As the cliché saying goes: “When it comes to love, never settle for less than you deserve.” But when it comes to insurance coverage, sometimes settling for less than the full limits of a policy is an effective compromise that saves time and avoids costly litigation. However, if losses may reach excess policies, then policyholders should take a second look before signing on the dotted line. Excess liability policies often include a limitation requiring the “exhaustion” of underlying policy limits before excess coverage is triggered. If the policyholder settles with an underlying insurer for less than the underlying policy limits, excess insurers may dispute whether the settlement qualifies as “exhaustion.”
Courts have followed different, conflicting rules in these scenarios. The seminal “exhaustion” case Zeig v. Massachusetts Bonding & Insurance Co., decided nearly 90 years ago, is generally favorable to policyholders. In that case, the relevant policy stated that coverage applied “only after all other insurance … shall have been exhausted in the payment of claims to the full amount of the expressed limits.” The excess insurer argued that the clause required actual payment of the underlying policy limits by the primary insurer, and that settlement for less than the full limits precluded coverage under the excess policy.
Judge Learned Hand—the judge with arguably the best name in the judiciary at the time—rejected that argument, reasoning that the excess insurer had no rational interest in whether the policyholder collected the full amount of the underlying primary policy as long as the excess insurer was only liable for losses exceeding the underlying policy limit. Under Zeig, then, a less than policy limits settlement with an underlying insurer “exhausts” the underlying policy for purposes of triggering excess coverage where the policyholder assumes liability for the difference between the settlement amount and the excess insurer’s attachment point.
In recent cases however, some courts have taken a more restrictive interpretation of such policy language, limiting coverage for policyholders. In Comerica Inc. v. Zurich American Insurance Co., the excess policy required the “actual payment of losses” by the underlying insurer and defined exhaustion of the underlying policy only through “payments of loss thereunder.” In Qualcomm, Inc. v. Certain Underwriters at Lloyd’s, London, the excess policy’s exhaustion clause provided that the excess insurer “shall be liable only after the insurers under each of the Underlying Policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”
In both of these cases, the policyholders settled with their primary insurers for less than the full amount of their primary policies and then sought to recover losses exceeding the primary policies’ limits from their excess carriers. Each of the courts held that these terms required the policyholders to recover from their primary insurers up to their primary policy limits before they could recover under their excess policies. Policyholders often emphasize that in Comerica and Qualcomm, it was important that the policies expressly required the underlying insurer to have paid the payment underlying losses, unlike in Zeig, where the policy required exhaustion by “payment … to the full amount of the expressed limits”—but didn’t specify whether the policyholder or insurer must make the payment. Because they settled with their primary carriers for less than full limits, the policyholders in Comerica and Qualcomm could not collect excess policy coverage.
Most courts continue to acknowledge that Zeig establishes the basic rule for exhaustion of underlying limits, but Comerica and Qualcomm make clear that it is important to pay attention to the language of policies lying above the policies under which you negotiate any settlement. So policyholders should carefully review and if necessary negotiate the “exhaustion” policy language proposed by excess insurers to ensure that it minimizes or eliminates the risk of an “exhaustion” defense before facing a settlement with underlying insurers. When negotiating a settlement agreement with underlying insurers, policyholders should also ensure that the agreement explicitly states that the policy limits are exhausted by the settlement. Taking these steps may help to ensure that you aren’t caught napping in the face of an excess insurer’s “exhaustion” defense or wake up to find you’ve lost your excess coverage.