Insured cannot arbitrarily allocate settlement proceeds to non-covered damages in order to preserve coverage claims against a non-contributing insurer.

Judge Lee Rosenthal, of Texas’ U.S. Southern District, recently prohibited an insured from unilaterally allocating general settlement amounts from its subcontractors to uncovered damages, in order to preserve claims against insurers “that would cover the damages if the loss was properly allocated to that policy.”  In  Am. Guarantee & Liab. Ins. Co. v. United States Fire Ins. Co., 255 F. Supp. 3d 677, 686 (S.D. Tex. 2017), general contractor S&P contracted with Zapata County to build a courthouse that exhibited various construction defects after completion.  American Guarantee defended S&P in Zapata County’s construction suit, which went to arbitration, culminating in a roughly $8 million award against S&P.  S&P’s subcontractors were parties to the arbitration until S&P settled with them for an aggregate $4.49 million.

S&P’s primary coverage layer was $1.5 million, but S&P satisfied the award with the $4,492,500 subcontractor settlements, about $2 million from American Guarantee, approximately $1.1 million from Amerisure, and approximately $440,000 from S&P itself.  S&P, American Guarantee, and Amerisure then sued excess insurer US Fire, claiming the excess layer was reached by the award. (Amerisure also argued, among other things, it owed nothing because S&P had selected the American Guarantee policy as its primary coverage.)  US Fire argued that subtracting “supplemental payments” that did not count against the primary policy limits (attorney’s fees, arbitration fees, prejudgment interest), and the award for non-covered mold remediation from the total arbitration award of $8 million left roughly $3.24 million of potentially covered claims, which is less than the $4.49 million in subcontractor settlements plus the primary layer of insurance, precluding the necessity of reaching the excess coverage. Id. at 679-80.  Thus, the excess layer could be reached only by an “accounting trick” by which S&P allocated the subcontractor settlements to the supplementary payments and the non-covered mold remediation, thus leaving a shortfall in coverage of the actual covered damages and triggering the excess layer. S&P justified its position as an extension of the Lennar decision’s targeted coverage holding, arguing “if an insured such as S&P is in the best position to allocate damages among its own insurance policies, it is logical for it to allocate those damages among recoveries from other parties.”   Id. at 683 (citing Lennar Corp. v. Markel Am. Ins. Co., 413 S.W.3d 750 (Tex. 2013) (holding it is the insured that is in the best position to select coverage among multiple insurers)).

Judge Rosenthal stated “[t]he issue here is whether an insured can round up general settlements from its subcontractors, unilaterally decide that they will be allocated to uncovered damages, and then go after the insurers that would cover the damages if the loss was properly allocated to that policy.”  Id. at 686.  The Court held that it was S&P’s burden to show that it had not already been compensated for the covered loss by settlement money it received from the subcontractors, the parties responsible for the damages in the first place. The Court analogized the situation to that in RSR Corp. v. Int’l Ins. Co., 612 F.3d 851 (5th Cir. 2010), which had held the insured had the burden of showing that settlements paid by other insurers had not fully compensated it for the damages assessed against it.  Judge Rosenthal held there was no real distinction between RSR Corp and S&P’s attempted allocation of settlements from other responsible parties (the subcontractors) to non-covered liability amounts.  Id. at 688 (“In both circumstances, the insured suffered a partially covered loss, received a bucket of undifferentiated money to cover the loss, and then tried to recover on an excess policy, arguing that it did not have to apply the settlement money to the covered loss.”).  Thus, the burden of segregating covered and non-covered damages rested on the insured because, as the settling party, it was in a superior position to prove how the settlements were intended to be allocated.  Id. at 688-89.   The Court found that “S&P did, and US Fire did not, have the power to structure its subcontractor settlements to ensure a clear allocation of the settlement proceeds by specifying which amounts were for covered damages and which amounts were for uncovered damages” but “chose not to do so.”  Id. at 689.

The Court held “S&P’s burden was to present summary judgment evidence from which a factfinder could determine what portion of a specific subcontractor settlement reimbursed S&P for a specific uncovered loss” and that “[m]erely showing that some unspecified portion of a settlement may have had something to do with an uncovered loss does not meet an insured’s burden to demonstrate a covered loss.” Id. at 690. Thus, because S&P had no actual evidence that the undifferentiated subcontractor settlements were intended to cover the non-covered supplemental payments and mold claims, the Court held the excess insurer was entitled to summary judgment on the claims that the excess layer was reached.  Id. The Court also noted, in the alternative, that “[e]quitable principles weigh heavily against allowing S&P to benefit by reversing its previous position” that the “settlement agreements were general and undifferentiated, and that [S&P] could not show what portion of what settlement amount was properly allocated to covered and what portion to uncovered damages.”  Id. at 691.  Thus, S&P’s late attempts to present evidence of some differentiation and allocation in the subcontractor settlements were “disingenuous” and rejected.  Id. This decision is an important reminder about the critical and at times result-determinative centrality of distributing burdens of proof in coverage and settlement issues.  The decision, however, has been appealed to the Fifth Circuit, which is scheduled to hear oral argument in June, so stay tuned.