Complete Exhaustion of Primary Coverage

This line of cases generally traces back to the Qualcomm decision, in which the insured settled with its primary insurer for an amount below the primary policy limits, but absorbed the resulting gap to demonstrate exhaustion. Qualcomm, Inc. v. Certain Underwriters at Lloyd's, London, 161 Cal. App. 4th 184 (2008). The court rejected this argument, enforcing the excess policy's language, which stated that the policy would
attach “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.”

Courts since then have continued to rely upon specific policy language to determine whether an insured can “fill the gap” by making out-of-pocket payments to demonstrate exhaustion and trigger excess coverage. In Intel Corp. v. Am. Guarantee & Liability Ins. Co., 51 A.3d 442 (Del. 2012), the Delaware Supreme Court applied California law and held that the insured's below-limits settlement with the primary insurer precluded defense coverage under the excess insurer's policy. Specifically, the insured settled with its primary insurer for $27.5 million of its $50 million limits which included defense costs. The insured paid the remaining $22.5 million in defense costs out-of-pocket, and then sought coverage from AGLI, its next-level insurer.

The Delaware Supreme Court upheld the decision that AGLI's duty to defend was not triggered. The policy contained an endorsement stating that it shall not be obligated to defend any claim or suit “before the Underlying Insurance Limits shown in Item 6 of the Declarations are exhausted by payment of judgments or settlements.” Id. at 448. The court refused to hold that the phrase “payment of judgments or settlements” encompassed an insured's own payment of defense costs. California courts, instead, would require the actual payment of the full underlying limits. Although the $27.5 million settlement with the primary insurer could count as a credit toward exhaustion, the out-of-pocket payments to fill the gap did not satisfy AGLI's exhaustion requirement. Likening the case to Qualcomm, the court found that the plain policy language on exhaustion controlled despite any competing public policy concerns.

A Recent Ruling

A similar result was reached in Washington. In Quellos Group LLC v. Federal Ins. Co., 2013 Wash. App. LEXIS 2626 (Nov. 12, 2013), the insured investment management company entered into settlements with multiple clients for wrongful acts committed for which they were ultimately indicted by the United States Attorney. All told, the insured paid $35 million for settlements and expended $45 million in defense costs and other costs incurred in connection with the governmental investigation. The primary policy had limits of $10 million per year for the applicable three-year span. Quellos obtained excess coverage from Federal Insurance, and second-tier excess coverage from Indian Harbor.

Due to coverage issues, the insured ultimately entered into a settlement agreement whereby the primary insurer paid $15 million dollars of its $30 million limits. The insured agreed to pay the gap, but the excess insurers claimed that exhaustion had not been shown. The Federal policy stated that it attached “only after the insurers of the Underlying Insurance shall have paid in legal currency the full amount of the Underlying Limit for such Policy Period.” The Indian Harbor policy stated that the policy attached “only after all of the Underlying Insurance has been exhausted by the actual payment of loss by the applicable insurers thereunder.”

The court found that the clear and unambiguous language of the policies compelled the conclusion that excess coverage was not triggered by the insured's agreement to fill the gap left by its settlement with its primary insurer. The phrase “only after” in the policies means that the requirement of payment by the primary insurer is a condition to the excess insurer's coverage. Moreover, the provisions in the excess carriers' policies were not standardized language. Indeed, an amendment was available from Indian Harbor that would have allowed the insured to pay the underlying limits in order prove exhaustion and trigger excess coverage. Because the language was unambiguous, the court was confined to enforce the policy as written and to affirm the dismissal of the lawsuit against Federal and Indian Harbor.

The Second Circuit Weighs In

On the other hand, the Second Circuit has deflected the issue in a recent decision dealing with nearly identical exhaustion language. In Mehdi Ali v. Federal Ins. Co., 719 F.3d 83 (2nd Cir. 2012), the insured defendants were former officers and directors of a computer industry company that had entered bankruptcy. Since the bankruptcy, the company and its officers and directors were named in a variety of lawsuits throughout the world.

The insured appealed the district court's decision that held that the insured must demonstrate actual payments to prove exhaustion and to trigger the excess policies. The insured argued that exhaustion could be shown by payments made by the insured or the insurer. The excess policies of Federal Insurance and Travelers were at issue. The Federal policy stated that it would attach “only after all Underlying Insurance has been exhausted by payment of claims.” The Travelers policy stated that it attached “only after all such Underlying Insurance has been exhausted ' solely as the result of actual payment of losses thereunder by the applicable insurers.”

The Second Circuit disagreed with the statement of issue on appeal, noting that the district court simply held that a showing that an insured's obligations exceeded the primary limits was not sufficient to trigger excess coverage. The insured sought a declaration only to determine whether the mere obligation in excess of primary limits would trigger excess coverage. It did not seek a declaration on who had to make those payments to demonstrate exhaustion (insurers and/or the insured). Therefore, the district court was not in error by ruling simply that the insured must demonstrate “payment of losses” and not merely the accrual of liability in order to trigger excess coverage. The district court's opinion did not state one way or another who would need to make the payments to trigger the coverage.

In so holding, the court rejected the insured's reliance on Zeig v. Mass. Bonding & Ins. Co., 23 F.2d 665 (1928), regarding the trigger of excess policies when an insured settles for below-limits with its primary insurer for two reasons. First, the Zeig case involved a first-party property policy rather than an excess liability policy. As the court explained, interpreting exhaustion clauses differently for different types of coverage is not inherently errant or unusual. Second, Zeig dealt with the below-limit settlement of a claim whose value was fixed prior to settlement. In this case, the insureds' request for relief focuses on obligations to pay third parties. Therefore, the court found that excess insurers have good reason to require actual payment to deter the possibility of settlement manipulation.

Conclusion

Despite the Second Circuit's deflection on the issue, the continued trend of courts seems to be to enforce exhaustion language as written. This reinforces the principle that an insured's settlement with lower-level insurers can have significant impact on coverage under excess policies. Indeed, such settlements can result in the effective forfeiture of millions of dollars in excess insurance.

William Shelley co-chairs the nationwide' Insurance Group at Gordon & Rees, and is the Office Managing Partner of the firm's Philadelphia office. Jeannie Park Lee is an associate in the firm's Insurance Group.

In December 2012, we wrote an article in which we noted a trend in courts requiring an insured to demonstrate that its primary policy has been exhausted solely by payment of the primary insurer. (See http://bit.ly/1hrbGTK.) This was in order to access excess layers of coverage based upon exhaustion language in the excess policies.

The cases decided since the last article continue to demonstrate the importance of including clear exhaustion language in excess policies, and the impact that settlements with primary insurers could potentially have when seeking to recover from higher-level policies.

'History

This line of cases generally traces back to the Qualcomm decision, in which the insured settled with its primary insurer for an amount below the primary policy limits, but absorbed the resulting gap to demonstrate exhaustion. Qualcomm, Inc. v. Certain Underwriters at Lloyd's, London , 161 Cal. App. 4th 184 (2008). The court rejected this argument, enforcing the excess policy's language, which stated that the policy would
attach “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.”

Courts since then have continued to rely upon specific policy language to determine whether an insured can “fill the gap” by making out-of-pocket payments to demonstrate exhaustion and trigger excess coverage. In Intel Corp. v. Am. Guarantee & Liability Ins. Co. , 51 A.3d 442 (Del. 2012), the Delaware Supreme Court applied California law and held that the insured's below-limits settlement with the primary insurer precluded defense coverage under the excess insurer's policy. Specifically, the insured settled with its primary insurer for $27.5 million of its $50 million limits which included defense costs. The insured paid the remaining $22.5 million in defense costs out-of-pocket, and then sought coverage from AGLI, its next-level insurer.

The Delaware Supreme Court upheld the decision that AGLI's duty to defend was not triggered. The policy contained an endorsement stating that it shall not be obligated to defend any claim or suit “before the Underlying Insurance Limits shown in Item 6 of the Declarations are exhausted by payment of judgments or settlements.” Id. at 448. The court refused to hold that the phrase “payment of judgments or settlements” encompassed an insured's own payment of defense costs. California courts, instead, would require the actual payment of the full underlying limits. Although the $27.5 million settlement with the primary insurer could count as a credit toward exhaustion, the out-of-pocket payments to fill the gap did not satisfy AGLI's exhaustion requirement. Likening the case to Qualcomm, the court found that the plain policy language on exhaustion controlled despite any competing public policy concerns.

A Recent Ruling

A similar result was reached in Washington. In Quellos Group LLC v. Federal Ins. Co., 2013 Wash. App. LEXIS 2626 (Nov. 12, 2013), the insured investment management company entered into settlements with multiple clients for wrongful acts committed for which they were ultimately indicted by the United States Attorney. All told, the insured paid $35 million for settlements and expended $45 million in defense costs and other costs incurred in connection with the governmental investigation. The primary policy had limits of $10 million per year for the applicable three-year span. Quellos obtained excess coverage from Federal Insurance, and second-tier excess coverage from Indian Harbor.

Due to coverage issues, the insured ultimately entered into a settlement agreement whereby the primary insurer paid $15 million dollars of its $30 million limits. The insured agreed to pay the gap, but the excess insurers claimed that exhaustion had not been shown. The Federal policy stated that it attached “only after the insurers of the Underlying Insurance shall have paid in legal currency the full amount of the Underlying Limit for such Policy Period.” The Indian Harbor policy stated that the policy attached “only after all of the Underlying Insurance has been exhausted by the actual payment of loss by the applicable insurers thereunder.”

The court found that the clear and unambiguous language of the policies compelled the conclusion that excess coverage was not triggered by the insured's agreement to fill the gap left by its settlement with its primary insurer. The phrase “only after” in the policies means that the requirement of payment by the primary insurer is a condition to the excess insurer's coverage. Moreover, the provisions in the excess carriers' policies were not standardized language. Indeed, an amendment was available from Indian Harbor that would have allowed the insured to pay the underlying limits in order prove exhaustion and trigger excess coverage. Because the language was unambiguous, the court was confined to enforce the policy as written and to affirm the dismissal of the lawsuit against Federal and Indian Harbor.

The Second Circuit Weighs In

On the other hand, the Second Circuit has deflected the issue in a recent decision dealing with nearly identical exhaustion language. In Mehdi Ali v. Federal Ins. Co. , 719 F.3d 83 (2nd Cir. 2012), the insured defendants were former officers and directors of a computer industry company that had entered bankruptcy. Since the bankruptcy, the company and its officers and directors were named in a variety of lawsuits throughout the world.

The insured appealed the district court's decision that held that the insured must demonstrate actual payments to prove exhaustion and to trigger the excess policies. The insured argued that exhaustion could be shown by payments made by the insured or the insurer. The excess policies of Federal Insurance and Travelers were at issue. The Federal policy stated that it would attach “only after all Underlying Insurance has been exhausted by payment of claims.” The Travelers policy stated that it attached “only after all such Underlying Insurance has been exhausted ' solely as the result of actual payment of losses thereunder by the applicable insurers.”

The Second Circuit disagreed with the statement of issue on appeal, noting that the district court simply held that a showing that an insured's obligations exceeded the primary limits was not sufficient to trigger excess coverage. The insured sought a declaration only to determine whether the mere obligation in excess of primary limits would trigger excess coverage. It did not seek a declaration on who had to make those payments to demonstrate exhaustion (insurers and/or the insured). Therefore, the district court was not in error by ruling simply that the insured must demonstrate “payment of losses” and not merely the accrual of liability in order to trigger excess coverage. The district court's opinion did not state one way or another who would need to make the payments to trigger the coverage.

In so holding, the court rejected the insured's reliance on Zeig v. Mass. Bonding & Ins. Co. , 23 F.2d 665 (1928), regarding the trigger of excess policies when an insured settles for below-limits with its primary insurer for two reasons. First, the Zeig case involved a first-party property policy rather than an excess liability policy. As the court explained, interpreting exhaustion clauses differently for different types of coverage is not inherently errant or unusual. Second, Zeig dealt with the below-limit settlement of a claim whose value was fixed prior to settlement. In this case, the insureds' request for relief focuses on obligations to pay third parties. Therefore, the court found that excess insurers have good reason to require actual payment to deter the possibility of settlement manipulation.

Conclusion

Despite the Second Circuit's deflection on the issue, the continued trend of courts seems to be to enforce exhaustion language as written. This reinforces the principle that an insured's settlement with lower-level insurers can have significant impact on coverage under excess policies. Indeed, such settlements can result in the effective forfeiture of millions of dollars in excess insurance.

William Shelley co-chairs the nationwide' Insurance Group at Gordon & Rees, and is the Office Managing Partner of the firm's Philadelphia office. Jeannie Park Lee is an associate in the firm's Insurance Group.