October 08, 2018

Indemnity Agreements as "Other Insurance" — The Consequences of Unallocated Settlement Proceeds

Lawrence O. Held

Introduction

The typical insurance contract contains an "other insurance" clause that addresses recovery when losses are covered by any other form of insurance. In the case of an excess insurance policy, the “other insurance” clause may simply require that any underlying insurance or self-insurance mechanism be exhausted before the excess policy will take effect. Questions arise when considering what risk shifting mechanisms are contemplated by the other insurance clause. Texas courts have addressed this issue in RSR Corp. v. International Insurance Co., where unallocated settlements with first layer insurance providers triggered the other insurance clause of the excess provider and limited recovery.

A recent case from the United States Court of Appeals for the Fifth Circuit addresses the result when the settlements are pursuant to an indemnity agreement with a subcontractor. In Satterfield and Pontikes Const., Inc., v. Amerisure Mutual Insurance Company, the Court found that an excess insurance provider was justified in denying a general contractor's claim under the assumption that proceeds from unallocated general settlement agreements with subcontractors were allocated first to covered, rather than noncovered, damages.

Facts

Zapata County ("County") contracted with Satterfield and Pontikes Construction, Inc. ("S&P") to construct a new courthouse. S&P then obtained three contractual risk shifting mechanisms. The first of those mechanisms was a series of indemnity agreements S&P entered into with each of its subcontractors. The other two mechanisms were insurance agreements with the American Guarantee and Liability Insurance Company ("AGLIC") and U.S. Fire. The AGLIC policy had a per-occurrence limit of $1 million and an aggregate limit of $2 million. The U.S. Fire policy took effect after any "Other insurance" was drained and provided excess coverage up to a limit of $25 million. The U.S. Fire policy did not provide coverage for damage related to mold, bacteria, or fungi, and did not cover legal fees, attorney's fees, or interest.

S&P soon found need for its risk shifting mechanisms when the project took a wrong turn. The County terminated S&P following several issues in construction and then sued S&P for damages. The parties entered into arbitration and S&P notified its insurance providers and brought its subcontractors in through their indemnity agreements. The arbitration panel awarded the County the following:

  1. $2,800,000 for mold remediation and dome reconstruction;
  2. $855,000 for the replacement of the courthouse roof;
  3. $2,417,000 for fireproofing replacement, window repairs, and cleaning;
  4. $430,458 for prejudgment interest; and
  5. $1,500,000 for reasonable attorney's fees.

S&P subsequently entered into a series of general settlements with its subcontractors. During this process, U.S. Fire informed S&P that it would not object to any "reasonable settlements." The aggregate of the subcontractor settlements was approximately $4.5 million. S&P then looked to its insurance providers to cover the difference. U.S. Fire declined to contribute, arguing that S&P had not exhausted its coverage from "Other Insurance" as defined by its policy. S&P and AGLIC opted to split the difference and then filed suit against U.S. Fire for breaching the policy.

On a motion for summary judgment by both parties, the lower court found for U.S. Fire. The lower court relied on RSR Corp. v. International Insurance Co., holding that S&P had failed to meet its duty to allocate the subcontractor settlements amongst the arbitration awards that they covered. S&P and AGLIC appealed, and the case was heard by the United States Court of Appeals for the Fifth Circuit.

The Court of Appeals addressed two key issues:

  1. Whether the proceeds from the settlements constituted "Other Insurance;" and
  2. Whether S&P had a duty to allocate the proceeds of the settlements to the damages they covered.

Subcontractor Settlements as "Other Insurance"

S&P's argument was that the subcontractor settlements did not constitute "Other Insurance" as defined in U.S. Fire's policy. If S&P was correct, then total covered losses under U.S. Fire's policy should have equated to approximately $2 million after AGLIC's contribution. However, if the subcontractor settlements constituted "Other Insurance," then the retained limit was never reached. In that scenario, U.S. Fire would not have a duty to contribute because the subcontractor settlements exceeded the amount of damages covered under U.S. Fire's policy and the only remaining amounts were from noncovered damages and costs.

In Texas, the interpretation of an insurance policy is a matter of law. To interpret the contract, the court will look to the undisputed facts of the claim and apply the plain language of the policy. Thus, insurance disputes are often resolved at the summary judgment stage as a question of law

Here, the plain language of the policy defined other insurance as a "mechanism by which an Insured arranges for funding of the legal liabilities for which [U.S. Fire's] policy also provides coverage." S&P claimed that the indemnity agreements were simply another form of contractual risk transfer, which by their nature or construction, were intended to shore up leaks or gaps in insurance coverage. However, the Court found that the agreements were not drafted as such, and no authority existed to support the argument. The Court applied the plain language of the policy and ruled that the proceeds constituted "Other Insurance."  With this decision, U.S. Fire avoided roughly $2 million in liability, while S&P lost and was forced to pay the same amount out of pocket.

Insured's Duty to Allocate Settlement Proceeds

The second issue was whether S&P had a duty to allocate the settlement proceeds to the damages they covered. S&P argued that it could allocate the funds as it saw fit to maximize its coverage. S&P based part of its argument on the "Actual Injury" rule of Texas Law, which states that when damage to an insured occurs during a period covered by separate and distinct insurance policies, all of the policies are triggered and the insured may collect from the policy with the highest coverage limit. The Court declined to extend the Actual Injury rule, as the issue was the unilateral allocation of settlement proceeds and the burden was on the insured to identify the portion of a loss that was caused by a covered condition.

The Court's main focus was on the fact that U.S. Fire constituted a nonsettling party. The Texas Supreme Court has previously ruled that nonsettling parties should not be penalized for events over which they have no control. U.S. Fire had no power over the structure or allocation of the proceeds. While U.S. Fire stated that it would not object to any reasonable settlement, the statement was construed as relating to the amount of the settlement and not as permission to allocate the proceeds to noncovered damages. Thus, S&P failed to meet its burden to properly allocate the settlement proceeds.

In both the lower court and the Court of Appeals, S&P attempted to introduce the argument that some of the subcontractor settlements were closely linked to the noncovered damages. For example, the waterproofing subcontractor's work likely caused the mold damage. The argument was rejected on procedural grounds because it was introduced after summary judgment. The Court did, however, comment that even if the argument was timely, the alleged link was not the depth of allocation that U.S. Fire believed it was entitled to and S&P admitted its failure to provide a detailed allocation.  Therefore, contractors should allocate settlement proceeds to specific damages to the greatest extent possible to avoid confusion and denied claims later.

Lessons Learned

The question remains: what depth of allocation was U.S. Fire entitled to? Furthermore, what depth of allocation is permitted? The Texas Supreme Court provided guidance in its ruling in Ellender. When discussing what allocation would have been fair to a nonsettling party, the Texas Supreme Court stated that:

[T]he better rule is to require a settling party to tender to the trial court, before judgment, a settlement agreement allocating between actual and punitive damages as a condition precedent to limiting dollar-for-dollar settlement credits to settlement amounts representing actual damages.

Citing Ellender, the Texas Supreme Court has also stated that "in some contexts, we have permitted settling parties to agree how to allocate settlement proceeds." A settlement agreement allocating proceeds may itself be proof of a proper allocation.

What a practitioner can note is that all methods of recovery must be carefully considered when entering into settlement negotiations with subcontractors. Attorneys should be acutely aware of their state's laws regarding proper and permissible allocation of settlement proceeds. Failure to show proper allocation, and failure to include the excess provider in settlement negotiations, may result in the denial of a claim by the contractor’s excess coverage provider under the "other insurance" clause of the provider's policy.

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Lawrence O. Held

Tri-City Electrical Contractors, Inc., Altamonte, FL, Young Lawyers Division