Covered vs. Uncovered Allegations. A claim against insured D&Os may include both allegations which are insured under the policy and allegations which are not insured. For example, a claim may allege liability by a D&O in his or her capacity both as a director or officer and as a shareholder of the corporation. The D&O policy covers loss attributable to the alleged D&O liability, but not to the alleged shareholder liability. Similarly, a claim against D&Os may allege both liability covered by the D&O policy and liability not covered by virtue of one or more policy exclusions.

Absent a fair allocation, insureds would obtain more coverage than they purchased and the insurer would pay more losses than it contractually agreed. Over time, such a result would jeopardize the viability of the insurance product because insurers would be unable to make informed decisions regarding the underwriting and pricing of the insurance policy. In essence, the insurers would be forced to cover risks which were not identified, quantified, accepted or priced by the insurer during the underwriting process.

When both covered and non-covered losses are intermingled, it is not feasible to precisely calculate which losses are covered and which losses are not covered. Therefore, courts seek to approximate the amount of losses attributable to the covered and non-covered matters. An estimate of a fair allocation based on the relevant facts should be the goal.

Allocation for insurance purposes involves a two-step process. First, one must determine what allocation methodology should be used. As summarized below, courts have recognized several different allocation methodologies in different contexts. Absent an agreement by the parties either in the policy or otherwise, this question ultimately is a question of law to be determined by a court or tribunal. Second, the selected methodology(ies) must be applied to the facts of a particular case.

The following discussion summarizes the various allocation methodologies recognized by courts. To minimize the risk that a particular methodology creates an unreasonably high or low allocation of loss to covered or non-covered matters, parties frequently use several alternative allocation methodologies and then compare the results of the different methodologies. If the different methodologies yield generally comparable or consistent allocation conclusions, the parties have a higher level of confidence in the resulting range of allocation. However, if the alternative methodologies yield significantly different allocation results, the parties should reevaluate the alternative methodologies and either refine the analysis or discount a particular methodology as being inappropriate in light of the unique circumstances of that case.

“Pro Rata” Methodology

Particularly where loss is factually difficult to allocate, courts and parties have apportioned loss on a pro rata basis. For example, if a lawsuit has ten distinct causes of action but only six of which are covered under the policy, sixty percent (60%) of the defense costs would be attributable to defense of the covered causes of action and forty percent (40%) would be attributable to defense of the non-covered causes of action. The primary benefit of this pro rata allocation approach is that the implementation of this methodology is relatively easy and less likely to generate disputes when compared with other more fact-intense methodologies.

An important part of a pro rata allocation process is to group similarly situated parties or claims for purposes of determining the correct number of groups among which the loss should be prorated. For example, if a claim is asserted against the uninsured company and nine insured D&Os, it may be reasonable to treat the nine D&O defendants as a single group for the pro rata allocation analysis, resulting in a 50/50 allocation with the company, rather than a 90/10 allocation which would apply if each defendant is treated separately. This grouping of defendants necessarily requires a factual analysis of the underlying lawsuit, thereby reducing a perception that a pro rata allocation may be somewhat artificial and potentially inequitable.

“Relative Exposure” Methodology

Many courts recognize an alternative allocation methodology which seeks to apportion defense costs and settlement amounts between covered and non-covered parties or matters based upon the relative exposure of the parties to the covered and non-covered matters. The underlying premise of this allocation methodology is that the relative cost of defending and settling various claims should be proportionate to each defendant's exposure to each claim. For example, if one claim creates much higher liability or damage exposure than another claim, the defense costs and settlement amount for that higher exposure claim should be much higher.

In making an assessment of an insured's legal and financial exposures to covered claims, on the one hand, and non-covered claims, on the other hand, some of the relevant factors to consider may include the following:

1. What is the comparative likelihood that the insured will be found liable for each covered claim and for each non-covered claim? For example, what is the likelihood of a plaintiff or defendant verdict at trial and on appeal for each claim in light of the nature, complexity and emotional appeal of each claim?

2. Are the elements for a prima facie case against the insured for the covered claims easier or harder to prove than for the non-covered claims? For example, does the complaint allege facts which establish a prima facie case for each claim if proven, what is the likelihood plaintiff will be able to prove all such facts for each claim and is plaintiff's legal theory for each claim likely to be sustained by the court?

3. Are the defenses available to the insured for each covered claim harder or easier to prove than for the non-covered claims? For example, what is the likelihood the insured will be able to prove facts sufficient to establish a defense for each claim and is the insured's legal theory for defending each claim likely to be sustained by the court?

4. Will defense of the covered claims or the non-covered claims require considerably more effort, activity and thus cost? For example, will the covered or non-covered claims require a lot more motion practice, research, discovery and investigation?

5. Is there a higher or lower likelihood that the court will resolve by motion practice rather than at trial the covered claims versus the non-covered claims? For example, what is the likelihood defendant's motion to dismiss each claim will be granted and what is the likelihood either plaintiff or defendant will prevail in a motion for summary judgment, material motions in limine or other material pretrial motions?

6. What are plaintiff's most likely recoverable damages from the covered claims versus non-covered claims?

7. Do any of the covered claims or non-covered claims present to the insured broader concerns which create potential losses or adverse results outside the context of the litigation? For example, do some claims present greater risks to the insured beyond the liability exposure in the claim, such as risks to reputation, to multiple “follow-on” claims, to increased operating expenses or to undesirable personnel practices.

In essence, this “relative exposure” allocation methodology seeks to avoid misleading and artificial allocations based upon overly simplistic approaches or self-serving documents. Instead, this methodology seeks to determine the true motivations and dynamics of the litigation, and to apportion the financial burden of defending and settling the litigation based upon the insured's relative exposures to covered and non-covered claims. In other words, an appropriate “relative exposure” allocation should reflect the true gravamen of the litigation.

Some courts have criticized the “relative exposure” methodology as being too fact specific and somewhat subjective in its application. However, the process of determining the amount of covered loss under an insurance policy should not be based upon the easiest methodology, but rather the methodology most consistent with the policy terms. The “relative exposure” methodology satisfies that goal.

“Reasonably Related” Methodology

Numerous courts have applied the so-called “reasonably related” methodology for allocating defense costs. First adopted in a 1985 Maryland case, this allocation methodology requires the insurer to pay all defense costs which are reasonably related to the defense of covered claims against insured defendants. See, Continental Cas. Co. v. Board of Educ., 302 Md. 516, 489 A.2d 536 (1985). Importantly, though, the Maryland court ruled that defense costs were reasonably related to covered claims “if they would have been rendered and incurred by reasonably competent counsel engaged to defend” an action which involved only the covered claims. For example, if defense counsel representing only insured persons in connection with insured claims would have performed a task such as attending a deposition, then all of the fees and expenses incurred by defense counsel with respect to that task are covered even though that task also benefitted the defense of non-covered claims or non-covered defendants.

This allocation methodology is generally viewed as a pro-insured approach to allocation because it in essence creates a presumption that all defense costs are covered unless the defense costs are completely unrelated to the defense of covered claims. Insurers frequently argue this approach artificially skews the allocation process in favor of the insureds and in essence allows the insureds to obtain defense costs coverage for non-covered claims as long as defense counsel would have performed the same tasks in defense of the covered claims. Logically, that result is arguably no more reasonable or fair than the opposite result pursuant to which defense costs would not be covered if attributable to tasks which would be performed by defense counsel in defending only non-covered claims.

To address this arguable inequity under the “reasonably related” methodology, some courts recognize that this methodology should not ignore the relative exposure between covered claims against insured persons and all other claims. For example, in the 1985 Maryland case which first articulated the “reasonably related” test, the court recognized that the test should not result in the allocation to the insurance policy of defense costs which “were excessively disproportionate to the risk of liability” of the insureds to covered claims.

Larger Settlement Rule

For purposes of allocating settlements under D&O insurance policies, a number of courts have adopted an allocation methodology very similar to the “reasonably related” methodology for allocating defenses. Frequently called the “larger settlement rule,” this allocation methodology allocates a portion of the settlement to uncovered loss only if and to the extent the settlement is larger by reason of the uninsured defendant or uninsured claim. Like the “reasonably related” allocation method for defense costs, the “larger settlement rule” in essence creates an artificial presumption that the entire settlement amount is covered even though the settlement resolves uninsured claims against uninsured defendants.

Courts first created this allocation methodology in the context of allocating settlement amounts between insured directors and officers and the uninsured company. See, e.g., Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424 (9th Cir. 1995); Caterpillar, Inc. v. Great Am. Ins. Co., 62 F.3d 955 (7th Cir. 1995). The allocation of a settlement between the insured directors and officers and the uninsured company is particularly difficult because the uninsured company only acts through the insured directors and officers. Hence, the courts developed the “larger settlement rule” in that context to recognize that most if not all of the settlement should be allocated to the active wrongdoers (i.e., the insured directors and officers) rather than the passive defendant (i.e., the uninsured company).

Policy Allocation Provisions

In light of the historical frequency and at times highly contentious nature of allocation disputes under D&O policies, D&O policies began including an allocation provision beginning in the mid-1990s. Today, almost all D&O policies contain some type of allocation provision, but those provisions vary significantly. The following describes the most common variations.

1.Need to Allocate

Some allocation policy provisions simply recognize the need to allocate and a commitment by the insurer and the insureds to use their best efforts to agree upon a fair allocation. Sample policy language follows:

If both Loss covered by this policy and loss not covered by this policy are incurred, either because a Claim against the Insureds includes both covered and uncovered matters or because a Claim is made against both a covered Insured and others, including the Insured Organization, the Insureds and the Insurer shall use their best efforts to agree upon a fair and proper allocation of such amount between covered Loss and uncovered loss.

Under this type of provision, courts have generally adopted whatever allocation methodology they believe to be most appropriate, which most frequently is the pro-insured “reasonably related” and “larger settlement rule” methods.

2.Relative Exposure

Other policies state in the allocation provision not only the need to allocate, but also the type of methodology to be used in determining a fair allocation. Most frequently, this type of provision adopts some type of “relative exposure” methodology. Sample policy language follows:

If in any Claim the Insureds incur Loss jointly with others (including other Insureds) who are not afforded coverage under this Policy for such Claim or incur both Loss covered by this Policy and other amounts which are not covered by this Policy, the Insureds and the Insurer shall allocate such amounts between covered Loss and uncovered loss based on the relative legal and financial exposures of the parties to covered and uncovered matters.

Another variation of this approach states that the allocation shall be based not only on the relative legal and financial exposures of the parties, but also the relative benefits of the parties from a settlement that must be allocated.

3.Predetermined Allocation

Instead of merely recognizing the need to allocate and describing how to allocate, a few D&O policies predetermine the allocation, at least with respect to certain loss in certain types of claims. Sample policy language follows:

If in any Securities Claim the Insureds incur both Loss that is covered under this Policy and loss that is not covered under this Policy, the Insureds and the Insurer shall allocate such amount between covered Loss and non-covered loss as follows:

(i)The portion, if any, of such amount that is in part covered and in part not covered under Insuring Clause 2 shall be allocated in its entirety to covered Loss, subject, however, to the applicable Retention and Coinsurance Percentage set forth in the Declarations; and

(ii)The portion, if any, of such amount that is in part covered and in part not covered under Insuring Clause 1 or 3 shall be allocated between covered Loss and non-covered loss based on the relative legal and financial exposures of the Insureds to covered and non-covered matters and, in the event of a settlement in such Securities Claim, based also on the relative benefits to the Insureds from settlement of the covered matters and from settlement of the non-covered matters; provided that the amount so allocated to covered Loss under Insuring Clause 3 shall be subject to the Retention and Coinsurance Percentage set forth in the Declarations.

The Insurer shall not be liable under this Policy for the portion of such amount allocated to non-covered loss. The allocation described in (i) above shall be final and binding on the Insurer and the Insureds under Insuring Clause 2, but shall not apply to any allocation under Insuring Clauses 1 and 3.

Other variations of this type of allocation provision may apply only to defense costs or only to settlements, may apply different predetermined percentages to defense costs and settlements, or may apply a minimum allocation percentage for negotiation purposes, rather than a fixed percentage.

4.Interim Defense Costs Allocation

Some D&O policies which require the parties to agree upon a fair allocation address what portion of defense costs will be advanced by the insurer if the parties cannot agree upon an appropriate allocation. Such a provision usually states that the insurer will advance the portion of defense costs which the insurer believes to be covered until a final adjudication is negotiated or determined by a court. Sample policy language follows:

If the Insureds and the Insurer cannot agree on an allocation of Defense Costs:

(i)no presumption as to allocation shall exist in any arbitration, suit or other proceeding; and

(ii)the Insurer shall advance on a current basis Defense Costs which the Insurer believes to be covered under this Policy until a different allocation is negotiated, arbitrated or judicially determined.

In the event of an allocation dispute, some D&O policies also either require the parties to arbitrate the allocation dispute or permit the insureds to elect to arbitrate the dispute even though other coverage disputes under the policy are not subject to arbitration.

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