After loss is incurred and a complaint has been filed, problems usually arise when the insurer asserts a right to apportion or carve out of the claim adjustment that part of loss attributable to the uncovered person(s), claim(s) or capacity from which loss results.

Actions brought by plaintiffs, which include elements of all three types of allocation, can be particularly problematic as illustrated in the following graphic depiction.

The very concept that the insurer proposes through the undertaking of an allocation to pay only some percentage of the total loss is often viewed by insureds as a display of bad faith by the insurer. Many insureds complain that the potential of allocation was never discussed with them prior to purchase of the insurance. Because many D&O liability policies do not even contain the word allocation, insureds often hear about it only after a claim has been made. Some insurers will first introduce the concept of allocation in the context of or in conjunction with a reservation-of-rights letter. Unless great care has been taken by the insurer, the reservation-of-rights letter may be misconstrued by the insured as a denial of coverage.

Attempting to outline the concept of allocation in the same breath as a perceived coverage denial usually drives the claim process into low gear. Insurance brokers too are often criticized for not forewarning their insureds about the likelihood that an allocation will be an integral part of most D&O loss adjustments. Astute brokers counsel insureds and prepare them for the potential problems and pitfalls. No other aspect of D&O insurance is so hotly contested and the source of such bad will between insured and insurer than the allocation issue.

Unless insureds are educated about the potential for allocation and are prepared to deal with the inevitable problems, they risk the consequences of either accepting the proposed allocation formula or a long and protracted battle with their insurer. Conflict over allocation not only compounds the problem of making an effective defense against plaintiffs, it often siphons off valuable corporate resources when they are most needed to pay for the costs of defense.

The purpose of the following discussion is to alert and educate readers about the underlying problems and issues of allocation. Thoroughly understanding the underlying factors at issue is crucial to avoiding much agony during a claim adjustment.

Potential Problems with Allocation

To help understand why allocation remains a potentially contentious issue in D&O insurance, it is beneficial to examine some of the fundamental differences between D&O policies and more common forms of liability insurance, such as the standard ISO Commercial General Liability (CGL) policy.

Although most D&O policies are referred to as liability policies and are commonly titled liability policies, D&O insurance and conventional liability insurance are fundamentally different. Comparison of the two, other than to highlight their differences, can be misleading.

D&O insurance is different than conventional liability insurance in two important ways. First, many D&O policies are designed to indemnify the insured for at least some components of loss. To indemnify means to reimburse loss only after liability has been established and the loss has been paid or incurred by the insured. The CGL policy and many other forms of liability insurance are generally written to pay-on-behalf of the insured. This means that the loss is paid by the insurer on behalf of the insured and without the insured incurring out-of-pocket expense.

Some D&O policies do contain pay-on-behalf language, but many also contain limitations that give the insurer full discretion over when loss, such as defense expenses, will be paid.

A second more important difference between the two forms of insurance is in the treatment of defense. Commercial general liability insurance policies have been, to a great extent, standardized over the years. The most common of these standardized policies are developed for the insurance industry by the Insurance Services Office (ISO). Most of the CGL and other liability forms developed by ISO are designed to require the insurer to tender a defense on behalf of the insured. The language most commonly used over the last several years reads in part as follows:

We will pay those sums that the insured becomes legally obligated to pay as damages because of any act, error or omission, of the insured, or of any other person for whose acts the insured is legally liable, to which this insurance applies. We will have the right and duty to defend the insured against any “suit” seeking those damages.

                                                                                     ISO Form CG 04 35 12 07

Where a duty to defend exists, courts reviewing duty-to-defend language have found that the insurer must provide a defense for the insured even where a complaint contains some allegations that would fall outside the scope of the policy's coverage. Because of this feature, the CGL policy and many other forms of liability insurance are said to provide a broader duty to defend than to indemnify. This is an extremely important component of most CGL policies, which is not usually found in D&O insurance. Because the CGL insurer is in many cases required to defend uncovered claims, the requirement to allocate, at least as respects defense, is absent.

Most D&O policies do not provide an affirmative duty to defend, but some not-for-profit and association D&O policies do provide an affirmative duty to defend..

Consider the following duty-to-defend language common to most D&O policies. Such language generally reads in part as follows:

It shall be the duty of the Directors and Officers and not the duty of the Underwriters to defend claims made against the Directors and Officers.

Although D&O policies do impose restrictions upon the incurring of expenses and the ability to make settlements by insured directors and officers, these policies clearly are absent the affirmative duty to provide a defense found in most CGL forms. The courts usually have determined that without specific and clear language to the contrary, an insurer is not required to provide defense.

The crux of the allocation problem under D&O policies is that because the policy is designed to indemnify only after liability is established, payment of loss, including defense expenses, may be withheld (at least in theory) until conclusion of the underlying litigation, which may be many years later. Defense is a component of loss, but because there is no duty to defend, the insurer may attempt to defer such payment until liability has been clearly established.

Problems regarding allocation usually first arise because many D&O policies contain provisions for advancing defense expenses as they are incurred. This feature requires a methodology for apportioning loss between covered and uncovered elements. Because most policies do not provide a formula for allocation and because questions of coverage often cannot be determined until conclusion of underlying litigation, allocation frequently results in a lengthy dispute between insured and insurer.

Allocation of Loss between Covered and Uncovered Persons and Entities

Complaints against directors and officers may include some defendants not covered by the D&O policy. In securities actions brought by shareholders it is common for the corporation to be named along with the directors and officers. Other types of claims also may include the corporation as a codefendant. Although the corporation is an insured under the D&O policy, it is insured only to the extent indemnification is made to its directors and officers. Direct actions against the corporation are usually not covered. “Entity” coverage is sometimes available to specifically insure the corporation for direct actions made against it. Under D&O insurance, loss associated with or attributable to non-insureds is not covered. Other uncovered parties—such as the corporation's financial consultants, legal counsel, accountants and others—also may be included in a common cause of action along with the directors and officers. Viewed graphically, allocating the defense costs of the various covered and uncovered parties might appear to be a simple task by employing separate defenses for each party.

Unfortunately, such a strategy is often undesirable and the corporation and its directors and officers may choose a combined defensive strategy. A combined defense involves one or more of the defendants (frequently the directors, officers and the corporation) being defended by the same law firm(s).

Defense of D&O claims is often complex, protracted and expensive. Undertaking separate defenses, while alleviating some of the problems of allocating at least the defense portion of loss, would necessarily require a large duplication of efforts and costs. There may be other valid reasons to avoid a strategy of separate defenses. A strong, well-coordinated joint defense helps to avoid a perception by the plaintiffs that internal conflicts exist, which might be indicated by separate defenses.

Even when insured and insurer agree that allocation should be undertaken, there is little guidance on how to achieve a proper and fair allocation. There is, however, authority for the proposition that allocation should be based on the relative culpability of the insured directors and officers versus that of the uninsured corporation. See, for example, Pepsico, Inc., v. Continental Casualty, 640 F.Supp. 656 (S.D.N.Y. 1986).

The Pepsico court dealt with the allocation issue in the context of a Rule 10b-5 action against Pepsico, its directors and officers and accountants. Pepsico settled the underlying suit and sought reimbursement, contending that the D&O insurer should pay the entire amount. The court rejected this contention, holding instead that the allocation between Pepsico, the accountants, and the insured directors and officers should be made on the basis of an approximation of each party's relative exposure.

It is unlikely the Pepsico approach will be followed in the Ninth Circuit. Contribution among tortfeasors based upon relative fault is also the usual rule in the Ninth Circuit. See Smith v. Mulvaney, 827 F.2d 558 (9th Cir. 1987).

Under Pepsico, arguably the insurer should pay the entire loss, minus any deductible, in a lawsuit based on the conduct of directors and officers. This would hold true, for example, where a lawsuit arises from an action of the board of directors, based upon recommendations of senior management. On the other hand, the insurer may be justified in requesting the corporation contribute to settlement of a lawsuit arising from erroneous acts or omissions of corporate employees who are not directors or officers.

The Pepsico court noted that evidence of good-faith settlement of the underlying securities litigation created a presumption that the settlement was covered under the D&O policy. The court also noted that the D&O insurer had the burden of proof regarding the amount of the settlement that could be excluded from the policy coverage. Although placing the burden of proof on the insurer to substantiate allocation has been rejected by some jurisdictions, it appears that this would be the rule in states such as California.

Allocation between Covered and Uncovered Claims

Regarding defense of an action against directors and officers, the Ninth Circuit acknowledged the difficulty of reasonably apportioning between covered and uncovered claims. See Gon v. First State Ins. Co., 871 F.2d 863 (8th Cir. 1989).

In Gon the court stated that although the insurer is entitled to apportion expenses between covered and uncovered claims, it cannot do so at the expense of its insureds. The court favored apportionment early in the underlying suit and also said that although some excluded claims (such as liable or slander) are easy to distinguish from covered claims by analyzing the underlying complaint, apportionment is more difficult when the nature of the claims made in the complaint do not clearly indicate whether they would be covered or uncovered.

The Ninth Circuit found that the insurer must pay all legal expenses as incurred subject to apportionment and reimbursement for defense of uncovered claims after settlement and judgment in the underlying action. The court further advised that the district court may well wish to consider the use of a master or other case-management technique to monitor legal fees in order to distinguish between covered and uncovered expenses and to permit an early apportionment.

Although the district court was not ordered to use a master, the suggestion to do so has been followed in coverage litigation as an economical method of resolving otherwise unresolvable allocation disputes.

The California Supreme Court appears to be in agreement that insurers have the burden of proof with respect to allocation of defense costs. In Hogan v. Midland National Ins. Co., 3 Cal. 3d 553 (1970) the California Supreme Court stated: