Can a Drop Down clause in a master policy provide excess layer coverage?

Drop Down clauses in a master policy are designed to provide coverage at the primary level on the terms of the primary policy in circumstances in which primary limits have been exhausted by prior claims. In Flexsys America LP v XL Insurance [2009] EWHC 1115, a claim had exhausted the local policy and excess layer coverage was not available under the master policy due to narrower terms. The question before the court was whether a Drop Down clause in the master policy could operate so as to provide excess layer coverage for that claim on the same terms as the local policy.  Mr Justice Tomlinson held it did not, on the wording in question, but the judgment raises some interesting points on the operation of Drop Down clauses and their interaction with Difference in Limits/Difference in Conditions clauses.

Facts

The Claimant, Flexsys America LP ("Flexsys") was a United States corporation and part of a worldwide group of companies specialising in the manufacture and distribution of chemicals (the "Flexsys Group"). The Flexsys Group had in place a global insurance programme consisting of a Master Policy for Public and Products Liability (underwritten by XL Insurance Co Ltd ("XL Insurance")) which insured the Flexsys Group and was subject to English law (the "Master Policy"); and a number of local policies, which insured subsidiaries in various jurisdictions. Flexsys was insured under one such local policy for Public and Products Liability, which was subject to Ohio law, by XL Select Insurance Company ("XL Select"), a US insurance company (the "Local Policy").

Flexsys was sued in the District Court of the Central District of California by a Korean company making allegations of improper and illegal conduct against Flexsys and others. The Complaint was amended and dismissed several times and, at the time of judgment in the present case, there was an appeal to be heard by the US Court of Appeals for the Ninth Circuit on the latest dismissal of the claim. Flexsys had incurred costs of around US$2,000,000 in defending the claims and the Local Policy included on the part of XL Select a "duty to defend". In the first instance, Flexsys sought an indemnity under the Local Policy in respect of those legal costs under the cover provided for "Personal and Advertising Injury Liability". XL Select eventually agreed a settlement with Flexsys in the sum of US$1,000,000, which was both the general aggregate limit and the specific limit for the claim under the Local Policy. Under the settlement agreement XL Select expressly did not admit the existence of coverage.

In the present case, Flexsys sought the balance of its legal costs incurred to date and a declaration of a right to an indemnity under the Master Policy up to the US$25,000,000 aggregate limit of indemnity in respect of costs to be incurred and any damages that subsequently become due pursuant to the Californian action. The claim was based on a Drop Down clause in the Master Policy, which Flexsys argued operated in the present circumstances to drop the Master Policy into the place of the Local Policy, subject to the terms and conditions of the Local Policy, but bringing with it the higher limit of indemnity provided by the Master Policy. XL Insurance denied that interpretation. The Master Policy, XL Insurance said, would not provide excess layer coverage where a claim was recoverable under the Local Policy but not the Master Policy and also argued that, based on the allegations made in the Californian action, there was no coverage under the Local Policy in any event.

The Master Policy

The arguments of the parties were based on alternative constructions of the following memoranda:

"Memorandum C: Difference in Limits

With regard to Insured domiciled outside Great Britain, Northern Ireland, the Channel Islands or the Isle of Man the Insurer shall pay up to the Limit of Indemnity under this contract but only in respect of that part of the loss which exceeds the Limit of Indemnity of the policies issued locally and the total Limit of Indemnity under this contract shall be reduced by the amount of the Limit of Indemnity provided under the Local Policies.

Memorandum D: Difference in Conditions

This Policy will provide indemnity where the terms and Conditions hereon are broader than the local policy for an Insured company outside Great Britain Northern Ireland the Channel Islands or the Isle of Man in respect of claims made which are not recoverable under such local policies.

Memorandum E: Drop Down Clause

In the event of partial exhaustion of a local policy this Policy will pay in excess of the reduced underlying Limit of Indemnity
In the event of total exhaustion of a local policy this Policy will continue in force as the underlying insurance subject to the terms Exceptions and Conditions of the particular local Policy."

There was no duty to defend under the Master Policy and defence costs were only recoverable if incurred with insurer consent.

The principal reason why Flexsys made its claim under the Drop Down clause was that it was not open to Flexsys to rely on Memorandum C and the excess coverage thereby provided as the claim did not fall to be indemnified under the terms of the Master Policy (the terms of the Master Policy being more narrowly drawn on coverage for "Advertising Injury").

Judgment

Mr Justice Tomlinson considered quite briefly the purpose of Master Policies and Drop Down clauses. In the absence of expert evidence, and based on an agreed statement of facts between the parties, the Judge noted that there were several different clauses in use in the London Market and that each clause must be construed according to its own terms. The agreed statement noted that, in a global insurance programme, master policies usually provide cover in excess of the local polices (as was the case here). However, the question of how a particular Drop Down clause operated and, in the present case, whether it provided the excess coverage sought by Flexsys, would depend on the terms of the policy. Construing the Master Policy, Tomlinson J gave several reasons why XL Insurance's construction of the relevant terms was preferable.

First, Tomlinson J observed that Memorandum D dealt with cases in which the terms of the Master Policy were broader than the Local Policy and yet was silent on the converse situation. From that it was implicit that the Master Policy would not ordinarily respond in circumstances in which the Master Policy was narrower than the Local Policy and a claim fell to be indemnified under the Local Policy but not the Master Policy.

Second, Tomlinson J held that if Flexsys were correct in its arguments, the terms of the Master Policy limiting cover for liability for Advertising Injury would be meaningless. If so, the Master Policy would respond to a claim that was not covered according to its terms and on more favourable terms than the Local Policy since the US$25,000,000 limit of indemnity would apply. A further oddity would be that there would be a duty to defend and indemnify legal costs up to that limit of indemnity when the Master Policy contained no such duty and, in fact, provided that defence costs were only recoverable when incurred with insurers' consent.

Third, Tomlinson J noted it was common ground that the first sentence of Memorandum E was designed to resolve an ambiguity caused by Memorandum C. It was to make plain that, in the event of prior claims partially exhausting the limit of indemnity under the Local Policy, the Master Policy would provide coverage to the extent that a claim exceeded the limit of indemnity remaining unexhausted under the Local Policy and not only to the extent it exceeded the underlying aggregate limit. A similar meaning should be attached to the word "exhaustion" in the second sentence of Memorandum E as referring to prior claims. In other words, the second sentence of Memorandum E provides for a reinstatement of the Local Policy when prior claims have exhausted the limits of the Local Policy and did not provide excess coverage when those limits had been exhausted by the instant claim. That construction was also consistent with cover under the Master Policy "dropping down" to the primary level on the same terms as the primary cover and not operating as an excess layer.

Fourth, Tomlinson J considered that Flexsys' interpretation of the Drop Down clause required a rather unnatural reading to be attached to the phrase "subject to the terms, Exceptions and Conditions of the particular Local Policy" in Memorandum E in that those terms would not include the limits of indemnity under the Local Policy.

Having decided the claim in favour of XL Insurance on that point, the issue of coverage under the Local Policy did not arise for determination. However, as the Court had heard evidence on the point and in case the claim proceeded to appeal, Tomlinson J gave his conclusions on the issue, which were that the claim was not covered under the Local Policy.
 

Comment

Tomlinson J made clear that this case, involving an exceptional claim under the Advertising Injury extension rather than a paradigm claim under the Public and Products Liability coverage, turned on the interpretation of the particular policy in issue. Nevertheless, although Tomlinson J declined to make any general statements on the operation of Drop Down clauses and/or master policies, it is helpful that the judgment is in line with market perceptions as to how Drop Down clauses operate.

In light of the discussion insurers may wish to review wordings of Drop Down clauses currently in use and ensure that there is no risk of ambiguity leading to similar (and unexpected) claims. Although XL Insurance was vindicated on the terms of the Master Policy and Drop Down clause in issue, it would be preferable for insurers and insureds alike to have clarity as to the operation of these important provisions.

The claim arose only because of the difference in cover provided by the Local and Master Policy for the underlying claim made against Flexsys. Whilst the Difference in Conditions coverage in the Master Policy gave the insured some comfort that it would have at least the breadth of indemnity in the Master Policy, even if coverage under the Local Policy was less extensive, the same was not true where the Local Policy coverage was more generous than the Master Policy. If insurers and insureds intend that the coverage under the Local and Master Policy (as excess coverage) should be co-extensive, then express language would be required to make clear that the Master Policy does not just fill gaps in the Local Policy cover but also expands as required to provide a corresponding indemnity where the Local Policy coverage is broader. Such an outcome, if achievable on commercial terms, does not compromise the proper operation of a Drop Down clause, which is directed towards the situation where limits under the Local Policy are exhausted by prior claims.

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© Herbert Smith LLP 2009