By Donald S. Malecki, CPCU

It is not unusual today to hear derogatory remarks about umbrella liability policies. They have long been criticized for having holes in them, or for providing less coverage than their scheduled underlying policies. In fact, in an earlier column I stated emphatically that the umbrella liability policy no longer exists.

Still in existence are excess liability policies that provide higher limits in the event the limits of scheduled underlying policies are deemed to be inadequate to cover some catastrophic event. In fact, excess policies are recommended when all of the important primary coverages are in place and all that is necessary are excess limits.

Excess policies are typically written in one of four ways:

* Stand-alone excess. This is a self-contained policy that consists of all of its own terms and conditions. It does not incorporate any of the terms and conditions of the underlying policies.

* Straight excess. This policy does nothing more than provide excess limits. It is commonly used as a buffer layer to qualify an insured for an umbrella or excess when the limits of underlying policies are inadequate. For example, an excess insurer may require a primary limit of $1 million in a case where only $500,000 is available. In this case, it is necessary to obtain a buffer layer of $500,000. Buffer layers are common during hard markets, and for entities with consistently poor loss history that desire liability coverages above the usual primary policies.

* Follow form excess. This policy is intended to provide exactly the same coverage terms and conditions as the underlying policies (other than for limits). Its significance is that in the event of a conflict with the terms or conditions of the primary policy, it is the primary policy's terms or conditions in question that control.

It is rare to find this type of policy today and that is the reason why reference to the term "follow form" or "following form" is a misnomer. The question that needs to be asked when a policy is referred to as "follow form" is: What policy controls in the event of a conflict, the excess policy or the underlying one? Chances are the excess policy will control.

* Conditional follow form excess. This is the most common type of follow form excess liability policy. It is the antithesis of the follow form excess because, in the event of a conflict with a primary policy, the terms and conditions of the conditional follow form policy take precedence. For example, if the conditional follow form contains an absolute pollution exclusion and the primary CGL policy contains the usual unendorsed pollution exclusion built into the policy, the conditional follow form excess policy will not provide pollution coverage.

Like umbrella policies, many excess liability policies also drop down over reduced or exhausted underlying aggregates. If these policies are silent on this point, they are implied to do so, since an insurer can easily say otherwise.

Combination excess and umbrella policy

In addition to the foregoing types of excess liability policies, there is yet another "breed" of umbrella coverage known as the "A/B Format." It, in essence, is a combination of both an excess and umbrella liability policy. The letter "A" commonly connotes the excess coverage, and the letter "B" signifies umbrella liability coverage.

Approximately 20% of insurers provide this format. In fact, the American Association of Insurance Services (AAIS) offers this policy for its member companies. Its policy more appropriately refers to the excess coverage with the letter "E" and umbrella coverage with the letter "U." Whatever symbols are used, this type of policy probably was introduced not only to be more competitive but also to be more accommodating to insureds who maintain primary coverages written both on occurrence and a claims-made basis.

The "A" portion of these policies (excess) is generally conditional following form. As mentioned above, this means that if there is any conflict between the terms or conditions of the excess and primary policy, the excess policy takes precedence. The "B" portion of the policy is simply an umbrella policy as buyers and sellers have come to associate that term.

Probably the best way to explain this A/B Format is this way: If coverage applies to a primary exposure, excess "A" coverage likewise applies. If coverage "A" does not apply, then coverage "B" is triggered, subject to its terms and conditions. One of the important exceptions of when both "A" and "B" could apply is when the coverage of the primary policy and excess "A" part is exhausted and additional coverage and defense are required. When this happens, coverage "B" must respond, since it is intended to apply when there is no coverage under "A."

Admittedly, it is going to be difficult to find coverage under the "B" portion (other than the defense scenario mentioned above), because the umbrella coverage is likely to be as restrictive as it would be if the policy were written as a stand-alone one. For example, it is not unusual for part "B" umbrella to flatly exclude personal and advertising injury coverage. Therefore, what personal and advertising injury coverage is applicable will be provided by the primary policy part "A" of the A/B Format policy.

Coverage falling through the cracks

An actual case where an insured was able to obtain umbrella coverage under its A/B Format policy, contrary to the expectations of the insurer, is Westview Associates v. Guaranty National Insurance Company, 717 N.Y.S. 2d 75 (Ct.App.2000).

The case arose when an infant (tenant) allegedly sustained injuries by exposure to lead paint, and her parents filed suit against the landlord (insureds). The insurer refused to provide the insureds with defense or indemnity, relying on the lead paint and pollution exclusions of the underlying CGL policy, and the pollution exclusion in the A/B Format policy. What the insurer evidently did not understand is that to deny coverage properly, Coverage B would have had to contain the lead exclusion, too.

The insureds purchased a CGL policy that contained a lead paint exclusion. The umbrella/excess policy the insureds purchased consisted of the A/B Format liability policy. Coverage A read in pertinent part: "We will pay those sums the 'insured' becomes legally obligated to pay as damages arising out of an 'Occurrence' which are in excess of the 'Underlying Insurance' stated in Schedule A of this policy. The coverage provisions of the Scheduled 'Underlying Policies' are incorporated as part of this policy."

Coverage B of this policy read: "With respect to any loss covered by the terms and conditions of this policy, but not covered as warranted by the 'Underlying Policies' listed in Schedule A, or any other 'Underlying Insured,' we will pay on your behalf for loss caused by an 'Occurrence' which is in excess of the 'Retained Limit' for liability imposed on you by law or assumed by you under contract for 'Bodily Injury,' 'Personal Injury,' 'Property Damage,' or 'Advertising Injury.'"

Since the insured's CGL policy contained a lead paint exclusion, so, too, did Coverage A of the excess policy, since "A" is never broader than the underlying. In the words of the court, "Coverage A contains a provision specifically incorporating the 'coverage provisions' of the underlying policy. Indeed, by definition, 'excess' coverage covers the same types of claims as the primary policy, but for additional amounts."

By contrast, said the court, Coverage B provides additional primary coverage for injuries not covered in the underlying policy. Unlike Coverage A, added the court, Coverage B does not incorporate the exclusions contained in the underlying policy. "Significantly, there is no incorporation-by-reference clause in Coverage B and no exclusion for lead paint appears there," said the court.

The court observed that Coverage B contained specific exclusions for other types of injuries, including alcohol, asbestos and pollution claims, but not for lead paint. These provisions would have been completely unnecessary, said the court, if, as the insurer argued, all of the exclusions in the CGL policy are incorporated by reference into the entirety of the umbrella/excess policy.

The court in this case did a nice job of explaining the mechanics of this policy. In doing so, it concluded, in part, that Coverage A and B serve different purposes. Coverage A provides excess coverage, and Coverage B provides additional primary coverage not addressed by the primary policy.

In disputing the lower court's decision, the higher court here stated that if Coverage B incorporated the exclusions in Coverage A, it would negate Coverage B and leave the insured with only the excess protection of Coverage A.

An additional surprise

As a general rule, an umbrella policy was meant to be written to apply over scheduled underlying policies. Although excess liability policies can be written to apply directly over scheduled underlying policies when no umbrella policy is available, the common use for an excess policy is above an umbrella policy, or as a straight excess, providing buffer layers up to the desired limit.

What sometimes happens is that underwriters will issue umbrella policies in place of straight excess coverage in the upper layers of an entity's insurance portfolio. How that may work in the event of a catastrophic loss often takes a lot of time and energy to figure out. It is sometimes referred to as a "lawyers' bill of rights."

Where the big surprise to insurers often comes is when excess layers are written above the A/B Format policy, and the excess layers are transformed into the identical A/B Format policy below them! It is somewhat complicated to discuss here, given space limitations, but suffice it to say, the excess layer applies coverage excess to Coverage A of the A/B Format, subject to the terms and conditions of the above excess layer in the event of any conflict between the two policies.

However, the Coverage B of the A/B Format policy also is incorporated into the excess layer(s), because it is not in conflict with any portion of the above excess layer's insuring agreement, since the two coverages are totally different in concept. Thus, the excess layer(s) incorporates all of the Coverage B's terms and conditions that are not in conflict--the result being that the Coverage B insuring agreement and all terms that do not conflict with the excess layer(s) are incorporated into, and form a part of, the excess layer(s).

How underwriters can avoid this transformation from occurring may be a subject for a future article. For purposes here, it is necessary to mention only that when all excess layers above an A/B Format policy are transformed into that same A/B Format, some advantages may be possible. For one thing, the defense coverage of these excess layers may be activated much sooner than the insurer has planned.

Conclusion

It is more than likely that because the insurer mentioned above had to honor coverage for the lack of a lead paint exclusion in its A/B Format policy, it now has one, making it more difficult to trigger that policy's coverage for lead
paint poisoning.

That is the general idea of an A/B Format policy--that is, to cover the truly unexpected, catastrophic loss that is unforeseen but nonetheless possible. All other large losses that are more possible and likely to happen are to be taken care of by primary and excess layers.

The problem, of course, is when an unexpected and catastrophic loss occurs that may be subject to Coverage B of the A/B Format. When producers have time on their hands, they should ponder some examples in the event they are asked by their clients who, incidentally, are becoming more inquisitive with each passing year.

In querying one underwriter about this A/B Format policy, I was told that the insurer made Coverage B subject to many exclusions because it does not want any surprises. That is a warped philosophy! This idea, in essence, is to put the matter of surprise onto the insured who is the one least likely to be able to handle an unexpected, catastrophic loss.

This latter situation often is referred to in risk management parlance as "passive retention" or surprise! However, the surprise is on the consumer who can least afford to assume big losses, and has no ability to spread the risk. For the time being, it would be in the best interests of producers to add "excess" to their vocabulary and to use that term in the place of the term "umbrella" when addressing the catastrophic exposures of clients.

The author

Donald S. Malecki, CPCU, is chairman and CEO of Donald S. Malecki & Associates, Inc. He is an active member of the CPCU Society, on the Examination Committee of the American Institute for CPCU, and is an active member of the Society of Risk Management Consultants.