Posted on: 6/13/2011
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It is axiomatic that excess insurers do not assume liability under an excess policy until a predetermined amount of underlying coverage has been exhausted. Notwithstanding this simple statement, defining "exhaustion" has proven to be a chronic challenge. Much of that challenge is caused by the myriad ways excess policies define exhaustion. Some definitions of exhaustion are broad and generic, such as agreements to pay ultimate net loss only "after all primary and other underlying insurance has been exhausted." Others provide that the excess policy does not attach until the insured's underlying insurer "shall have paid the amount of the policy limits." Still others are more precise providing that "liability for any covered loss shall attach only after the insurers of the Underlying Policies have been paid, in the applicable legal currency, the full amount of the Underlying Limit and the Insureds shall have paid the full amount the uninsured retention, if any applicable to the primary Underlying Policy."
While numerous issues spin-off of the interpretation of exhaustion, the focus of this article will be on whether it is necessary that underlying insurers actually pay the full amount of the underlying limits and that the insured actually pay the full amount of any self-insured retention for exhaustion to occur and excess liability to attach. In the past year, courts have arrived at different conclusions depending upon the language of the excess policy and, in one case, public policy considerations.
General Principles Of Insurance Contract Interpretation
Determining the meaning of exhaustion involves the interpretation of a particular insurance contract. General principles governing the interpretation of insurance contracts are relatively uniform throughout the United States. Those principles include that (1) the interpretation of an insurance policy is usually a legal question to be determined by the court; (2) the interpretation requires a judicial determination of the common interest of the parties; (3) the parties' intent is determined in accordance with the common and ordinary meaning of the words used in the policy, unless the words have a technical meaning; (4) the insurance contract must be construed as a whole, according to the entirety of its terms and conditions and as modified by any endorsements; (5) if language is unambiguous, the agreement is enforced as written; and (6) if an ambiguity exists, the ambiguous language is generally construed in favor of the insured.
Zeig v. Massachusetts Bonding
The analysis for most decisions concerning whether on underlying policy has been exhausted spins off of Justice Augustus N. Hand's opinion in Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928). In Zeig, the excess insurer contended that the insured must collect the full amount of the $15,000 underlying policies in order to "exhaust" that insurance. The court's initial reaction was that "[s]uch a construction of the policy sued on seems unnecessarily stringent. . . . [The excess insurer] had no rational interest in whether the insured collected the full amount of the primary policies, so long as it was only called upon to pay such portion of the loss as was in excess of the limits of those policies. To require an absolute collection of the primary insurance to its full limit would in many, if not most, cases involve delay, promote litigation, and prevent an adjustment of disputes which is both convenient and commendable." Id. at 666. Nonetheless, the court also said that "[i]t is doubtless true that the parties could impose such a condition precedent to liability upon the policy, if they chose to do so." Id. Therefore, insofar as such a condition is "harmful to the insured" and "of no rational advantage to the insurer," it should be enforced "only … when the terms of the contract demand it." Id. The court went on to conclude that the terms of the excess policy did not demand that the policyholder collect the full amount of the underlying policies because the clause provided only that underlying policies be "exhausted in the payment of claims to the full amount of the expressed limits." The court reasoned that "[t]he claims are paid in the full amount of the policies, if they are settled or discharged, and the primary insurance is thereby exhausted. There is no need of interpreting the word 'payment' as only relating to payment in cash." Id.
Since the Zeig decision, courts have generally taken a hard look at the definition of exhaustion and concluded that if the policy language is unambiguous and admits of only one construction, they will enforce the contract as written. On the other hand, if the policy language is ambiguous and could be reasonably construed as not requiring full payment of the underlying policies, the courts will not require full payment, so long as the underlying policies are credited with the full amount of their policy limits and any applicable self-insured retentions.
Recent Decisions Enforcing Unambiguous Exhaustion Requirements
Several recent cases, employing classic rules of contract interpretation, conclude that unambiguous exhaustion provisions requiring actual payment of the full amount of the underlying insurance are enforceable and hold that failure to actually pay the underlying policy (including any self-insured retention) is a failure to exhaust and the excess insurer has no obligation.
In Rosciti v. Liberty Mutual Insurance Co., 2010 WL 3432305 (D.R.I.), the plaintiffs sued the seller of defective mobile homes causing personal injuries allegedly caused by exposure to mold. The seller/insured, who was self insured to $500,000, was bankrupt and could not pay the $500,000 below his excess policy. The excess policy provided that the insurer shall be obligated to pay "only after there has been a complete expenditure of retained limits by means of payments for judgments, settlements, or defense costs" and that "under no circumstances shall the bankruptcy, insolvency, or inability to pay require us to drop down or in any way assume any obligation associated with your retained limit." Id. at *4. The court concluded that the insured must completely expend its retained limit before the excess policy attaches. Id. at *5.
In Forecast Homes, Inc. v. Steadfast Ins. Co., 181 Cal. App. 4th 1466 (4th Dist. 2010) a general contractor required that its subcontractors add the general contractor to its general liability policy as an additional insured. The general contractor was later sued and sought coverage from the subcontractor's insurer. The insurer denied coverage on the grounds that the subcontractor had not paid the SIR which was a precondition of coverage. The policy stated "… it is a condition precedent to our liability that you make actual payment of all damages and defense costs for each occurrence or offense, until you have paid self-insured retention amount and defense costs equal to the per occurrence amount shown in the Schedule. Payments by others, including but not limited to additional insureds or insurers, do not serve to satisfy the self-insured retention." Id. at 1472. "It is well-recognized that self-insurance retentions are the equivalent to primary liability insurance, and that policies which are subject to self-insured retentions are excess policies having no duty to indemnify until the self-insured retention is exhausted." Id. at 1474.
The court held the exhaustion requirement was unambiguous and that contractually prohibiting the additional insured the right to pay the SIR does not violate public policy. "Given [the general contractor's] bargaining position with the subcontractors, it is difficult to fathom what public policy would be advanced by requiring the court to rewrite an unambiguous policy provision and essentially insert an additional phrase permitting the additional insured to satisfy the SIR obligation." Id. at 1482. The court reasoned that it was the subcontractor, not the general contractor, that formed the insurance contract with the insurer and that the subcontractor may have had good reasons to want to control the SIR. The court appeared to be unsympathetic to the general contractor's plight insofar as the subcontract provided that the general contractor had the right to approve the insurance. "Under these circumstances, public policy does not allow a reviewing court to interfere and change the bargain the parties reached merely because certain recognizable risks came to pass." Id. at 1483.
Lastly, in Great American Insurance Co. v. Bally Total Fitness Holding Corp., 2010 WL 2542191 (N.D. Ill. 2010), the policyholder allegedly incurred $33 million in legal fees defending suits arising from its past financial statements. The policyholder sought coverage from its primary D&O carrier and four excess insurers. The policyholder settled with the primary carrier and the first and second excess carriers. The settlement sums from each of those insurers was for less than their respective limits of liability. The third and fourth excess insurers then refused to settle on the grounds that the underlying policies had not been exhausted. The third layer excess policy stated that: "It is expressly agreed that liability for any covered loss shall attach to the Insurer only after the insurers of the Underlying Policies shall have paid … the full amount of the Underlying Limit and the Insureds shall have paid the full amount of the uninsured retention, if any, applicable to the primary Underlying Policy." Id. at *2. The court concluded that the exhaustion language was unambiguous and that the underlying policies were not exhausted. Id. at *4.
Recent Decisions Finding Exhaustion Requirements To Be Ambiguous Or Against Public Policy
In the past year, the Seventh Circuit found that an umbrella policy did not clearly require exhaustion of an underlying policy by payment alone. Trinity Homes, LLC v. Ohio Casualty Insurance Company, 629 F.3d 653 (7th Cir. 2010) (interpreting Indiana law). The umbrella policy provided that "[i]f the limits of 'underlying insurance' have been exhausted by payment of claims, this policy will continue in force as 'underlying insurance'." The Seventh Circuit held that "[w]hile the umbrella agreement does state that a CGL policy is exhausted when the policy limit has been completely expended, it does not clearly provide that the full limit must be paid out by the CGL insurer alone. As such, the policy is ambiguous and susceptible to the meaning put forth by [the insured] that a CGL policy can be exhausted when an insured and a CGL insurer enter into a settlement agreement where the primary insurer will pay a large percentage of the total limit and the insured takes responsibility for the remainder." Id. at 658. The court also observed that its construction of the umbrella policy "is also reinforced by Indiana public policy favoring out-of-court settlements." Id. at 659.
A recent case from the Eastern District of Louisiana takes the cases favoring exhaustion one step further, holding that umbrella policies that require actual payment of the full underlying policies are unenforceable. Lightfoot v. Hartford Fire Insurance Company, 2011 WL 197982 (E.D. La.). The court held that a settlement with the primary carrier for less than its policy limits exhausts the policy so long as it is credited to the full extent of its policy limits. The court relied on Louisiana state court decisions stating that an excess insurer lacked "any real interest in the settlement effected." Id. at *3. Therefore, the exhaustion requirement in the excess policy is "immaterial" when the underlying insurer has been credited with full amount of the underlying policy. Id. at *4. The court appears to be saying that, as a matter of public policy, it will not enforce even unambiguous exhaustion provisions requiring actual payment of the full amount of the underlying insurance.
As a second ground for its decision, the court also found that the exhaustion requirement was ambiguous. The excess policy required that the insured maintain coverage within specified limits and that the condition "shall be in full force and effect, except for reduction or exhaustion of these underlying aggregate limits solely by payment of covered losses by the underlying insurers during the policy year." Id. at *5. The court determined that the provision was "ambiguous and that the insured's responsibility to maintain underlying coverage within specified limits has no bearing on whether the underlying policy must be paid in full by the underlying insurer as part of a settlement." Id. The court went on to hold that "[b]ecause the [excess] policy does not define exhaust nor explain how the underlying insurance can be exhausted, the Court finds that the [underlying] policy can be exhausted in different ways. For example, the [underlying] policy may have been exhausted when Plaintiff and [underlying insurer] entered into a settlement agreement, whereby [underlying insurer] paid a percentage of the total limit and Plaintiff assumed responsibility for the remainder as was done in the instant case." Id. at *5.
The cases decided over the last year demonstrate that the precise definition of exhaustion can only be determined from a close review of the policy language. Those policies that contain clear and unambiguous language requiring that the insureds and the underlying insurers shall have paid in full the SIR and underlying policy limits will be enforced by the courts. However, parties and their counsel should continue to closely watch for any decisions that follow Lightfoot, as this case has concluded that public policy considerations trump the clear and unambiguous language of the excess policies.
Selman Beritman LLP
Los Angeles, CA