Bankruptcy Treatment of Self-Insured Retentions and Deductibles
By Erin L. Webb – September 12, 2012
What happens when a company with outstanding insured liabilities files for bankruptcy? What if the company’s liability insurance policies contain self-insured retentions (SIRs) or deductible amounts? With the company financially unable to pay any SIR or deductible, who is left “holding the bag”?
With limited exceptions, courts generally do not allow insurance companies to escape their obligations to bankrupt policyholders simply because the policyholder lacks the financial resources to pay an SIR or deductible. As always, the starting point will be the precise language of the liability policies involved. But state insurance law requirements, public policy, and bankruptcy rules can all affect the outcome.
It is important to distinguish whether the policy contains an SIR or a deductible, because they operate differently. Where there is an SIR, the policyholder typically must pay the SIR before the insurance company’s obligation is triggered. In contrast, under typical policy language, the insurance company will generally pay the deductible amount first and then seek reimbursement from the policyholder. This distinction plays an important role in a court’s analysis of how the policy operates and who must pay in the event of a policyholder’s insolvency.
The key issues are as follows: Will coverage be available if the policyholder cannot pay the SIR, or does the policyholder’s failure to pay the SIR vitiate coverage? If there is underlying liability that would be covered by the policy, and there is a deductible provision, how is the insurance company compensated for that deductible payment in the event of a policyholder’s bankruptcy? Most courts find that the attachment point of the policy remains the same, but the insurer may not escape payment based on the policyholder’s inability to pay the SIR or deductible.
An Insolvent Policyholder’s Inability to Pay an SIR Does Not Vitiate Coverage
The dominant view among courts that have addressed the issue is that a liability insurer must pay the full amount of its policy for covered liabilities, regardless of the policyholder’s bankruptcy. Many states have statutes that require liability insurance policies to have language stating that the policyholder’s bankruptcy or insolvency will not affect coverage. In those states, courts will generally not void coverage based on the policyholder’s financial inability to pay the SIR. Even in such instances, however, the insurer maintains the benefit of the SIR terms and thus is not required to “drop down” and pay the SIR that the insolvent policyholder is unable to pay. In other words, the court will enforce the contractual obligations but will not impose an additional liability on the insurer. This means that the claimant against the insolvent policyholder is left “holding the bag” and must seek the amount of the SIR in the bankruptcy process.
One of the leading cases on this point is Home Insurance Co. of Illinois v. Hooper. In this Illinois state intermediate appellate court case, the policyholder had a comprehensive liability and product liability insurance policy with limits of $1 million per occurrence and an SIR of $250,000 per occurrence and $750,000 in the aggregate. The insurer contended that it had no obligation to indemnify its insolvent policyholder for an underlying personal injury lawsuit unless and until the policyholder made “actual payment” of the “entire amount” of the SIR. The insurer argued that the plain language of the policy demanded this result.
The policyholder argued that the policy should “drop down” and cover the amount of the SIR that it was unable to pay because of its bankruptcy. The policyholder also argued that the SIR language on which the insurer relied violated Illinois public policy as expressed in Illinois’ Insurance Law section 388. That statute provides as follows:
No policy of insurance against liability or indemnity for loss or damage to any person other than the insured, for which any insured is liable, shall be issued or delivered … unless it contains in substance a provision that the insolvency or bankruptcy of the insured shall not release the company from the payment of damages for injuries sustained … .
The trial court rejected both of the policyholder’s arguments and granted summary judgment for the insurer. The appellate court reversed, finding that the “operative effect of the language of the self-insured provision is directly contrary to the public policy as declared by the legislative enactment of section 388.”
The appellate court in Hooper also relied on the policy language in an endorsement. The endorsement stated that the insurance company’s liability was “limited to pay only those: ‘claims which resulted in the amounts cumulatively equaling or exceeding $ 250,000, such that the amounts paid or payable by the company, plus the amounts paid or potentially payable by the Named Insured, shall equal $ 1,000,000.’” Because of the language describing amounts “paid or payable by the Named Insured,” the court rejected the insurer’s argument that only “actual payment” would suffice to meet the terms of the policy.
The appellate court affirmed the trial court on the “drop down” issue, however, holding that the insurer had “the obligation to cover any judgment in excess of $250,000 but is not obligated for the first $250,000.” Other courts presented with this issue have reached similar results.
But some courts have reached different conclusions. In another Illinois case, this time in a federal district court applying Illinois law, the court reached a different conclusion and determined that the insurer, not the underlying claimant, must absorb the cost of the SIR. In Keck, the court found that the SIR was satisfied by including the amount of the SIR as an unsecured claim for the insurance company, notwithstanding that the policies contained no “drop down” provision and the insurance company was not obligated to provide coverage until the SIR was paid. The insurance company effectively had to “pay” the SIR with an “IOU” from the estate of the policyholder. The court noted that preserving the attachment point of the policy meant that the insurer’s obligation was “not increased by a penny.”
SIRs and Defending Claims
A New York federal district court applying Illinois law held that the same result reached in Hooper should apply whether or not an SIR includes defense costs. The court also addressed the practical issue of how to deal with the defense costs within the SIR in the bankruptcy context. “Any amounts incurred by [the insurer] for the costs of defending the personal injury suits that fall within the self-insured retention should be filed with the bankruptcy estate as unsecured claims and be dealt with accordingly.”
Another New York federal district court reached the same result and rejected the insurance company’s argument that it should be reimbursed for those defense costs as an “administrative expense” with priority before general unsecured claims. In Ames, the insurance company argued that the insurer would have no alternative but to assume the defense of claims if the policyholder was allowed to abandon its defense, because claims starting out well below the SIR could quickly proliferate into a judgment well in excess of the deductible if allowed to proceed. The court refused to consider the defense costs to be an “administrative expense.” Rather, the court held, no order required the insurance company to defend the claims below the SIR and it was simply choosing to do so as a prudent business decision.
If the insurer chooses to defend claims that are below its SIR, the defense costs paid by the insurance company may not “count” toward satisfying the SIR if the policy provides that the policyholder’s payment of defense costs do not exhaust the SIR. In Kleban v. National Union Fire Insurance Co. of Pennsylvania, the Superior Court of Pennsylvania ruled that the claimant was entitled only to the amount of his claim less the $250,000 SIR. The court rejected the claimant’s argument that the insurance company’s payment of $316,000 in defense costs—for which it would receive an unsecured claim in the bankruptcy along with the $250,000 SIR—satisfied the SIR requirement.
Paying SIRs as a Condition of Coverage
Some courts, however, have found that payment of an applicable SIR constitutes a condition precedent to coverage. By so concluding, these courts find that the policyholder is entitled to no coverage if it cannot pay the required amount. For example, in Pak-Mor Manufacturing Co. v. Royal Surplus Lines Insurance Co., the policyholder under a CGL policy instituted a declaratory judgment action in a Texas bankruptcy to resolve this issue. The insurer moved for summary judgment, contending that it had “‘no obligation to defend or indemnify . . . because [the policyholder] has not satisfied its self insured retention.’” The bankruptcy court denied the insurer’s motion and granted partial summary judgment in favor of the policyholder.
The insurer appealed to the district court. That court reversed and based its decision on policy language. The district court stated that it was constrained to apply the policy as written and rejected the policyholder’s reliance on Hooper and cases like it. The court distinguished Hooper because it relied on the Illinois state statute requiring liability insurance policies to contain language stating that “the insolvency or bankruptcy of the insured shall not release the insurer from the payment of damages.” The court noted that Texas had no such statute, thus rendering the Hooper court’s reasoning inapplicable.
Other courts have noted that the reasoning behind statutes such as the one in Illinois is to ensure that funds are available for injured claimants as a matter of public policy. For example, the court in Columbia Casualty Co. v. Federal Press Co., a federal bankruptcy court applying Indiana law, analyzed a similar Indiana statute. The court in Federal Press stated that the Indiana statute “embodies the public policy of permitting an injured victim to recover under a valid insurance policy from the insurer itself in the event the insured is unable to pay due to its insolvency or bankruptcy.” Thus, public policy would likely apply with the same result reached in Hooper in states with statutes like the one quoted above and the one cited in Hooper.
The court in Pak-Mor also noted that the policyholder could “pay the retained limit in any form it desires so long as the Bankruptcy Court confirms that the payment is performed in a credible and reliable manner.” This ruling may be able to be reconciled with the Keck court’s reasoning that commanded the liability insurer to “stand in line” with the other unsecured creditors for whatever funds were available from the insolvent policyholder’s estate. It may be that, even under an analysis like the one in Pak-Mor, the policyholder could “pay” the SIR by including it as an unsecured claim in a bankruptcy or receivership, thereby activating the insurance company’s obligation to pay its policy limits.
Right to Reimbursement of Deductible Generally Treated as Unsecured Claim
What about a deductible? Does it make sense to treat a deductible differently, because insurers generally pay a deductible first and later seek reimbursement from the policyholder? At least one of the few courts that have addressed this issue in the liability insurance context required the insurance company to pay the deductible in the first instance and then treated the insurance company’s right to reimbursement as a general unsecured claim.
Another court faced with this issue went a step further and granted the insurance company administrative expense priority for some deductible payments under a liability policy. For administrative expense priority, the insurer must make the proper showing under the relevant bankruptcy statutes. If that is successful, the insurer’s claim can be paid before unsecured claims.
The courts that have addressed the issue have focused on two prerequisites that exist before the payment by the insurer of a deductible or other insurance-related expense may be considered an administrative expense. First, the deductible must be related to a liability claim that arose after the policyholder filed for bankruptcy. Second, the insurance company must make a showing that its payment of the deductible was “beneficial” to the policyholder-debtor. One court has described it as follows:
An expense is administrative only if it arises out of a transaction with the bankruptcy estate and only to the extent that the consideration underlying the claim was both supplied to and beneficial to the debtor in possession in the operation of the business. A claim is not entitled to administrative expense status simply because the right to payment arises postpetition.
A liability insurer that advances the deductible for an insured that petitions for bankruptcy may therefore have a claim for administrative expenses for “post-petition” claims but possess only a “general unsecured claim” for claims that “arose pre-petition.”
An insolvent policyholder’s inability to pay an SIR does not allow a liability insurer to escape its policy obligations in most jurisdictions. Some courts, however, will void coverage based on the policyholder’s financial inability to pay. For all but the few jurisdictions where coverage is voided, the amount of an SIR usually is deducted from the payment to the injured party with a claim against the policyholder. The liability insurer, however, must pay the rest of the covered claim.
An insurer of an insolvent policyholder will generally not be required to defend claims below an SIR but will often choose to do so as a business decision so that the underlying claim does not proceed without a defense. Courts have generally allowed such insurers to be reimbursed for those defense costs in the form of an unsecured claim against the policyholder’s estate.
In the case of a deductible, the policy usually operates such that the insurer pays first and is entitled to reimbursement from the policyholder. Most courts deem the insurer’s right to reimbursement to be an unsecured claim in the policyholder’s bankruptcy. Some courts give the payment by an insurer of a deductible a higher priority as an “administrative expense” if the event giving rise to the liability arose after the policyholder filed for bankruptcy and the insurance company demonstrates that its payment was “beneficial” to the policyholder.
Keywords: bankruptcy, self-insured retentions, bankrupt policyholders, conditions of coverage
Erin L. Webb is an associate with Dickstein Shapiro LLP, Washington, D.C.
 Erin L. Webb is an associate in the Insurance Coverage Practice in the Washington, D.C., office of Dickstein Shapiro LLP. She represents policyholders in insurance coverage litigation. She has experience with a wide range of insurance coverage issues, with a particular focus on representing energy and utility companies in obtaining coverage for their liabilities. The material contained in this article was the subject of a roundtable discussion at the March 2012 American Bar Association Insurance Coverage Litigation Committee meeting.
 William T. Barker, 2-7 Law of Liability Insurance § 7.02 (2011).
 William T. Barker, 2-7 Law of Liability Insurance § 7.02.
 Different policy language may yield different “drop down” results in different jurisdictions. See, e.g., Premcor USA, Inc. v. Am. Home Assurance Co., No. 03 C 7377, 2004 U.S. Dist. LEXIS 9275, at *17–20 (N.D. Ill. May 20, 2004) (holding that where the policy in question stated that it was “in excess of . . . the amount recoverable under the underlying insurance,” the language required the policy to “drop down” and cover the gap left by an insolvent insurer, but an endorsement stating that the insurance company’s “‘liability . . . shall not be increased . . . by the refusal or inability of any underlying insurer to pay, whether by Reasons of Insolvency, Bankruptcy or otherwise’” superseded that language and precluded drop down (quoting policy)), aff’d, 400 F. 3d 523 (7th Cir. 2005), amended by No. 04-2549, 2005 U.S. App. LEXIS 6961 (7th Cir. Apr. 21, 2005).
 Complex issues result when large numbers of claimants are involved or when many years and layers of the policyholder’s insurance are implicated. See, e.g., In re Pittsburgh Corning Corp., 417 B.R. 289, 296, 302–3, 311 (Bankr. W.D. Pa. 2006).
 Hooper, 691 N.E.2d at 67.
 Hooper, 691 N.E.2d at 67.
 Hooper, 691 N.E.2d at 70.
 Hooper, 691 N.E.2d at 70.
 Hooper, 691 N.E.2d at 70.
 Hooper, 691 N.E.2d at 70.
 See, e.g., Rosciti v. Ins. Co. of Pa., 659 F.3d 92, 97–101 (1st Cir. 2011) (applying Rhode Island law); Admiral Ins. Co. v. FF Acquisition Corp. (In re FF Acquisition Corp.), 422 B.R. 64, 67–68 (Bankr. N.D. Miss. 2009); Admiral Ins. Co. v. Grace Indus., Inc., 409 B.R. 275, 279–80 (E.D.N.Y. 2009) (applying New York law); In re OES Envtl., Inc., 319 B.R. 266, 269 (Bankr. M.D. Fla. 2004) (citing Hooper); Columbia Cas. Co. v. Fed. Press Co. (In re Fed. Press Co.), 104 B.R. 56, 62–65 (Bankr. N.D. Ind. 1989) (applying Indiana law); Liberty Mut. Ins. Co. v. Wheelwright Trucking Co., 851 So. 2d 466, 486–88 (Ala. 2002) (applying Georgia law); Rollo v. Servico N.Y., Inc., 79 A.D.3d 1799, 1800–1 (N.Y. App. Div. 4th Dep’t 2010). There are also authorities holding that insurance policies are not “executory contracts” that can be escaped due to the nonperformance of an insolvent policyholder. See, e.g., Olah v. Baird (In re Baird), 567 F.3d 1207, 1211–12 (10th Cir. 2009) (quoting Am. Safety Indem. Co. v. Vanderveer Estates Holding, LLC (In re Vanderveer Estates Holding, LLC), 328 B.R. 18, 26 (Bankr. E.D.N.Y. 2005), aff’d sub nom. Am. Safety Indem. Co. v. Official Comm. of Unsecured Creditors, No. 05 CV 5877 ARR, 2006 WL 2850612 (E.D.N.Y Oct. 3, 2006)).
 In re Keck, Mahin & Cate, 241 B.R. at 595–97.
 Am. Safety Indem. Co. v. Official Comm. of Unsecured Creditors, No. 05 CV 5877 ARR, 2006 WL 2850612, at *3–4 (E.D.N.Y. Oct. 3, 2006).
 American Safety Indemnity Co., No. 05 CV 5877 ARR, 2006 WL 2850612, at *4 (E.D.N.Y. Oct. 3, 2006).
 Argonaut Ins. Co. v. Ames Dep’t Stores, Inc. (In re Ames Dep’t. Stores, Inc.), No. 93 Civ. 4014 (KMW), 1995 U.S. Dist. LEXIS 6704, at *9–10 (S.D.N.Y. May 17, 1995) (citing Firearms Imp. & Exp. Corp. v. United Capitol Ins. Co. (In re Firearms Imp. & Exp. Corp.), 131 B.R. 1009, 1015–16 (Bankr. S.D. Fla. 1991)).
 Ames Department Stores, Inc., 1995 U.S. Dist. LEXIS 6704, at *4–5.
 Ames Department Stores, Inc., 1995 U.S. Dist. LEXIS 6704, at *4–5; see also Admiral Ins. Co. v. Grace Indus., Inc. (In re Grace Indus., Inc.), 409 B.R. 275, 279–80 (E.D.N.Y. 2009).
 Kleban v. Nat’l Union Fire Ins. Co. of Pa., 771 A.2d 39, 43–44 (Pa. Super. Ct. 2001).
 Kleban, 771 A.2d at 43–44.
 Pak-Mor Mfg. Co. v. Royal Surplus Lines Ins. Co., No. SA-05-CA-135-RF, 2005 U.S. Dist. LEXIS 34683, at *2–4 (W.D. Tex. Nov. 3, 2005).
 Pak-Mor Manufacturing Co., 2005 U.S. Dist. LEXIS 34683, at *4.
 Pak-Mor Manufacturing Co., 2005 U.S. Dist. LEXIS 34683, at *5–6.
 Pak-Mor Manufacturing Co., 2005 U.S. Dist. LEXIS 34683, at *2.
 Pak-Mor Manufacturing Co., 2005 U.S. Dist. LEXIS 34683, at *10–11.
 Pak-Mor Manufacturing Co., 2005 U.S. Dist. LEXIS 34683, at *25; see also Gulf Underwriters Ins. Co. v. Burris, 804 F. Supp. 2d 953, 957–59 (D. Minn. 2011) (despite state statute, holding that insurance policy was “executory contract” and that failure to pay SIR was a condition precedent that the policyholder could not fulfill).
 See, e.g., Columbia Cas. Co. v. Fed. Press Co. (In re Fed. Press Co.), 104 B.R. 56, 62–63 (Bankr. N.D. Ind. 1989).
 Several jurisdictions have this type of statute for liability insurance policies. See, e.g., 22 Guam Code Ann. § 18306; 215 Ill. Comp. Stat. 5/388; Ind. Code § 27-1-13-7; La. Rev. Stat. 22:1269; Md. Code Ann., Ins. § 19-102; Mich. Comp. Laws Serv. § 500.3006; Minn. Stat. § 60A.08; N.J. Stat. § 17:28-2; N.Y. Ins. Law § 3420; Or. Rev. Stat. § 742.031; 40 Pa. Stat. § 117; Utah Code Ann. § 31A-22-201; 8 Vt. Stat. Ann. § 4203; Va. Code Ann. § 38.2-2200.
 In re Keck, Mahin & Cate, 241 B.R. 583, 596 (Bankr. N.D. Ill. 1999) (finding that, though policies contained no “drop down” provision and insurer was not obligated to provide coverage until SIR was paid, inclusion of SIR as unsecured claim in Chapter 11 proceeding satisfied this condition; noting that insurer’s obligation “will not be increased by a penny”).
 Zurich Am. Ins. Co. v. Lexington Coal Co., LLC (In re HNRC Dissolution Co.), 371 B.R. 210, 231, 233 (E.D. Ky. 2007), aff’d, 536 F.3d 683 (6th Cir. 2008) (involving insurer’s claim for administrative expense priority for deductibles it paid for workers’ compensation, commercial automobile, and general liability coverage); but see Evans v. La. Patients’ Comp. Fund, 869 So. 2d 234, 239 (La. Ct. App. 2004) (in medical insurance context, “[i]f an insured goes bankrupt, the insurer is still liable up to policy limits; the insurer does not drop down to cover the deductible unless the contract of insurance so provides or a statute so mandates”). In addition, at least one court has held that a deductible applies only to indemnity and not defense costs. See, e.g., Forecast Homes, Inc. v. Steadfast Ins. Co., 181 Cal. App. 4th 1466, 1473–74 (2010) (internal citations and quotations omitted) (“Unlike a deductible which generally relates only to damages, an SIR also applies to defense costs and settlement of any claim.”). Thus, the insurer would be responsible for defense costs for claims for which indemnity amounts are below the deductible, with no right to reimbursement, under a policy with a deductible.
 W. Va. Hosp. Ins. Corp. v. Broaddus Hosp. Ass’n (In re Broaddus Hosp. Ass’n), 159 B.R. 763, 769, 770–71 (Bankr. N.D. W. Va. 1993) (involving coverage for defense of underlying “civil actions”).
 Deductibles and other expenses affecting benefits for employees of the insolvent policyholder are usually found to be “beneficial” to the policyholder’s estate. See, e.g., In re Oread, Inc., 269 B.R. 871, 878 (Bankr. D. Kan. 2001) (health insurance premiums); In re Eli Witt Co., 213 B.R. 396, 399 (Bankr. M.D. Fla. 1997) (workers’ compensation deductibles).
 Broaddus Hospital Ass’n, 159 B.R. at 769, 770–71 (involving coverage for defense of underlying “civil actions”).