Specialty Podcast: D&O Allocation Disputes and a New Federal Framework for AI Risk

Intro (00:00):
You are listening to the Alliant Specialty Podcast, dedicated to insurance and risk management solutions and trends shaping the market today.

Mike Radak (00:09):
Hi, everybody. Thanks for joining us for today's episode of Alliant Specialty's Claims and Legal Podcast, where we highlight important legal developments in the financial lines insurance world. I'm joined by our resident cyber expert and attorney, David Finz, as usual. Today I'm going to discuss a really interesting case out of the Southern District of New York that is chockfull of insurance legal issues and is a really favorable result from a policy holder perspective, which is nice to see from where we sit. If you'd like to learn more about this article, it is the lead article in our monthly Executive Liability Insights newsletter for this month. I'll go through the highlights here, and then David is going to talk to us a bit about the recent executive order on AI that came down recently. There's a lot to address in the case I'm talking about, so I'm just going to get to it. This case involved an appeal of a coverage arbitration by an excess carrier that the arbitration panel had ruled against. The underlying matter that resulted in the arbitration involved a lawsuit submitted to a D&O Tower of Insurance for the insured company. That lawsuit ultimately settled for tens of millions of dollars. The insured had submitted the claim to its D&O carriers, and after the underlying matter settled, the insured began working with the carriers to cover the settlement. Because several of the carriers at the bottom of the tower asserted that there were both covered and uncovered allegations, the primary carrier worked out allocation percentages between covered and uncovered claims that they agreed to cover for the settlement. Ultimately the primary carrier paid a percentage of the settlement and the insured paid the rest. The insured tried to work out a similar allocation with the first three excess layers that would've been implicated in the settlement.

Because they couldn't successfully agree on a number, the matter went to coverage arbitration. At the arbitration, the first two layers of excess relatively quickly settled out, agreed on an allocation number with the insured, but it was the third excess carrier that remained as a defendant in the arbitration and would not agree to settle the matter. One of the key issues in this coverage arbitration was whether Delaware's larger settlement rule applied. Under that rule, a loss is fully recoverable unless the insurer can show that the non-covered conduct increased its liability. As opposed to the other side of the coin, which was New York's relative exposure rule, under which the insurer and the insured allocate settlement costs between covered and non-covered parties with the insurer bearing the burden to prove the amount that should be excluded from coverage. After some argument, the panel applied the relative exposure rule, and the arbitrators ruled in favor of the insured finding that the carrier owed 100% of their limits for the settlement. The panel really did a great job analyzing all the various legal issues that were involved, including best efforts on allocation. The decision also highlighted the fact that during the coverage arbitration, the carrier's own expert criticized the carrier's efforts in trying to do best efforts to settle the matter. It was also noted that the carrier's expert had actually never read the policy, which I find super interesting and kind of shocking for an expert witness. That aside, the carrier appealed the arbitration award on the basis that the panel improperly refused to consider settlement-related evidence for the purpose of determining the loss. In that regard, they were referencing the percentage numbers that the insured had discussed with the carriers that had settled out. The appellate court reviewed whether the arbitration panel had disregarded New York law and the party's agreement by misconstruing the policy's best efforts requirement and whether the arbitration panel had erroneously applied the larger settlement rule. The appellate court again affirmed the matter in favor of the insured and ruled 100% against the insurer.

They found that the excess carrier did not carry its heavy burden to show that the arbitration proceedings were fundamentally unfair, violated due process. They found that the insured acted reasonably by making several offers to settle with the excess carrier that they were at issue with. They found that the panel actually did apply the relative exposure test, despite the carrier's arguments that they did not. There were several additional arguments that were raised by the insurance carrier that the court just dismissed outright and found baseless and meritless. In looking at the result of this matter, there's a lot of important legal issues that were addressed by the appellate court and the arbitration panel, but it's disappointing that an excess carrier would make the insured go to such lengths to recover under an insurance policy as the insured was entitled to do. In this case, the court got it exactly right with their ruling. It also highlights the fact that courts will almost always defer to an arbitration panel's decision in these insurance disputes. This was a victory for policy holders, no matter how you look at it. It's a reminder that the insurer bears the burden in proving the relative exposure under the New York rule. If they fail to meet that burden, the courts are going to find full coverage for the insured as they did here. It was good to see the court get it right. These are the types of issues that Alliant's Claims and Legal team advocates for our insureds on, on a daily basis, and we can help with. This absolutely should have been a covered claim, as evidenced by the three insurers at the bottom of the tower paying their portions, but it's an interesting, interesting decision if you have the time to read it. With that said, I'll turn it over to David to talk about some developments in the cyber world.

David Finz (05:47):
Thanks, Mike. So this is not a topic that we have covered in a previous issue of our newsletter, but it will almost certainly be the subject of an article in an upcoming issue of our newsletter. Last week, the president issued an executive order establishing a national policy framework for AI. Now, the primary goal of this order was to establish what he called a minimally burdensome national standard for artificial intelligence. This is in order to ensure that the U.S. remains dominant in this technology for the sake of our economy and our national security. Now, this executive order asserts that state level AI regulations can be, and I'm using the executive order's words here, excessive, conflicting and sometimes ideologically driven, and that this approach threatens innovation and hinders the U.S. in its race with its adversaries around the development of AI. The core policy here is to create a new framework, and there's several key actions and directives that are part of this executive order, and I'm going to touch upon them briefly here. First of all, the president is establishing an AI litigation task force. Within 30 days of this EO being signed, the attorney general must establish this task force, whose sole responsibility is to challenge state AI laws that the federal government says are inconsistent with this EO. Now, one way of doing this will be to identify laws that the president claims unconstitutionally regulate interstate commerce or are preempted by federal regulations. Now, separate and apart from this, the Secretary of Commerce must publish an evaluation of existing state AI laws within 90 days.

They're going to be targeting laws that require AI models to alter their truthful outputs or compel disclosure and reporting, that in their opinion would violate the First Amendment. States with such laws on the books could be deemed ineligible for funds under the broadband equity access and development or BEAD program. Federal agencies must also assess their discretionary grant programs to see if they can condition grants on states either not enacting conflicting AI laws, or at least agreeing not to enforce existing laws. Now, there are some roles here for federal regulatory agencies as well. The chairman of the FCC must initiate a proceeding within 90 days of commerce's evaluation to determine whether to adopt federal reporting and disclosure standards for AI models that would preempt conflicting state laws. The chairman of the Federal Trade Commission must issue a policy statement within 90 days on how the FTC would enforce its act's prohibition on unfair and deceptive trade practices and how that applies to AI models. Now, this includes providing a framework for determining whether state AI laws are in fact preempted by the FTC act and if so, when. The special advisor for AI and crypto and the assistant to the president for science and technology are charged with jointly preparing a legislative recommendation to Congress to establish a uniform policy framework for AI that will preempt conflicting state laws. We can expect congressional Republicans to sponsor such legislation. Now, there's going to be certain exemptions to this preemption, such as state laws relating to child safety, to data center infrastructure and also for state government procurement and use of AI, so there are certain areas that will be carved out of this EO. Now, whether someone agrees or disagrees with what the president is doing, we do have to talk about why it's significant because we've begun to see a proliferation of state laws that govern the use of AI. From the standpoint of a business trying to develop or deploy artificial intelligence, these laws can make the development of the technology problematic because what's acceptable in one jurisdiction may be prohibited in another and what's required in one jurisdiction may be prohibited in another. As we develop this new technology, we're coming up against countries like China, where the economic planning is more centralized, and they don't necessarily have these obstacles to overcome. The White House has taken the position that we need a unified policy as a matter of national security. Now, what does all of this have to do with insurance? As I've said in prior episodes, artificial intelligence is not just a cyber issue, it cuts across many lines of coverage. You could have bodily injury and property damage that results from the deployment of AI, and obviously that could hit the general liability or property policies, but let's even just set that aside for the moment. More along the lines of the specialty lines of coverage that we focus on here, AI could lead to the development of claims in the employment practice arena where bias is alleged in the hiring process.

It could also, when it's utilized for the delivery of services, could lead to charges that those services were rendered negligently and that could result in a professional liability claim. You have obvious media exposure here around copyright infringement, misappropriation of image, defamation, all of which could result from the improper use of AI. You have to look across all of these lines of coverage in order to determine what the exposures are. Having a single framework to consult hopefully would streamline the process of reviewing a company's own controls in order to stay in compliance. Now, I do have to say, this executive order is going to take several months to roll out, but I think that state agencies and state legislators are definitely on notice that we're going to be headed towards a national standard. This is Washington's efforts to tap the brakes, if you will, on the development of AI frameworks at the state level. It's important for businesses to keep this in mind as they decide how they want to deploy AI in their own operations and what best practices they want to put into place as we move towards a single unified national standard. With that, I'm going to turn it back over to you, Mike.

Mike Radak (11:49):
Thanks, David. Great stuff. I know we're going to see the legal landscape constantly changing with AI becoming more and more integrated in business in our daily lives, and I look forward to seeing the insurance industry reaction once we start seeing more and more claims related to AI. Thanks to our listeners for tuning in today. If you'd like more information on some of these recent developments, please reach out and definitely subscribe to our Executive Liability Insights monthly newsletter. If you'd like more information on Alliant and a more rewarding way to manage risk, please reach out for more info and visit our website at www.Alliant.com. Thank you.