. 
In
essence, the insurer argued that “each excess insurer in an
insurance tower can force the insured to prove that every
payment made by the underlying insurers fit the definition
of ‘Loss,’ that no exceptions or limitations on coverage were
overlooked, and generally that there had been no
overpayments at the lower levels of coverage.”
 Id. at 1174
.

    The Costco court rejected this argument, observing that
an excess insurer generally “may not . . . second-guess the
coverage determinations of the underlying insurers” absent
a “contractual right to interfere in their adjustment
processes.”
 Id. at 1173. 
Instead, while an excess insurer is
not bound by the underlying insurers’ policy interpretations,

         the weight of authority holds that an excess
         insurer may not challenge the underlying
         insurers’ payment decisions in order to argue
         that their policy limits were not (or should not
         have been) exhausted . . . unless there is an
         indication that the payments were motivated
         by fraud or bad faith.



     5
      The policy provided that Costco’s third layer excess insurer would
drop down to provide coverage “only in the event of the reduction or
exhaustion of the Underlying [$35 million] Limit by reasons of the
insurers of the Underlying Policies paying in legal currency 
Loss.”
387 F. Supp. 3d at 1174
.
        AXIS REINSURANCE V. NORTHRUP GRUMMAN                            11


Id. at 1173–74 
(citations omitted). The Costco court went
on to note that the policy provision at issue was “ambiguous
in the context presented . . . and in light of other policy
language,” and that it therefore “must be construed against
the insurer and in favor of the insured” under applicable state
law.
 Id. at 1174 
(citing Holden v. Farmers Ins. Co. of Wash.,
169 Wash. 2d 750
, 756 (2010)).

   We adopt the general rule set out in Costco, which the
weight of authority clearly supports. 6 We agree with

     6
       See Allan D. Windt, Insurance Claims and Disputes, § 6:45A (6th
ed. 2018) (“[A]t least absent fraud/bad faith, an excess insurer is bound
by the fact that the primary insurer has paid, and cannot contest (a) that
such payment reduces the primary insurer’s applicable aggregate, or
(b) that the excess insurer must provide policy benefits when the
aggregate in any relevant primary policy has been exhausted.”); Edward
E. Gillen Co. v. Ins. Co. of the State of Pa., No. 10-C-564, 
2011 WL
1694431
, at *4 (E.D. Wis. May 3, 2011) (holding that an excess liability
insurer “is free . . . to contest coverage under its own policy [but] cannot
avoid or reduce liability under its own policy by challenging a separate
insurer’s decision to settle or pay out claims at a prior layer of
insurance”); ARM Props. Mgmt. Grp. v. RSUI Indem. Co., A-07-CA-
718-SS, 
2008 WL 5973220
, at *5–7 (W.D. Tex. Aug. 25, 2008)
(rejecting excess insurer’s argument that the underlying policy limits had
not been exhausted because the underlying insurers had made payments
outside the scope of coverage, had failed to apply exceptions to coverage,
or had otherwise overpaid); Ins. Co. of N. Am. v. Kayser-Roth Corp.,
770 A.2d 403
, 416-17 (R.I. 2001) (“[A]bsent fraud between the insured
and the primary carrier, ‘the insured does not carry the burden of proving
the soundness of the primary carrier’s decision to pay . . . [I]t is for the
excess carrier to seek redress from the underlying carrier should the
excess carrier believe that the underlying carrier has exposed it to
liability or caused it harm by mishandling the claim in some respect.”);
UNR Indus., Inc. v. Cont’l Ins. Co., No. 83 A 2523, 
1988 WL 121574
,
at *16–17 (N.D. Ill. Nov. 9, 1988), amended, No. 85 C 3532, 
1989 WL
265493 
(N.D. Ill. Jan. 11, 1989) (rejecting excess insurer’s unsupported
theory that it could “proceed against its insured because of the primary
insurer’s alleged ‘improper exhaustion’ of primary coverage or
12      AXIS REINSURANCE V. NORTHRUP GRUMMAN

Northrop that the district court’s alternative rule—that
excess insurers generally may contest the soundness of
underlying insurers’ payment decisions—“would undermine
the confidence of both insureds and insurers in the
dependability of settlements,” eliminating one of the primary
incentives for obtaining insurance in the first place.
Furthermore, such a rule would introduce a host of
inefficiencies into the insurance industry, with no obvious
countervailing benefits to insurers or policyholders.

    The district court was concerned that adoption of the
Costco rule “would render the terms of excess insurer
policies useless,” because “[w]ere AXIS required to pay,
without any opportunity to dispute the validity of its
payment, any excess insurer could be liable to cover
payments totally outside the scope of its excess coverage
policy.” We do not share the district court’s concern, which
ignores that AXIS never disputed the validity of the claim
that Northrop asked it to cover—the Grabek Settlement.
Instead, AXIS sought to reduce its liability for that
concededly valid claim by disputing the validity of a
different claim, the DOL Settlement, which it was never
asked to cover. Under the Costco approach, which we adopt,
an excess insurer remains free to contest claims submitted to
it during the claims adjustment process, even when an
underlying insurer has already determined that the same
claim falls within the scope of coverage. But, absent a
specific contractual provision, it may not second-guess other


‘negligent handling’ of a defense” where the excess insurer “alleged no
bad faith conduct by” the primary insurer); see also Amerisure Mut. Ins.
Co. v. Arch Specialty Ins. Co., 
784 F.3d 270
, 275 (5th Cir. 2015)
(expressing skepticism about, although not reaching, an excess insurer’s
“wrongful exhaustion” claim against an underlying insurer, where the
excess insurer was arguing on behalf of a common insured).
        AXIS REINSURANCE V. NORTHRUP GRUMMAN                          13

insurers’ payments of earlier claims without first showing
that those payments were motivated by fraud or bad faith.

    The district court’s perspective presumes that underlying
insurers are motivated to pay uncovered claims even in the
absence of fraud or bad faith. While such a possibility may
exist, we do not think that there are many instances where an
insurance company will pay out claims—let alone its
policy’s limit—when it is not obligated to do so (at least in
cases not involving fraud or bad faith). But even if AXIS
were correct that insurers sometimes choose to settle claims
that fall outside their scope of coverage “for what they
perceive[] as legitimate business reasons,” nothing prevents
AXIS or any other excess insurer from raising and
leveraging this concern during contractual negotiations with
their policyholders. For example, the excess insurer could
request higher premiums to account for this contingency, or
it could insert specific policy language reserving its right to
contest “improper erosion” by the underlying insurers under
certain conditions—so long as the provision does not
conflict with applicable law or public policy. 7

    Therefore, consistent with the limited caselaw and
secondary sources that have addressed excess insurer claims
of “improper erosion,” “improper exhaustion,” “wrongful
exhaustion,” and similar challenges to the payment decisions
of underlying insurers, we hold that an excess insurer may
not challenge those decisions in order to argue that the
underlying liability limits were not (or should not have been)

    7
       We note that Northrop argued only that the inclusion of “improper
erosion” clauses in excess policies would be impractical and unwise, not
that they would be per se illegal. Neither party has pointed to any public
policy or provision of the California Insurance Code prohibiting such
clauses as a matter of law, nor are we aware of any.
14     AXIS REINSURANCE V. NORTHRUP GRUMMAN

exhausted absent a showing of fraud or bad faith, or the
specific reservation of such a right in its contract with the
insured.

                              B

    Here, AXIS has not alleged fraud or bad faith. Thus, the
only question is whether the terms of its excess policy with
Northrop entitled it to assert improper erosion—that is, to
challenge the soundness of National Union’s and CNA’s
decision to cover the DOL Settlement and to demand
reimbursement from Northrop of the settlement amount
against a later, unrelated claim.

    To answer this question, we look to California law,
which both parties agree applies here. Under California law,
interpretation of an insurance policy is a question of law,
subject to the ordinary rules of contractual interpretation.
See Bank of the West v. Superior Court, 
2 Cal. 4th 1254
,
1264 (1992); Waller v. Truck Ins. Exch., Inc., 
11 Cal. 4th 1
,
18 (1995); AIU Ins. Co. v. Superior Court, 
51 Cal. 3d 807
,
818 (1990). Policy language must be interpreted “in context,
with regard to its intended function in the policy,” keeping
in mind that “[t]he fundamental goal of contractual
interpretation is to give effect to the mutual intention of the
parties.” Bank of the 
West, 2 Cal. 4th at 1264
–65 (citing Cal.
Civ. Code § 1636). “If contractual language is clear and
explicit, it governs.”
 Id. at 1264 
(citing Cal. Civ. Code
§ 1638). If there is ambiguity, however, it is generally
resolved against the insurer and in favor of coverage. Id.;
see AIU 
Ins., 51 Cal. 3d at 822 
(“[W]e generally interpret the
coverage clauses of insurance policies broadly, protecting
the objectively reasonable expectations of the insured.”). A
policy provision is ambiguous when it is capable of two or
more constructions, both of which are reasonable. 
Waller,
11 Cal. 4th at 18
.
       AXIS REINSURANCE V. NORTHRUP GRUMMAN                 15

    The AXIS policy requires, as a prerequisite to excess
coverage, exhaustion of the underlying insurance liability
limits “for covered loss” under those policies. But the policy
contains no language expressly providing AXIS with the
right to challenge the propriety of the underlying insurers’
payment decisions under this provision. It does not state that
AXIS may challenge those prior payments on grounds of
“improper erosion” or “improper exhaustion,” or that AXIS
may seek reimbursement of those payments against
unrelated, valid claims by asserting that the prior payments
were for “uncovered loss.” As AXIS conceded at oral
argument, the “covered loss” provision “is silent on the
ability to challenge,” and AXIS has pointed to no other
policy provision as a basis for its purported right to seek
reimbursement of the prior payment on grounds of
“improper erosion.”

    In short, the AXIS excess policy does not clearly and
unambiguously reserve for AXIS a right to challenge
National Union’s and CNA’s payment of the DOL
Settlement. Because the policy language as a whole
indicates that Northrop and AXIS did not mutually intend
for AXIS to have the right to second-guess the coverage
decisions of underlying insurers, we resolve whatever
ambiguity exists in the policy against the insurer, AXIS, and
in favor of Northrop’s objectively reasonable expectations
of coverage. See Bank of the 
West, 2 Cal. 4th at 1264
–65;
AIU 
Ins., 51 Cal. 3d at 822
.

                              C

    Because we hold that there is no general rule supporting
AXIS’s claim of improper erosion and AXIS did not
contractually reserve its right to assert this claim, we do not
reach the question of whether the DOL Settlement violated
California’s public policy against paying insurance benefits
16     AXIS REINSURANCE V. NORTHRUP GRUMMAN

to compensate an insured for disgorgement. See Bank of the
West, 2 Cal. 4th at 1266
, 1269. We do note, however, that
the statute that barred insurance coverage for disgorgement
in Bank of the West, California Insurance Code § 533.5,
applies only to civil actions brought by the state attorney
general, a district attorney, or a city prosecutor—not to
actions, like the DOL lawsuit, brought by the federal
government. See Bodell v. Walbrook Ins. Co., 
119 F.3d
1411
, 1417 (9th Cir. 1997); Mt. Hawley Ins. Co. v. Lopez,
215 Cal. App. 4th 1385
, 1390 (2013). Furthermore, Bank of
the West held that “one may not insure against the risk of
being ordered to return money or property that has been
wrongfully 
acquired.” 2 Cal. 4th at 1266 
(emphasis added).
That public policy rule may not be applicable where, as here,
there was no final adjudication of Northrop’s alleged ERISA
violations, Northrop made no admissions of guilt, and the
DOL asserted multiple theories of recovery besides
disgorgement. See, e.g., U.S. Bank Nat. Ass’n v. Indian
Harbor Ins. Co., 
68 F. Supp. 3d 1044
, 1050 (D. Minn. 2014)
(“When an underlying action alleging ill-gotten gains and
seeking disgorgement of those gains settles before trial, there
is no final adjudication in that action determining that the
gains were ill-gotten and ordering the return of those
gains.”).

    But even accepting that the DOL Settlement required
disgorgement and was, therefore, uninsurable as a matter of
California state law, AXIS is the wrong insurer to raise that
issue here. National Union and CNA could have raised this
defense and preserved it for appeal by denying coverage on
state law grounds when Northrop referred the DOL
Settlement to them for claim adjustment. These underlying
insurers’ failure to challenge the DOL Settlement under
Bank of the West at that time does not entitle AXIS, as the
secondary excess insurer, to raise the “uninsurable
       AXIS REINSURANCE V. NORTHRUP GRUMMAN                 17

disgorgement” issue now in relation to a separate insurance
claim that AXIS concedes falls within its scope of coverage.

    Thus, our holding that excess insurers generally may not
second-guess the payment decisions of underlying insurers
applies even in cases where, as here, those prior payments
arguably were for loss that is uninsurable as a matter of state
public policy. In such cases, as in all others, the burden is
on the excess insurer to show that the underlying insurers’
payments were motivated by fraud or bad faith, or that it has
a clear contractual right to challenge those payments—as
contrary to law or otherwise—in the context of unrelated
claims.

                              IV

    We conclude that no reasonable insured in Northrop’s
position would understand that it might have to justify its
underlying insurers’ payment decisions as a prerequisite to
obtaining excess coverage from AXIS. In reaching the
opposite conclusion, the district court misapplied our
unpublished decision in Shy, ignored the weight of authority
rejecting “improper erosion” as a valid basis for denying
coverage, and misconstrued the “covered loss” provision in
AXIS’s excess policy as a reservation of the right to second-
guess other insurers’ payments. Accordingly, we reverse the
district court’s summary judgment order and remand for
further proceedings consistent with this opinion.

   REVERSED and REMANDED.