Policyholders seeking insurance funds to settle a case often face an insurer’s demand that some amount should be allocated to uncovered claims or parties.  The issue arises often under directors and officers liability (D&O) policies, when settlements resolve the liability of covered directors and the uncovered company.  But general liability insurers also demand to “allocate” settlements, suggesting, for example, that half of the settlement is uncovered because the complaint alleges both negligent and intentional conduct.  Surprisingly, California courts have not clearly addressed the issue outside of the D&O context.  How should you respond? 

For D&O policies, courts first recognized the “larger settlement rule” in Harbor Ins. Co. v. Cont’l Bank Corp., 922 F.2d 357, 368 (7th Cir. 1990).  The question there was how to allocate a settlement between the potential liability of the covered directors and officers, and of the uncovered company.  The court held that the insurer is liable for the entire settlement, except for the amount, if any, by which the settlement was made larger because of claims against uninsured parties.  In other words, if the same dollars were paid to settle the potential liability of both, those dollars must be allocated to the covered claims against the directors and officers.

The Ninth Circuit affirmed the larger settlement rule in Nordstrom, Inc. v. Chubb & Sons, Inc., 54 F.3d 1424, 1433 (9th Cir. 1995) (Washington law); and Safeway Stores, Inc. v. Nat’l Union Fire Ins. Co., 64 F.3d 1282, 1287 88 (9th Cir. 1995) (California law).

While the larger settlement rule has mostly been applied in cases involving D&O policies, it has been applied to other insurance policies.  In PMI Mortgage Ins. Co. v. AISLIC, 2006 U.S. Dist. Lexis 82623 (N.D. Cal. 2006), amended 2007 U.S. Dist. Lexis 47079 (2007), affirmed 2008 U.S. App. Lexis 17885 (9th Cir. 2008), the court applied the larger settlement rule to a case against a mortgage insurer alleging violation of federal and state laws.  The court ruled that under the larger settlement rule, AISLIC’s Professional Liability Insurance policy covered the entire settlement because AISLIC failed to provide any evidence “to carry its burden of identifying, allocating, and quantifying, by dollar amount or percentage, any portion of the Baynham settlement to any of the three exclusions it invokes.”  2006 U.S. Dist. Lexis 82623 at *21 (emphasis added).  Peterson Tractor v. Travelers, 2005 U.S. App. Lexis 25559 (9th Cir. 2005), on remand at 2006 U. S. Dist. Lexis 20050 (N.D. Cal. 2006), applied the same methodology, though not the rule expressly, to a settlement under a general liability policy.

The larger settlement rule is, by another name, the same rule and rationale applied by California courts addressing allocation of defense costs under general liability policies.  In Buss v. Super. Ct., 16 Cal. 4th 30 (1997), the Court held that when an insurer seeks reimbursement of defense costs expended in connection with covered and uncovered claims, it can only recover “[d]efense costs that can be allocated solely to the claims that are not even potentially covered.”  Buss, 16 Cal. 4th at 52 (emphasis added).  Payments that can be allocated jointly to both covered and uncovered claims “by definition . . . are fully attributable” to covered claims.  Id. at 52-53. 

Buss’s holding that an insurer is obligated to pay all defense costs except those paid solely for uncovered claims applies equally to settlements.  When an insurer is asked to fund a settlement that resolves liability for covered claims and parties, the insurer is merely doing what the policy requires: “the insurer has been paid premiums by the insured” and thereby “bargained to bear these costs.”  Buss, 16 Cal. 4th at 49.  If the insurer does not incur any additional cost to obtain a release at the same time of uncovered claims, it should not obtain a windfall by seeking to “allocate” amounts that, as the Court observed in Buss,  were “required in any event.”  16 Cal. 4th at 53 n.15.  Only amounts paid “solely” to settle uncovered claims should be allocable. 

One case, LA Sound USA, Inc. v. St. Paul Fire & Marine Ins. Co., 156 Cal. App. 4th 1259 (2007), seems to apply Buss’s “heavy” burden to a general liability insurer seeking reimbursement of settlement as well as defense costs, but after it succeeded in rescinding the policy.  The result was left to the trial court on remand.  Notably, the California Supreme Court in State of California v. Allstate Ins. Co., 45 Cal. 4th 1008 (2009), held that to the extent that environmental damage resulted from both insured and uninsured causes, the entire amount was covered absent proof that some amount was attributable solely to uninsured causes.  Id. at 1031-32.  The Court, though, reached this conclusion through a “concurrent causation” analysis rather than through the logic of Buss.  Still, the same principle applies:  if an amount is paid to settle covered claims, it remains covered even if the amount paid also resolves liability for uncovered claims.

We therefore recommend resisting insurer demands to allocate settlements (or judgments) under any liability insurance policy without proof by the insurer that some amount was paid solely for uncovered claims or parties.