Exhaustion is a fundamental requirement that generally is discussed in connection with excess insurance. However, exhaustion is important to primary insurers in determining when they have satisfied their obligations, to policyholders seeking to extract the maximum value from their primary insurance assets and to policyholders and excess insurers alike in determining when excess insurance coverage begins and ends.
Horizontal Versus Vertical Exhaustion
The method of exhaustion is the threshold exhaustion issue presented. More specifically, the issue is whether only exhaustion of the limits of insurance contracts and retentions directly underlying the subject excess insurance contract must be exhausted (vertical exhaustion) or whether all underlying limits and retentions for all periods implicated by a loss must be exhausted (horizontal exhaustion) before an excess insurance contract is obligated to respond. By way of illustration, assume an excess policy it sitting above $1 million in underlying limits for its sole year of coverage in an insurance program that affords $20 million in underlying limits for all years implicated by the loss. The subject excess policy could be impacted by a loss of over $1 million if vertical exhaustion is permitted, while a loss of more than $20 million would be required to impact the subject excess policy if horizontal exhaustion is required.
From the perspective of the excess insurance contract, the issue often turns on whether phrases such as "underlying insurance" refers only to the schedule of underlying insurance listed in the excess contract or to all underlying layers of coverage and retentions in years implicated by the loss. Many times, however, the issue is resolved at least to some extent by the jurisdiction's rules regarding allocation methodology. See generally S. Seaman, J. Schulze Allocation of Losses in Complex Insurance Coverage Claims 3d (Thomson Reuters 2014) at Chapter 4 and Appendix A.
Horizontal exhaustion is the rule in jurisdictions applying a pro rata allocation. In fact, horizontal exhaustion and pro rata allocation go together like bread and butter, though there may be differences among jurisdictions concerning whether the horizontal exhaustion is accomplished by layer or by means of a rising bathtub approach.
Even in jurisdictions with some law supporting an "all sums" allocation — which also is commonly referred to as a "pick and choose" or "vertical spike" approach — some courts recognize that the fundamental distinctions between primary and excess insurance require horizontal exhaustion. See, e.g., Kajima Const. Services Inc. v. St. Paul Fire and Marine Ins. Co., 879 N.E.2d 305 (Ill. 2007); John Crane Inc. v. Admiral Ins. Co., 991 N.E.2d 474 (Ill. App. 2013), appeal denied, 996 N.E.2d 11 (Ill. 2013) and appeal denied, 996 N.E.2d 14 (Ill. 2013) (requiring policyholder to prove exhaustion of all primary policies prior to any excess or umbrella insurer being required to contribute to any settlement or judgment notwithstanding "all sums" allocation ruling and holding that policyholder must prove that the primary polices were exhausted as those limits were written); Kaiser Cement And Gypsum Corp. v. Insurance Company of the State of Pennsylvania, 155 Cal. Rptr. 3d 283 (Cal. App. 2d Dist. 2013).
Actual Verses Functional Exhaustion
Another major issue presented is how exhaustion may be accomplished. There is general agreement that the attachment point of the excess contract must be reached before an excess contract is required to respond. There often are disputes, however, as to whether the underlying exhaustion required to access an excess contract can be satisfied solely by payment of claims by the underlying insurer or insurers or whether some type of "functional" exhaustion will be permitted. In fact, this has been one of the hottest excess insurance issues in recent years.
Assume for the examples to follow that the policyholder has a primary liability insurance policy with $1 million in per occurrence limits and an excess policy sitting above the primary with $3 million in per occurrence limits in the single year of coverage implicated by a loss.
Sometimes the alleged functional exhaustion may take the form of the policyholder specifically paying the sum representing the gap between the amounts paid on a claim by the underlying insurer. In this example, if the claim is settled for $1.2 million, with the primary insurer paying only $800,000 of its $1 million in applicable limits, the policyholder may ultimately seek to pay $200,000 representing the difference between the amount paid by the primary insurer and the primary insurance limits. The policyholder then may seek to pursue the excess insurer for the remaining $200,000 claiming that, by paying the difference, the primary policy limits were functionally exhausted. Other times, the policyholder alleges functional exhaustion by virtue of the total amount of the loss exceeding the underlying limits. In our example, the policyholder might argue that the $1.2 million settlement exceeds the primary limits by $200,000 and seek that amount from the excess insurers.
Functional exhaustion disputes exist with respect to both traditional and long-tail claims. Fundamentally, like many coverage issues, exhaustion requirements are a matter of interpretation and application of the contract requirements. Review of the entire contract language is required as multiple provisions may address the issue and, of course, there are differences in the language employed from excess contract to excess contract. Many of the functional exhaustion decisions purport to turn on whether or not the court determines the language of the contract to be clear with respect to exhaustion requirements. Yet, the conflicting decisions cannot always be reconciled by differences in contract language.
Cases allowing "functional" exhaustion generally rely upon Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 665 (2d Cir. 1928). This old decision involved a burglary loss under a first-party insurance contact, was predicated upon the court's determination that the policy was ambiguous and expressly recognized that a different result would attain where warranted by the contract language.
Several recent decisions have not permitted "functional" exhaustion, holding that exhaustion of the underlying limit must be accomplished by the actual payment of the amount of limits by the underlying insurer. See, e.g., Comerica Inc. v. Zurich American Ins. Co., 498 F. Supp. 2d 1019 (E.D. Mich. 2007) (rejecting functional exhaustion by policyholder's payment of the difference between the amount paid by primary insurer and policy limit and holding actual payment of losses by the underlying insurer is required); Qualcom Inc. v. Certain Underwriters at Lloyd's, London, 73 Cal. Rptr. 3d 770 (Cal. App. 2008) (finding language of excess contract, when read in context of function of excess contract, requires actual payment by underlying insurer of no less than the underlying limits).
Recently, the United States Court of Appeals for the Second Circuit held that the policyholder must establish actual exhaustion by payment of claims. Ali v. Federal Ins. Co., 719 F.3d 83, 94 (2d Cir. 2013). The contract language of one of the excess insurers policies provided that excess liability coverage "shall attach only after all ... 'underlying insurance' has been exhausted by payment of claim(s)" and "exhaustion" of the underlying insurance occurs "solely as a result of payment of losses thereunder." The other excess insurer's policy stated the excess coverage "shall attach only after all such underlying insurance has been exhausted," and that exhaustion occurs "solely as a result of payment of losses thereunder." The Second Circuit agreed with the district court that the express language "establishes a clear condition precedent to the attachment of the excess policies" by expressly stating the coverage does not attach until payment of the underlying losses.
The Second Circuit noted that the district court did not hold that the underlying insurers must make payments before the obligations under the excess policies are reached, as the court did not specify which party was obligated to make the requisite payments. The district court noted that the maintenance clause did not relieve the insurers from coverage even if underlying coverage was not maintained, but rather the insurer shall not be liable to a greater extent than if the condition had been complied with. The policyholders simply sought a declaration that the excess policies' coverages are triggered once the respective attachment points are reached. The Second Circuit distinguished its earlier Zeig decision, noting there is nothing errant about interpreting an exhaustion clause in an excess liability policy differently than a similar clause in a first-party property policy, that the "freestanding federal common law" Zeig interpreted and applied no longer exists and that excess insurers have good reason to require actual payment up to the attachment points of the relevant policies, thus deterring the possibility of settlement manipulation. For a more detailed discussion and listing of cases, see S. Seaman, J. Schulze Allocation of Losses in Complex Insurance Coverage Claims 3d (Thomson Reuters 2014) at Chapter 10.
Where functional exhaustion is not permitted a policyholder that settles with an underlying insurer for less than limits may find itself without any coverage from higher level excess contracts. Accordingly, apart from arguing ambiguity, policyholders often argue that, where the policyholder pays the difference between the amount actually paid by the underlying insurer and the attachment point of the excess policy, the excess insurer is no worse off by reason of functional exhaustion by settlement and it would be unjust to limit the policyholder's ability to settle.
Contrary to policyholder contentions, requiring actual exhaustion is not a trap or "got you" argument. Rather, it reflects the realities of excess insurance. Excess insurers receive only a small premium relative to the large limits of liability provided, making excess insurance available at a reasonable cost. The excess insurer does not solely rely upon claims being settled for an amount in excess of the attachment point of the policy, it relies upon the claims implicating the excess contract after being subjected to the claims adjustment process of the underlying insurers such that the underlying insurers have reviewed and analyzed the claim, determined that there is coverage and determined that the settlement is reasonable such that the underlying insurers agree to pay the settlement amount.
The Tiring Examination Of Exhaustion
Having a good grasp of the exhaustion terrain — whether it is vertical or horizontal under the controlling law and whether or not functional exhaustion is permitted — is required. However, much of the exhaustion battle is fought in the weeds. Examination of proper exhaustion may involve multiple considerations depending upon the facts of the claim and coverage issues presented. We will highlight a couple of common issues for illustrative purposes.
Application Of Payments Against Proper Limits
A determination of proper exhaustion requires an understanding and application of the various limits of liability. Insurance contracts may contain a host of applicable limits of liability: per occurrence; per claimant; per accident; per claim; and aggregate limits. The limits may apply separately to property damage, bodily injury or personal injury. Alternatively, contracts may contain "combined single limits," such that payments made on bodily injury and property damage combine to reduce the limits of liability. Some contracts contain aggregate limits, while others do not. Aggregate limits may apply to all losses under the contract or only to some types of losses such as operations, premises or products/completed operations claims. Aggregates may apply on a policy basis or an annual basis.
Accordingly, one consideration relevant to analyzing exhaustion is determining whether the claims and payment are, and historically have been, applied properly against the limits. For instance, where the insurance contract only contains product aggregates, payments made on ongoing operation claims should not be applied against the aggregate. Similarly, payments made on workers' compensation claims should not be charged against general liability contract limits. Many times the determination is straight¬forward, but that is not always the case. In recent years, the issue of characterizing asbestos-related bodily injury claims against asbestos defendants who installed (as well as manufactured or distributed) asbestos containing products as products/completed operations claims or nonproduct (ongoing operations) claims has been vigorously litigated in several cases.
Proper Cost Characterization
Sometimes cost items must be reviewed to determine whether the dollars involved are defense costs or indemnity dollars. Under most commercial general liability policies defense costs are payable on a supplementary basis (i.e., they do not erode or impair the limits of liability). Thus, treating defense costs as indemnity costs may result in premature exhaustion of the primary policies and adversely impact the timing of impact or ultimately the extent of impact to excess policies. Many excess contracts do not provide coverage for defense costs, in which case defense costs should not be used to impair the excess contract limits. When defense costs are covered under excess policies, under some policies defense costs are payable within limits (i.e., erode limits) and under others policies they are payable in addition to limits. Usually, it is easy to identify whether costs are defense costs (e.g., counsel fees) or indemnity (e.g., settlement payments or payments made to satisfy a judgment against the policyholder). Other times, such as in the case of evaluating environmental remedial investigative and feasibility study costs, the answer requires reference to the law in the controlling jurisdiction as well as analysis of the costs themselves to determine whether they are defense costs or indemnity. In some instances, the application and impact of deductibles and self-Insured retentions also must be considered.
The review of specific items may establish that some components of an otherwise covered claim are improperly included. Many corporate policyholders are aggressive in the costs for which they seek recovery from their insurers and may include items that are not covered or rely upon highly inflated future cost estimates to maximize their recovery. Costs of doing business, maintenance, regulatory compliance, economic loss, civil fines and facility improvements, for example, may not be covered damages under third party liability contracts.
Cutting The Weeds
Although the exhaustion examination may require a lot of work on the part of insurers, it is important to remember that policyholders generally bear the burden of establishing proper exhaustion. Sophisticated policyholders recognize that, to reach higher layers of coverage, exhaustion must be established. They also recognize that lack of cooperation in providing proof of exhaustion jeopardizes their insurance recovery and sends the message to their insurers that they have concerns as to whether there has been proper exhaustion.
Where issues of proper impairment or exhaustion are presented, insurers often require an audit or file review to determine the proper status of underlying impairment or exhaustion. Often an examination of the specific costs allegedly exhausting or impairing underlying coverage is undertaken to determine whether payments have been properly applied to the applicable limits. Invoices, canceled checks and documents showing the application of payments may be among the items reviewed. Sometimes review of loss runs or other documents of the primary or underlying insurers is part of the process either to confirm or supplement the information provided by the policyholder or because the policyholder lacks some of the information.
Practical considerations confronting the insurer, such as the costs of reviewing documents and the extent to which policyholders and courts will permit review and challenges to exhaustion — also come into play. Numerous courts have allowed excess insurers to challenge payments and settlements of claims in which the excess insurers did not participate. See, e.g., Colony Nat. Ins. Co. v. Sorenson Medical Inc., (E.D. Ky. Dec. 21, 2011) (applying Utah law); Goodyear Tire & Rubber Co. v. National Union Fire Ins. Co., 694 F.3d 781 (6th Cir. 2012) (applying Ohio law); American Ins. Co. v. St. Jude Medical Inc., (D. Minn. Sept. 20, 2010) (applying Minnesota law); Royal Indemnity Co. v. C.H. Robinson Worldwide Inc., (Minn. Ct. App. 2009) (unpublished opinion); D.R. Horton Inc. v. American Guar. & Liab. Ins. Co., 864 F.Supp.2d 541, 548 (N.D. Tex. 2012) (applying Texas law), appeal dismissed, (5th Cir. 2012). New Jersey courts have been somewhat less accepting of efforts to challenge prior payments in the long tail claims context based upon Owens-Illinois Inc. v. United Ins. Co., 138 N.J. 437, 650 A.2d 974 (N.J. 1994) and its progeny.
Though court intervention is sometimes required, in most instances, insurers and policyholders are able to work through issues of exhaustion. Sophisticated policyholders and proactive insurers understand the advantages of periodic monitoring of impairment.
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