pays $500,000 of the first claim, and the excess insurer pays the remaining $100,000. The primary insurer only pays $250,000 of the second claim because of reaching the policy’s $750,000 aggregate limit. Because the excess insurer has no drop-down obligation, it only pays the $100,000 on the second claim (the amount in excess of $500,000), leaving Kevin with a $250,000 out-of-pocket liability.
Some excess policies contain endorsements excluding drop-down obligations.
Financial strength ratings.
In addition to reviewing policy language, individual risk assessments should include a review of the primary and excess insurers’ financial strength ratings. True risk exposure can easily be obfuscated when insurers are in poor financial health. Losses attributable to the insolvency of insurers are sometimes mitigated by policy language. For example, primary insurers may be required to defend a policyholder even against claims that exceed the policy’s benefit limits. Alternatively, excess insurance may provide coverage in excess of “amounts recoverable” from primary insurers even if insolvency prevents the exhaustion of benefits [Reserve Insurance v. Piscotta, 30 Cal. 3d 800 (1982)]. The most prudent way of avoiding losses of this nature, however, is to choose insurers financially sound enough to pay claims.
Affordable Protection from Enormous Losses
With the risk of litigation increasing and the size of jury awards growing, policyholders on the wrong side of liability actions can face enormous loss potential. Excess liability insurance offers an affordable means of insulating an individual or business’s assets and earnings potential from such catastrophic events. How much liability insurance is enough? The answer varies, but few should risk being without the protection altogether, since the potential for loss cannot be measured until it’s too late to do anything about it.