Legal Definitions - drop-down clause

A drop-down clause is a specific provision found within an excess insurance policy. This clause requires the excess insurer to "drop down" and begin providing coverage to the policyholder even if the primary or underlying insurance policy has not been fully used up or exhausted. This situation typically occurs when the primary insurance company becomes financially unable to pay claims, most commonly due to insolvency or bankruptcy. In essence, the drop-down clause ensures that the policyholder still receives coverage for losses that would normally fall within the primary insurer's responsibility, preventing a gap in protection.

• Example 1: Construction Company Insolvency

  Imagine "Urban Builders Inc.," a large construction firm, holds a primary liability insurance policy with "FirstLine Insurance" covering the first $5 million in claims. Above this, they have an excess liability policy with "Summit Protection" for an additional $20 million. During a period of economic downturn, FirstLine Insurance declares bankruptcy and is unable to pay any outstanding or new claims. Shortly after, a major structural failure occurs on an Urban Builders Inc. project, leading to $3 million in damages and legal costs.

  How it illustrates: Without a drop-down clause, Summit Protection would typically only begin paying once the $5 million primary policy limit was exhausted by actual payments. However, because FirstLine Insurance is insolvent, the drop-down clause in Summit Protection's policy activates. This compels Summit Protection to "drop down" and cover the $3 million claim, effectively stepping into the shoes of the bankrupt primary insurer, even though the primary policy wasn't exhausted by payments.

• Example 2: Healthcare Provider Malpractice Claims

  Consider "Community Health System," a network of hospitals and clinics, which carries a primary medical malpractice insurance policy for the first $2 million in claims from "Reliable Coverage Solutions." They also have an excess policy with "Global Umbrella Insurers" for claims exceeding $2 million, up to $15 million. Reliable Coverage Solutions faces severe financial distress due to a series of large payouts and is subsequently declared insolvent by regulators. A few months later, a new medical malpractice claim arises against Community Health System, seeking $1.8 million in damages.

  How it illustrates: In this scenario, the drop-down clause in Global Umbrella Insurers' policy would require them to cover the $1.8 million malpractice claim. Despite the fact that the $2 million primary policy limit was not reached by actual claim payments, the primary insurer's insolvency triggers the drop-down clause, making Global Umbrella Insurers responsible for the claim that would otherwise have been covered by Reliable Coverage Solutions.