Pre-Answer Security: Regulatory Protection for Policyholders in an Age of Insecurity

When corporate policyholders sue their insurers, the roster of defendants often includes an “unauthorized” insurer, whether it be Lloyd's of London (which is licensed in only two states, though it writes as an eligible surplus lines insurer in some or all of the other states), a London Market Company, or a domestic insurer not licensed to sell insurance in the state where suit was brought. Such insurers have avoided many of the stringent state regulations that govern “authorized” insurers. But in the majority of states, those insurers are subject to a quid pro quo in exchange for enjoying relaxed regulation: Unauthorized insurers (whether foreign or domestic, “eligible” as surplus lines carriers or not) are subject to a pre-Answer security requirement. That is, before they may answer a Complaint against them, unauthorized insurers must post cash, securities, or a bond sufficient to satisfy any judgment that may be entered against them.

Although not a newly enacted requirement, the pre-Answer bond is often overlooked as policyholders and their insurers hurtle into fast-paced litigation. Because obtaining such a bond can be “good insurance” against either an insolvency or a post-judgment battle to collect, policyholders should consider enforcing their right to demand a bond when litigating against an unauthorized insurer. Indeed, this may be a rare instance in which policyholders and at least some of their insurers ' the authorized ones ' can agree, since in jurisdictions that apply the “all sums” rule a bond can help minimize the risk that the authorized insurers will be left paying the share of the judgment that would have been borne by the unauthorized insurer had the policyholder been able to collect it.

The Statutory Framework

For present purposes, the insurance-writing world may be divided in two parts: authorized and unauthorized. Authorized or licensed insurers are subject to relatively strict state regulation. By contrast, many insurers do not become authorized in a given state, choosing either to become eligible surplus lines insurers (and thereby subject themselves to some lesser regulation) or not to submit at all to the state's regulatory process. It is these unauthorized insurers that are the subject of the pre-Answer security legislation.

Roughly 40 states have adopted a pre-Answer security requirement, based largely on a model act of the National Association of Insurance Commissioners (“NAIC”). See IV NAIC, Unauthorized Insurers Process Act, in Model Laws, Regulations and Guidelines (“Model Laws”) 850-5 to 850-8 (2003). The security requirement, which has withstood repeated attacks on its constitutionality, see, e.g., Curiale v. Ardra Ins. Co., 595 N.Y.S.2d 186, 188 (App. Div. 1993); Trihedron Int'l Assurance, Ltd. v. Superior Court, 218 Cal. App. 3d 934, 267 Cal. Rptr. 418 (1990), typically applies whether the lawsuit is in state court or federal court.

The model act provides, in pertinent part:

Before any unauthorized foreign or alien insurer shall file or cause to be filed any pleading in any action, suit or proceeding instituted against it, the unauthorized insurer shall deposit with the clerk of the court in which the action, suit or proceeding is pending, cash or securities or file with the clerk a bond with good and sufficient sureties, to be approved by the court, in an amount to be fixed by the court sufficient to secure the payment of any final judgment which may be rendered in the action; or procure a certificate of authority to transact the business of insurance in this state. Unauthorized Insurers Process Act '3.A, in Model Laws at 850-2 to 850-3. (Emphasis added.)

Accordingly, unless an unauthorized insurer is willing to subject itself to the more stringent regulations that govern authorized insurers, it must post cash, securities, or a bond before it may defend itself in the litigation. In some states, there may be other alternatives available to the unauthorized insurer, see, e.g., N.J. Stat. '17:51-2(a) (2004) (allowing the court to dispense with the bond requirement if the insurer establishes that it maintains in the United States funds sufficient to satisfy any final judgment), but such alternatives are absent from the model act and from the statutes enacted in many states.

The Reasons for a Security Requirement

In many jurisdictions, the pre-Answer security requirement has been on the books for more than 40 years. The model act itself dates to 1949, and some state legislatures adopted their own versions of the model act that very year, with others following in the ensuing decades. Yet the relative paucity of case law concerning pre-Answer security suggests that policyholders have not systematically enforced their rights under these statutes.

The policyholders that insist on pre-Answer security are by and large responding to the very real danger of insurer insolvency. Since at least the late 1980s, policyholders have witnessed the collapse of insurer after insurer. Companies of every stripe ' domestic and foreign, large and small ' have been forced to close their doors. The London Market in particular has been plagued by insolvencies, and some policyholders have found their London coverage largely eviscerated. Even Lloyd's of London, previously faced with unexpectedly large liabilities and internal scandals, had at points in the past been rumored to be near collapse. See “Lloyd's Spotlight Turns to Binders,” Insurance Day, May 24, 2004; “Lloyd's Lessons,” The Journal of Commerce, Aug. 29, 1996.

Given the erosion of the London Market, certain spectacular domestic bankruptcies, and the fact that many years may pass between the filing of the Complaint in a coverage action and the entry of a final judgment, policyholders worry that even solvent insurers named in the Complaint may be gone by the time of judgment. Pre-Answer security ensures that even if the defendant insurer is gone, its debt will be paid. The security requirement is thus well suited to its essential purpose. See, e.g., Retail Union Health and Welfare Fund v. Seabrum, 242 S.E.2d 18, 20 (Ga. 1978) (“The purpose of [the Georgia pre-Answer security statute] is to provide assurance that any judgment rendered against the insurer may be collected by the insured or beneficiary.”).

As most policyholders can attest, insurer insolvency is not limited to alien insurers or to surplus lines insurers. If policyholders could obtain pre-Answer security from authorized insurers, those that were familiar with the availability of such security no doubt would do so. But half a loaf being better than none, policyholders in litigation are well advised to examine their surplus lines portfolio in the light of the forum's pre-Answer security statute.

Pre-Answer security also protects the insured from the difficulty and added expense of enforcing a judgment in a distant forum. See, e.g., Akron Co. v. Fidelity Gen. Ins. Co., 250 F. Supp. 201 (N.D. Ohio 1964) (noting that Ohio's security requirement spares plaintiffs from having to institute proceedings in another forum to enforce a judgment). This benefit is far from negligible when the lawsuit involves the contractual obligations of overseas insurers.

Determining the Amount of the Security

The model act requires an unauthorized insurer to post security in an amount sufficient to “secure the payment of any final judgment which may be rendered in the action.” (Emphasis added.) In other words, the question for the court is what is the maximum amount that the insured could be awarded from each unauthorized insurer, assuming that the insured prevails on all claims against that insurer. See Procter v. Lockheed Corp., No. CV 731752, slip op. at 5 n.6 (Cal. Super. Ct. Santa Clara Cty. June 29, 1995) (interpreting the California statute).

In this regard, the pre-Answer security statute, which is part of a state's regulatory scheme for insurance, stands in marked contrast to statutes governing pre-judgment seizure or attachment of another's property. In New Jersey, for instance, those statutes typically provide that on a motion to vacate the seizure or attachment order, the plaintiff must sustain a burden of proof and show that it is likely to win a final judgment against the defendant. See, e.g., Allied Fin. Corp. v. Steel Panel Sales Corp., 205 A.2d 904 (App. Div. 1964) (discussing New Jersey's Attachment Act). But the New Jersey legislature did not see fit to include the same procedures in that state's pre-Answer security statute, nor does the model act contain such procedures.

The insured's liability in the underlying tort action need not have been established, let alone fixed in amount, before the court in the coverage action determines the amount of the pre-Answer security. See, e.g., Burnet v. Magnolia Quarterboats, Inc., 711 So. 2d 308, 310-12, 319 (La. Ct. App. 1998) (interpreting the Louisiana statute and upholding the bond requirement where the claims against the insured had not yet gone to trial).

This security-maximizing formulation ensures that the protection of the statute will not ultimately elude the policyholder. A lesser standard would subject the insured to the very risk that the security statute is designed to avoid, ie, that at the end of the case the insured will hold a paper judgment that goes fully or partially unpaid.

It is admittedly not always easy to determine the value of the insured's potential claim against each unauthorized insurer. Where the insured's liability for the underlying claims is not yet established or quantified, the insured's good-faith estimates of its potential liability should suffice. (Of course, the insured will want to submit its estimates to the court under seal so that they do not affect the underlying claims themselves.) Even such good-faith estimates may understate the quantum of the potential judgment against the unauthorized insurer, because the insured's liability could surpass the estimate, or additional claims could be brought against the insured during the pendency of the coverage litigation. But good-faith estimates should at least establish the floor.

Liability estimates are only part of the picture: The next question is how those liabilities are apportioned among the policyholder's insurers. In many jurisdictions, the rules to be applied in the coverage action concerning allocation, and perhaps even trigger, are not settled. The final liability of each unauthorized insurer, therefore, will often depend on legal and factual determinations that are unknowable at the beginning of the case.

Moreover, unless it is indisputable from the outset which state's (or states') law will apply, the insured will need to review the law of all of the states that are possible sources for the substantive law to be applied and assess how a given unauthorized insurer's liability could be affected by choice-of-law rulings that may be made later in the case.

To effectuate the statute's purpose, the insured should proffer a separate “reasonable best-case scenario” for its recovery against each unauthorized insurer that must put up pre-Answer security. To give a simple example, if an insured bought multiyear, primary coverage from a domestic unauthorized insurer and a 1-year excess policy from Lloyd's of London, the insured should present to the court a separate security request for each of these insurers, with each request calculated using different assumptions. Unless clear (and clearly applicable) legal rules preclude such a result, the insured should calculate the amount that the domestic carrier must post by assuming that all of that carrier's policies will be triggered, and that all of the liability will be allocated only among those policies. After all, at the end of the case, it may develop that no excess policies are put in play, and that the primary insurer is liable for the whole amount.

At the same time, however, so long as the “all sums” rule may be applied in the case, the insured should calculate the amount that Lloyd's must post by putting all of the liability into the Lloyd's policy year, subtracting the underlying limits for that year, and figuring up the bill. This would reflect, among other things, the possibility that, after full discovery and briefing, it turns out that coverage is triggered in the Lloyd's year but only that year, or that the other insurers may have a winning defense to coverage that is unavailable to Lloyd's, leaving Lloyd's to shoulder the entire coverage claim up to policy limits. Cf. Reading Co. v. Travelers Indem. Co., No. 87-2021, 1988 U.S. Dist. LEXIS 1408 (E.D. Pa. Feb. 18, 1988) (allowing plaintiff to choose to sue only the primary and excess carriers that wrote coverage during a 6-month period during 1968-69 and holding that those carriers would be liable up to their policy limits without proration, notwithstanding that the long-tail claims might have involved 35 years of damage and of insurance coverage).

It is the insured's right, if not obligation, to take these seemingly inconsistent positions. Unless the trigger rule, the scope rule, and even all of the pertinent facts are indisputable, neither the policyholder nor the insurers (nor the court) can know at the outset how the liabilities will ultimately be apportioned. The insured should not be forced to pick one likely scenario, when the result of a wrong guess could well mean that at the end of the case, the judgment against one or more unauthorized insurers exceeds the initial prediction of that insurer's liability. That result would frustrate the purpose of the statute and run directly counter to its text.

Lloyd's and the London Market Companies present a special case in this regard. In many coverage portfolios, Lloyd's and numerous Companies subscribed in varying quota shares to a large number of policies. But Lloyd's and the Companies typically litigate as a unit. As a compromise, in a particular case it may make sense for the policyholder to offer these insurers the opportunity to post a unified bond. That is, the insured may treat its London coverage as though it were written by one insurer, and calculate its best-case recovery from “London” collectively. In a case involving a large number of London insurers, this compromise will offer administrative advantages that the court may appreciate. The alternative is to calculate the potential liability of each London insurer separately, which will almost necessarily increase the total amount that those insurers are required to post. This is so because the policyholder will be required to employ different assumptions about the allocation of liability, each designed to maximize the exposure of a particular Company. The sum of the exposures so maximized will almost invariably exceed any amount calculated using only one set of assumptions for all of the Companies.

Conclusion

The pre-Answer security statute in force in most jurisdictions provides policyholders with an important protection: It ensures that unauthorized insurers will not escape judgment. Although the typical statute does not require any action by the policyholder to invoke this protection, in actual practice it is common for unauthorized insurers to ignore the pre-Answer security requirement and simply respond to a Complaint as would an authorized insurer. As a result, it normally falls to policyholders to remember this procedural protection and insist that unauthorized insurers comply with the statute that governs their case. Policyholders embarking on coverage litigation would do well to remember this often overlooked safeguard.

When corporate policyholders sue their insurers, the roster of defendants often includes an “unauthorized” insurer, whether it be Lloyd's of London (which is licensed in only two states, though it writes as an eligible surplus lines insurer in some or all of the other states), a London Market Company, or a domestic insurer not licensed to sell insurance in the state where suit was brought. Such insurers have avoided many of the stringent state regulations that govern “authorized” insurers. But in the majority of states, those insurers are subject to a quid pro quo in exchange for enjoying relaxed regulation: Unauthorized insurers (whether foreign or domestic, “eligible” as surplus lines carriers or not) are subject to a pre-Answer security requirement. That is, before they may answer a Complaint against them, unauthorized insurers must post cash, securities, or a bond sufficient to satisfy any judgment that may be entered against them.

Although not a newly enacted requirement, the pre-Answer bond is often overlooked as policyholders and their insurers hurtle into fast-paced litigation. Because obtaining such a bond can be “good insurance” against either an insolvency or a post-judgment battle to collect, policyholders should consider enforcing their right to demand a bond when litigating against an unauthorized insurer. Indeed, this may be a rare instance in which policyholders and at least some of their insurers ' the authorized ones ' can agree, since in jurisdictions that apply the “all sums” rule a bond can help minimize the risk that the authorized insurers will be left paying the share of the judgment that would have been borne by the unauthorized insurer had the policyholder been able to collect it.

The Statutory Framework

For present purposes, the insurance-writing world may be divided in two parts: authorized and unauthorized. Authorized or licensed insurers are subject to relatively strict state regulation. By contrast, many insurers do not become authorized in a given state, choosing either to become eligible surplus lines insurers (and thereby subject themselves to some lesser regulation) or not to submit at all to the state's regulatory process. It is these unauthorized insurers that are the subject of the pre-Answer security legislation.

Roughly 40 states have adopted a pre-Answer security requirement, based largely on a model act of the National Association of Insurance Commissioners (“NAIC”). See IV NAIC, Unauthorized Insurers Process Act, in Model Laws, Regulations and Guidelines (“Model Laws”) 850-5 to 850-8 (2003). The security requirement, which has withstood repeated attacks on its constitutionality, see, e.g., Curiale v. Ardra Ins. Co. , 595 N.Y.S.2d 186, 188 (App. Div. 1993); Trihedron Int'l Assurance, Ltd. v. Superior Court , 218 Cal. App. 3d 934, 267 Cal. Rptr. 418 (1990), typically applies whether the lawsuit is in state court or federal court.

The model act provides, in pertinent part:

Before any unauthorized foreign or alien insurer shall file or cause to be filed any pleading in any action, suit or proceeding instituted against it, the unauthorized insurer shall deposit with the clerk of the court in which the action, suit or proceeding is pending, cash or securities or file with the clerk a bond with good and sufficient sureties, to be approved by the court, in an amount to be fixed by the court sufficient to secure the payment of any final judgment which may be rendered in the action; or procure a certificate of authority to transact the business of insurance in this state. Unauthorized Insurers Process Act '3.A, in Model Laws at 850-2 to 850-3. (Emphasis added.)

Accordingly, unless an unauthorized insurer is willing to subject itself to the more stringent regulations that govern authorized insurers, it must post cash, securities, or a bond before it may defend itself in the litigation. In some states, there may be other alternatives available to the unauthorized insurer, see, e.g., N.J. Stat. '17:51-2(a) (2004) (allowing the court to dispense with the bond requirement if the insurer establishes that it maintains in the United States funds sufficient to satisfy any final judgment), but such alternatives are absent from the model act and from the statutes enacted in many states.

The Reasons for a Security Requirement

In many jurisdictions, the pre-Answer security requirement has been on the books for more than 40 years. The model act itself dates to 1949, and some state legislatures adopted their own versions of the model act that very year, with others following in the ensuing decades. Yet the relative paucity of case law concerning pre-Answer security suggests that policyholders have not systematically enforced their rights under these statutes.

The policyholders that insist on pre-Answer security are by and large responding to the very real danger of insurer insolvency. Since at least the late 1980s, policyholders have witnessed the collapse of insurer after insurer. Companies of every stripe ' domestic and foreign, large and small ' have been forced to close their doors. The London Market in particular has been plagued by insolvencies, and some policyholders have found their London coverage largely eviscerated. Even Lloyd's of London, previously faced with unexpectedly large liabilities and internal scandals, had at points in the past been rumored to be near collapse. See “Lloyd's Spotlight Turns to Binders,” Insurance Day, May 24, 2004; “Lloyd's Lessons,” The Journal of Commerce, Aug. 29, 1996.

Given the erosion of the London Market, certain spectacular domestic bankruptcies, and the fact that many years may pass between the filing of the Complaint in a coverage action and the entry of a final judgment, policyholders worry that even solvent insurers named in the Complaint may be gone by the time of judgment. Pre-Answer security ensures that even if the defendant insurer is gone, its debt will be paid. The security requirement is thus well suited to its essential purpose. See, e.g., Retail Union Health and Welfare Fund v. Seabrum , 242 S.E.2d 18, 20 (Ga. 1978) (“The purpose of [the Georgia pre-Answer security statute] is to provide assurance that any judgment rendered against the insurer may be collected by the insured or beneficiary.”).

As most policyholders can attest, insurer insolvency is not limited to alien insurers or to surplus lines insurers. If policyholders could obtain pre-Answer security from authorized insurers, those that were familiar with the availability of such security no doubt would do so. But half a loaf being better than none, policyholders in litigation are well advised to examine their surplus lines portfolio in the light of the forum's pre-Answer security statute.

Pre-Answer security also protects the insured from the difficulty and added expense of enforcing a judgment in a distant forum. See, e.g., Akron Co. v. Fidelity Gen. Ins. Co., 250 F. Supp. 201 (N.D. Ohio 1964) (noting that Ohio's security requirement spares plaintiffs from having to institute proceedings in another forum to enforce a judgment). This benefit is far from negligible when the lawsuit involves the contractual obligations of overseas insurers.

Determining the Amount of the Security

The model act requires an unauthorized insurer to post security in an amount sufficient to “secure the payment of any final judgment which may be rendered in the action.” (Emphasis added.) In other words, the question for the court is what is the maximum amount that the insured could be awarded from each unauthorized insurer, assuming that the insured prevails on all claims against that insurer. See Procter v. Lockheed Corp., No. CV 731752, slip op. at 5 n.6 (Cal. Super. Ct. Santa Clara Cty. June 29, 1995) (interpreting the California statute).

In this regard, the pre-Answer security statute, which is part of a state's regulatory scheme for insurance, stands in marked contrast to statutes governing pre-judgment seizure or attachment of another's property. In New Jersey, for instance, those statutes typically provide that on a motion to vacate the seizure or attachment order, the plaintiff must sustain a burden of proof and show that it is likely to win a final judgment against the defendant. See, e.g., Allied Fin. Corp. v. Steel Panel Sales Corp., 205 A.2d 904 (App. Div. 1964) (discussing New Jersey's Attachment Act). But the New Jersey legislature did not see fit to include the same procedures in that state's pre-Answer security statute, nor does the model act contain such procedures.

The insured's liability in the underlying tort action need not have been established, let alone fixed in amount, before the court in the coverage action determines the amount of the pre-Answer security. See, e.g., Burnet v. Magnolia Quarterboats , Inc., 711 So. 2d 308, 310-12, 319 (La. Ct. App. 1998) (interpreting the Louisiana statute and upholding the bond requirement where the claims against the insured had not yet gone to trial).

This security-maximizing formulation ensures that the protection of the statute will not ultimately elude the policyholder. A lesser standard would subject the insured to the very risk that the security statute is designed to avoid, ie, that at the end of the case the insured will hold a paper judgment that goes fully or partially unpaid.

It is admittedly not always easy to determine the value of the insured's potential claim against each unauthorized insurer. Where the insured's liability for the underlying claims is not yet established or quantified, the insured's good-faith estimates of its potential liability should suffice. (Of course, the insured will want to submit its estimates to the court under seal so that they do not affect the underlying claims themselves.) Even such good-faith estimates may understate the quantum of the potential judgment against the unauthorized insurer, because the insured's liability could surpass the estimate, or additional claims could be brought against the insured during the pendency of the coverage litigation. But good-faith estimates should at least establish the floor.

Liability estimates are only part of the picture: The next question is how those liabilities are apportioned among the policyholder's insurers. In many jurisdictions, the rules to be applied in the coverage action concerning allocation, and perhaps even trigger, are not settled. The final liability of each unauthorized insurer, therefore, will often depend on legal and factual determinations that are unknowable at the beginning of the case.

Moreover, unless it is indisputable from the outset which state's (or states') law will apply, the insured will need to review the law of all of the states that are possible sources for the substantive law to be applied and assess how a given unauthorized insurer's liability could be affected by choice-of-law rulings that may be made later in the case.

To effectuate the statute's purpose, the insured should proffer a separate “reasonable best-case scenario” for its recovery against each unauthorized insurer that must put up pre-Answer security. To give a simple example, if an insured bought multiyear, primary coverage from a domestic unauthorized insurer and a 1-year excess policy from Lloyd's of London, the insured should present to the court a separate security request for each of these insurers, with each request calculated using different assumptions. Unless clear (and clearly applicable) legal rules preclude such a result, the insured should calculate the amount that the domestic carrier must post by assuming that all of that carrier's policies will be triggered, and that all of the liability will be allocated only among those policies. After all, at the end of the case, it may develop that no excess policies are put in play, and that the primary insurer is liable for the whole amount.

At the same time, however, so long as the “all sums” rule may be applied in the case, the insured should calculate the amount that Lloyd's must post by putting all of the liability into the Lloyd's policy year, subtracting the underlying limits for that year, and figuring up the bill. This would reflect, among other things, the possibility that, after full discovery and briefing, it turns out that coverage is triggered in the Lloyd's year but only that year, or that the other insurers may have a winning defense to coverage that is unavailable to Lloyd's, leaving Lloyd's to shoulder the entire coverage claim up to policy limits. Cf. Reading Co. v. Travelers Indem. Co., No. 87-2021, 1988 U.S. Dist. LEXIS 1408 (E.D. Pa. Feb. 18, 1988) (allowing plaintiff to choose to sue only the primary and excess carriers that wrote coverage during a 6-month period during 1968-69 and holding that those carriers would be liable up to their policy limits without proration, notwithstanding that the long-tail claims might have involved 35 years of damage and of insurance coverage).

It is the insured's right, if not obligation, to take these seemingly inconsistent positions. Unless the trigger rule, the scope rule, and even all of the pertinent facts are indisputable, neither the policyholder nor the insurers (nor the court) can know at the outset how the liabilities will ultimately be apportioned. The insured should not be forced to pick one likely scenario, when the result of a wrong guess could well mean that at the end of the case, the judgment against one or more unauthorized insurers exceeds the initial prediction of that insurer's liability. That result would frustrate the purpose of the statute and run directly counter to its text.

Lloyd's and the London Market Companies present a special case in this regard. In many coverage portfolios, Lloyd's and numerous Companies subscribed in varying quota shares to a large number of policies. But Lloyd's and the Companies typically litigate as a unit. As a compromise, in a particular case it may make sense for the policyholder to offer these insurers the opportunity to post a unified bond. That is, the insured may treat its London coverage as though it were written by one insurer, and calculate its best-case recovery from “London” collectively. In a case involving a large number of London insurers, this compromise will offer administrative advantages that the court may appreciate. The alternative is to calculate the potential liability of each London insurer separately, which will almost necessarily increase the total amount that those insurers are required to post. This is so because the policyholder will be required to employ different assumptions about the allocation of liability, each designed to maximize the exposure of a particular Company. The sum of the exposures so maximized will almost invariably exceed any amount calculated using only one set of assumptions for all of the Companies.

Conclusion

The pre-Answer security statute in force in most jurisdictions provides policyholders with an important protection: It ensures that unauthorized insurers will not escape judgment. Although the typical statute does not require any action by the policyholder to invoke this protection, in actual practice it is common for unauthorized insurers to ignore the pre-Answer security requirement and simply respond to a Complaint as would an authorized insurer. As a result, it normally falls to policyholders to remember this procedural protection and insist that unauthorized insurers comply with the statute that governs their case. Policyholders embarking on coverage litigation would do well to remember this often overlooked safeguard.