It is not uncommon for a policyholder and its primary insurer to settle for less than the policy limit. In this scenario, the policyholder generally assumes that it will absorb the remaining costs up to the limit of the primary policy and then the excess insurer(s) will step in to cover anything additional. However, there are two conflicting lines of authority in the United States on the issue of coverage in this scenario that make the outcome far from certain. One holds that provided the actual loss reaches a policy’s attachment point, it does not matter how the lower tiers were exhausted. The other line of reasoning requires all lower tiers to have been exhausted by full payment in cash or legal currency by the insurer before the policies higher up the tower are triggered. A recent U.S. Court of Appeals case in the Fifth Circuit followed this latter line of reasoning to deny coverage at the excess insurance level, which suggests a growing trend among the courts to deny coverage in similar circumstances. Thus, this is an area that requires very careful drafting in insurance contracts to reduce ambiguity.
In Citigroup Inc. v. Federal Ins. Co. (5th Cir. August 5, 2011), Citigroup settled with its primary insurer for $15 million of its $50 million limit of liability in exchange for a release from coverage in connection with two claims that Citigroup had settled for $240 million. Citigroup then turned to its excess insurers for coverage in connection with losses above $50 million. The excess insurers denied coverage on the basis that Citigroup had not exhausted the limit of its primary policy, and Citigroup sued. The Fifth Circuit decided in favor of the excess insurers, holding that the exhaustion provisions in the four excess policies at issue were unambiguous in their requirement that the primary insurer had to pay Citigroup the total limit of liability in cash before excess coverage would attach. The court reached this decision despite the fact that two of the underlying policies at issue only referred to the need for payment to be made in full, without qualifying “payment” by the words “cash” or “legal currency,” as the other two policies did.
The Fifth Circuit’s holding follows a string of cases in recent years that have adopted a narrow reading of the exhaustion provisions of excess policies to deny coverage, even when there is no express requirement in such provisions that exhaustion must be accomplished through payment in cash or legal currency. In the case of Qualcomm, Inc. v. Certain Underwriters at Lloyd’s, London (161 Cal.App.4th 184, 73 Cal. RPtr. 3d 770 (Ct. App. 4th Dist. 2008), Qualcomm settled with its primary insurance provider for $16 million of a $20 million policy. It then sought excess coverage for its costs over the primary policy limit. Similar to two of the excess policies in the Fifth Circuit case, the excess policy at issue here referred to the need for payment to be made in full, but did not expressly require exhaustion of the underlying policy through payment in cash. Regardless, the court reasoned that the language of the exhaustion provision was unambiguous when read in its “ordinary and popular sense” and therefore required full payment in cash. Because the parties had settled, Qualcomm was not entitled to coverage under its excess policy.
On the other side of the debate is the case of Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928) and its progeny, including Reliance Ins. Co. v. Transamerica Ins. Co., 826 So. 2d 998 (Fla. 3d DCA 2001) and Stargatt v. Fidelity & Casualty of New York, 67 F.R.D. 689 (D. Del. 1975), aff’d, 578 F.2d 1375 (3d Cir. 1978). In Zeig, the policyholder had three primary policies and an excess policy intended to apply only after all other insurance had been “exhausted in the payment of claims to the full amount of the expressed limits.” The policyholder settled its claims with the primary insurers for less than the policy limits, and the excess insurer argued that its payment obligation had not been triggered because the primary policies had not been exhausted through cash payment. Here, the court disagreed, holding that “. . . claims are paid to the full amount of the policies, if they are settled and discharged, and the primary insurance is thereby exhausted. There is no need to interpret the word ‘payment’ as only relating to payment in cash. It is often used as meaning the satisfaction of a claim by compromise, or in other ways.” Furthermore, as a matter of public policy, the court held it would be burdensome to the insured to hold the words “exhausted in the payment of claims” to require collection of the full amount of the primary policy. “[A] result harmful to the insured, and of no rational advantage to the insurer, ought only to be reached when the terms of the contract demand it.” Any ruling to the contrary would “involve delay, promote litigation, and prevent an adjustment of disputes, which is both convenient and commendable.”
Even where the facts of the case have diverged from Zeig, for example, because the underlying policy language has expressly required payment in full in cash or legal currency, as in HLTH Corp. v. Agricultural Excess & Surplus Insurance Co., 2008 Del. Super. LEXIS 280, 2008 WL3413327 (Del. Super. July 31, 2008) and Mills Limited Partnership v. Liberty Mutual Insurance Company, 2010 Del. Super. LEXIS 563 (Del. Super. Nov. 5, 2010), those courts still chose to apply the public policy argument espoused by the Zeig court to allow excess coverage.
Although the proposition of the Second Circuit in Zeig has been supported by diverse jurisdictions throughout its 80-year history, recent jurisprudence appears to be favoring the strict interpretation rationale of the Fifth Circuit in the Citigroup case with respect to exhaustion provisions. In order to avoid costly litigation, it is important to draft the exhaustion provisions in Directors’ and Officers’ Liability Insurance policies at the excess layers carefully to remove any ambiguity. A possible solution would be to specify in an exhaustion provision that (i) either the insurer or the insured can pay a portion of the underlying limit and (ii) the insured has the contractual right to absorb a portion of settlement costs without forfeiting excess coverage. This should satisfy the goal of both insurer and insured for policy wording that establishes clear expectations on both parties from the outset.