In an insurance dispute arising from coverage of two ERISA settlements, the Ninth Circuit held that—as a matter of first impression—an excess insurer may not challenge the coverage decisions of underlying insurers, absent evidence of fraud or bad faith or a contractual provision reserving the right to challenge such decisions (AXIS Reinsurance Co. v. Northrop Grumman Corp., (9th Cir. Sept. 14, 2020)).

The employer-defendant in this case sponsored several employee savings and retirement plans and had three layers of coverage under an employee benefit plan fiduciary liability insurance program. The coverage consisted of a $15 million primary insurance policy, a $15 million first-tier excess policy, and a $15 million second-tier excess policy (see Practice Note, Insurance for ERISA Fiduciaries). The plaintiff in this case was the second-tier excess insurer.

In 2016 and 2017, the employer settled two lawsuits alleging violations of ERISA and sought coverage, as a result, from its insurers (see ERISA Litigation Toolkit). The first lawsuit was brought by the DOL and settled for an undisclosed amount that exhausted the limit under the primary policy and triggered coverage under the first-tier excess policy. (This lawsuit included allegations that the employer and plan fiduciaries permitted excessive fees and failed to remove an underperforming equity fund from its retirement plan.) The second suit, which was brought on behalf of a plan:

The second-tier coverage covered $9.7 million of the second settlement. Although it did not initially contest the second settlement's validity, the second-tier excess insurer informed the employer that it would seek reimbursement of the first settlement (involving the DOL), on the grounds that the first settlement was not for a covered loss under the policy. The second-tier insurer reasoned that the DOL settlement constituted "improper erosion" of the underlying policy limits and prematurely triggered coverage under the second-tier policy for the second settlement.

A district court ruled in favor of the second-tier excess insurer, and the employer appealed.

Reversing on appeal, the Ninth Circuit concluded that there was no general rule supporting the second-tier insurer's improper erosion theory. According to the Ninth Circuit, the dispute was governed by a 2019 case in which a district court held that excess insurers may not challenge underlying insurers' coverage decisions, absent a showing of fraud or bad faith or a contractual provision reserving that right (Costco Wholesale Corp. v. Arrowood Indem. Co., 387 F. Supp. 3d 1165 (W.D. Wash. 2019) ("Costco")). In adopting the Costco rule, the Ninth Circuit reasoned that an excess insurer may still challenge a claim for coverage under its excess policy, regardless of the underlying insurers' coverage determination concerning that claim. In this case, however, the second-tier excess insurer had failed to challenge coverage of the second settlement under its policy.

Applying the Costco rule, the Ninth Circuit reasoned that:

Given the Ninth Circuit's rejection of the improper erosion theory, the court did not rule on whether the employer's DOL settlement violated California's public policy against the use of insurance benefits to compensate an insured for disgorgement. (Regarding disgorgement as a remedy in ERISA fiduciary breach litigation, see Legal Update, In Fiduciary Litigation, VEBA Trust Assets Were ERISA Plan Assets: Damages.)

In this regard, the Ninth Circuit observed that—because the DOL settlement occurred out of court—there were no judicial findings or stipulations concerning the portion of the settlements that represented disgorgement (if any). The court also noted that, even assuming the DOL settlement required disgorgement and therefore was uninsurable under California law, the second-tier excess insurer was the wrong insurer to raise that issue in the current litigation. (Rather, the primary and first-tier excess insurer would have needed to raise the issue as a defense.) This meant that the Ninth Circuit's holding prohibiting excess insurers from second-guessing underlying insurers' payment decisions applies even as to prior payments for losses that are uninsurable under state public policy.

As the Ninth Circuit's ruling makes clear, benefits-related disputes between employer/plan sponsors and their insurance carriers will require analysis of the contractual terms governing such relationships. These contracts might include provisions giving an insurer the right to challenge prior payments, if not otherwise prohibited by applicable law. Though the litigation addressed above involved excess insurance policies and retirement plans, such relationships also arise in other benefits contexts—for example, between the employer/plan sponsor of a self-funded health plan and its stop-loss insurer (see generally Legal Update, Guidance Addresses ERISA Preemption of State Stop-Loss Insurance Laws and More).