Settlement and the Requirement of Underlying Exhaustion

At its essence, an insurance policy is simply a contract. ^(FN1)  In most jurisdictions, the general rule by which the clear and unambiguous terms of a contract will be interpreted is by assigning to those terms their plain, ordinary, or customary meaning.^(FN2)  The recent JP Morgan Chase & Co v. Indian Harbor Insurance Co.^(FN3) case is the latest legal installment concerning the plain and ordinary meaning of the exhaustion requirement contained in an excess insurance policy. Where an insured and an underlying insurer have settled a claim for less than a policy’s limits, will this policy still be considered ‘exhausted’, such that the obligation of the next overlying excess may be called on to respond? (FN4)  An examination of the legal interpretations espoused in JP Morgan and other rulings over time suggests that the issue has begun to crystallize.

Historically, Zeig v Massachusetts Bonding & Ins Co.^(FN5) has been understood as the leading or seminal case with regard to exhaustion provisions in excess insurance policies. ^(FN6)   In Zeig, the assured argued that its excess insurer was required to fulfill its obligations under its excess policy, even though the assured had settled with its primary insurer for less than the limits of its primary policy. ^(FN7)  The specific language of the excess policy at issue stated that primary insurance was to be “exhausted in the payment of claims to the full amount of the expressed limits”.^(FN8)   Reversing the lower court’s decision, the Second Circuit held that this language was ambiguous and observed that the insurer “had no rational interest in whether the insured collected 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”. ^(FN9)  The court also recognized that a contrary holding would “involve delay, promote litigation, and prevent an adjustment of disputes which is both convenient and commendable”. ^(FN10)

Thus, the Zeig court did not require that the assured actually collect the limits of its primary insurance policy before accessing its excess insurance.^(FN11)   The court reasoned that the word ‘payment’ as contained in the exhaustion language was not limited to payment in cash, but rather could include settlement or discharge of claims as well.^(FN12)   The excess insurer was therefore obliged to pay the amount of loss that exceeded the primary policy limits and fell within the excess policy limits.^(FN13)   The court acknowledged that other courts had interpreted identical exhaustion language to require actual collection of primary policy limits, but repudiated that reading as too “burdensome to the insured”.^(FN14)   The Second Circuit also stated that although the language at issue did not require actual collection of lower limits as a prerequisite to collection of excess insurance, “parties could impose such a condition precedent to liability upon the policy if they chose to do so”.^(FN15) 
 
In the 85 years since Zeig was published, many courts have followed the Second Circuit’s reasoning with regard to exhaustion requirements in excess insurance policies.^(FN16)

In Pereira v National Union Fire Insurance Co of Pittsburgh, Pa, the Southern District of New York addressed this issue in a situation where an assured could not collect on its first level of excess insurance because that insurer had become insolvent.^(FN17)   One of the insured’s higher-level excess insurers argued that it should not have to pay out on its policy because the insured would never be able to collect from the liquidating first-level excess insurer.^(FN18)   In this case, the policy in question stated that the higher-level excess insurer would be responsible for excess coverage, “only after all Underlying Insurance has been exhausted by actual payment of claims or losses thereunder”. ^(FN19)  Despite the fact that the policy language called for ‘actual payment’, in contrast to the Zeig policy language which simply called for ‘payment’, the Southern District of New York still deemed the policy language to be open to various interpretations, and followed the Zeig court’s reasoning that denying the assured its higher-level excess insurance coverage would be overly burdensome.^(FN20)   Further, the court stated that siding with the high-level excess insurer, in this case, would result in a windfall to that insurer.^(FN21)
  
In March 2012, the United States District Court for the Eastern District of Virginia continued the Zeig line of cases, holding that ‘actual payment’ language, similar to that in Pereira, did not create a requirement that underlying insurance be fully collected before excess insurance can be accessed.^(FN22)  Maximus, Inc v Twin City Fire Insurance Co involved an assured which had settled with its primary insurer, as well as its first and second-level excess insurers, and was being denied coverage by its third-level excess insurer on the basis that entering into below-limit settlements with its underlying insurers and “filling the gap” itself did not qualify as exhaustion of the underlying policies.^(FN23)

The specific exhaustion language in the relevant excess policy stated that the policy would “apply only after all applicable Underlying Insurance with respect to an Insurance Product ha[d] been exhausted by actual payment under such Underlying Insurance”.^(FN24)  The court found this language to be ambiguous, noting that there was no explicit definition of the phrase ‘actual payment’ in the policy, and agreeing with the insured that the word ‘actual’ could be understood either to require payment of the entire underlying limits by underlying insurers, or simply to mean that payment must be “real, as opposed to preliminary or hypothetical”.^(FN25)   The court’s discussion in Maximus suggests that if an excess insurer wishes to require all underlying insurers to pay their limits before the excess insurer’s policy is triggered, the policy should explicitly “state[] that actual payment requires payment of the full limit of an underlying policy by the lower-tier carriers”, and contain language to “expressly preclude the insured from filling the gap to exhaust the underlying policy”.^(FN26)

Although many courts still follow Zeig, there has been a host of cases in recent years that have reinforced the observation first espoused in Zeig that parties are free to impose a condition precedent within the insurance contract that the policy will respond only after actual payment of underlying policy limits by each of the underlying insurers. These cases have therefore held, based on the unambiguous nature of such language, that the insured is prevented from collecting under its excess policies after entering into below-limits settlements with their underlying insurers. ^(FN27)  More importantly, these cases offer some insight into how exhaustion requirements may be phrased, such that excess policies would not be triggered where below-limit settlements have been entered into with underlying insurers.
 
For example, in Great American Insurance Co v Bally Total Fitness Holding Corp, the insureds were seeking coverage from their third and fourth-level excess insurers after having settled below-limits with their primary insurer and their first and second-level excess insurers.^(FN28)  The third-level excess insurer argued that its policy was not triggered in this situation based on the following language: “[L]iability for any covered Loss shall attach to the Insurers only after the insurers of the Underlying Policies shall have paid in the applicable legal currency, the full amount of the Underlying Limit.”^(FN29)

The assureds’ fourth-level excess insurer made the same argument based on its policy language, stating that coverage under the policy would:

“[A]pply (1) only in excess of all Underlying Insurance and (2) only after all Underlying Insurance has been exhausted by payment of the total underlying limit of insurance and (3) only if each and every Underlying Insurance Policy has responded by payment of loss as a result of any wrongful act”.^(FN30)

The court ruled in favor of the excess insurers under their respective policy language.^(FN31)

The recently decided JP Morgan case also provides several examples of excess policy language that may be sufficient to require underlying insurance limits to be paid in full before the excess policy in question is triggered. This case involved several different excess policies with varying exhaustion requirements, all of which were deemed by the court to protect the interests of the excess insurers.^(FN32)  Of significant interest, however, is the fact that one of these policies stated that it would “apply only after all applicable Underlying Insurance with respect to an Insurance Product has been exhausted by actual payment under such Underlying Insurance”.^(FN33)  As illustrated by the holding in Maximus above, identical policy language has been interpreted to allow for excess insurance to be triggered even without actual collection of underlying insurance limits.^(FN34)  Thus, it does not seem that this particular language is the strongest example on which a pro-excess insurer result might be based.

The exhaustion requirements found in certain excess policies discussed in JP Morgan would appear to provide stronger protections of the rights of excess insurers. For example, one policy provided that the excess insurer would “only be liable to make payment under this policy after the total amount of the Underlying Limit of Liability ha[d] been paid in legal currency by the insurers of the Underlying Insurance as covered loss thereunder”, while another stated that liability under its terms would “attach[] only when the Underlying Insurer(s) shall have paid or have been held liable to pay, the full amount of the Underlying Limit(s)”.^(FN35)  Such language might be strengthened further to the extent an excess insurer has taken heed of the Maximus court’s suggestion that language that “expressly preclude[s] the insured from filling the gap to exhaust the underlying policy” be included within the exhaustion requirement.^(FN36)

Thus, even though an insured may commit to fill any gaps created by below-limit settlements entered into between it and certain of its excess insurers, specific language may well have been crafted within the exhaustion requirement of an overlying excess insurer’s policy that would eliminate that insurer’s obligation to respond to a loss. As recognized in Zeig, this would indeed create a burden for the insured which has bargained for the benefit of having such excess coverage in place, especially where that insured has committed to fill any underlying gaps in coverage. Moreover, the prospect that an upper-layer excess insurer may be relieved of its coverage obligations may well serve to have a chilling effect on the possibility of settlement with underlying insurers. An insured and its lower-layer excess insurers, which might otherwise seek to settle a claim for an amount less than full limits due to the prospects of costly coverage litigation and/or with consideration to the time value of money, may find they have no other choice than to litigate the matter to its natural conclusion – the possibility of the insured losing the benefit of upper-layer protection being too great a possibility to overcome. 

In this respect, while recent case law has served to crystallize the issues concerning the interpretation of underlying exhaustion requirements, the burdens that may be placed on the insured and its underlying insurers have become more certain as well.

1  Ballentine’s Law Dictionary (3rd ed 2010) (defining a ‘policy of insurance’ as “the contract between the insured and the insurer”). 
2  Maximus, Inc v Twin City Fire Ins Co, 856 FSupp 2d 797, 800 (ED Va 2012) (quoting SNL Fin, LC v Phila Indem Ins Co, 445 Fed App’x 363, 367 (4th Cir 2011) for the Virginia law that “an insurance policy is a contract, and, as in the case of any other contract, the words used are given their ordinary and customary meaning when they are susceptible of such construction”); Trinity Homes LLC v Ohio Casualty Ins Co, No 1:04-cv-1920-SEB-DML, 2009 US Dist LEXIS 88697, at *14 (SD Ind 2009) (quoting Tate v Secura Ins, 587 NE2d 665, 668 (Ind 1992) for the law of the State of Indiana that clear and unambiguous insurance policy language should be given “its plain and ordinary meaning”); Comerica, Inc v Zurich American Ins Co, 498 FSupp 2d 1019, 1027 (ED Mich 2007) (“Under Michigan law, an insurance policy is to be enforced according to its plain language.”); Pereira v National Union Fire Ins Co of Pittsburgh, Pa, No 04 Civ 1134 (LTS), 2006 US Dist LEXIS 49263, at *13 (SDNY 2006) (quoting Zunenshine v Executive Risk Indem, Inc, No 97 Civ 5525 (MBM), 1998 US Dist LEXIS 12699, at *9 (SDNY Aug 17 1998) for the New York law that “when a contract is not ambiguous, the court should assign the plain and ordinary meaning to each term and interpret the contract without the aid of extrinsic evidence); Qualcomm, Inc v Certain Underwriters at Lloyd’s, London, 73 Cal Rptr 3d 770, 775 (Cal Ct App 2008) (quoting Palacin v Allstate Ins Co, 14 Cal Rptr 3d 731, 734 (Cal Ct App 2004) for the California law that contract interpretation is to be based on “[t]he clear and explicit meaning of [written contract] provisions, interpreted in their ordinary and popular sense”); JP Morgan Chase & Co v Indian Harbor Ins Co, 947 NYS2d 17, 21-22 (NY App Div 2012) (quoting Outboard Marine Corp v Liberty Mut Ins Co, 154 Ill 2d 90, 108 for the proposition that under Illinois law, “[i]f the words in the [insurance] policy are unambiguous, a court must afford them their plain, ordinary and popular meaning” (emphasis omitted)).
3  947 NYS2d 17. 
4 See Angelo Savino & Matthew Klebanoff, “Exhaustion Implications for Multi-Policy Settlements”, Plus Journal, August 2012, at 2; Edward J Stein, Mind The Gap: Perils in Pursuing Excess Coverage, Anderson Kill Financial Insurance Law Blog, August 8 2012, www.financialinsurancelaw.com/2012/08/08/mind-the-gap-perils-in-pursuing-excess-coverage/.
5  23 F2d 665 (2d Cir 1928).
6  See Savino & Klebanoff, supra note iv, at 2; Stein, supra note iv.
7 Zeig, 23 F2d at 666.
8  Id.
9  Id.
10 Id.
11 Id.
12 Id.
13 Id.
14 Id.
15 Id.
16 See Comerica (listing Stargatt v Fid and Cas Co of New York, 67 FRD 689 (D Del 1975) and Gasquet v Commercial Union Ins Co, 391 So 2d 466 (La Ct App 1980) as examples of cases following the Zeig court’s reasoning. See also Lexington Ins Co v Tokio Marine & Nichido Fire Ins Co Ltd, 2012 US Dist LEXIS 59635 (SDNY March 28 2012); Maximus; Pereira.
17 Pereira at *23-27.  
18 Id, at *24. 
19 Id, at *23-24.  
20 See id, at *25-26.
21 Id, at *26. 
22 Maximus. 
23 Id at 798-99.
24 Id at 801. 
25 Id at 801-02.  
26 Id at 801. 
27 See Citigroup Inc v Federal Ins Co, 649 F.3d 367 (5th Cir 2011); Great American Ins Co v Bally Total Fitness Holding Corp, No 06 C 4554, 2010 US Dist LEXIS 61553 (ND Ill June 22 2010); Comerica; Qualcomm; JP Morgan; Forest Laboratories, Inc v Arch Ins Co, No 600219/10, 2012 NY Misc LEXIS 4770 (NY Sup Ct Sept 12 2012).  
28 2010 US Dist LEXIS 61553, at *8-12.
29 Id, at *7.  
30 Id, at *7-8.  
31 Id, at *10-11.
32 JP Morgan at 21.
33 Id. 
34 See supra text accompanying notes xxii-xxvi.
35 JP Morgan at 21. The language of these policies is in sync with the Maximus court’s (which followed Zeig’s reasoning) suggestion that in order to protect their rights, excess insurers draft lower-level insurance exhaustion requirements which “state[] that actual payment requires payment of the full limit of an underlying policy by the lower-tier carriers”. See supra note xxvi and accompanying text.
36 See supra note xxvi and accompanying text.