Although no New York state court has specifically addressed the issue, it has been the prevailing view among most insurance practitioners for decades that courts in New York would allow a policyholder to trigger excess coverage if it incurred losses sufficient to exhaust the limits of underlying coverage even if, for whatever reason, the underlying insurers did not actually pay the losses.  This view was based on the Second Circuit’s decision in Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928).  The Zeig court held that the insured could settle with the primary carrier for less than the primary limits and still trigger coverage under the excess policy, provided that the insured was responsible for the gap between the amount of the primary settlement and the excess policy’s attachment point.  While the Second Circuit held that actual payment by the underlying insurer was not necessary, it also stated, “It is doubtless true that the parties could impose such a condition precedent to liability upon the policy, if they chose to do so.”  Id.  Thus, it remained unclear, following Zeig, whether an excess insurer could, as a condition to paying under its policy, require actual payment by the underlying insurers by including clear language imposing such a condition.

In a recent decision, Ali v. Federal Ins. Co., No. 11-5000-cv (2d Cir. June 4, 2013), the Second Circuit did little to clarify this issue.  See http://www.ca2.uscourts.gov/decisions/isysquery/7e0c43c4-1c80-4f16-ada0-609c84774137/9/doc/11-5000_opn.pdf#xml=http://www.ca2.uscourts.gov/decisions/isysquery/7e0c43c4-1c80-4f16-ada0-609c84774137/9/hilite/.  In a somewhat abstract decision, the Second Circuit held that if a policyholder merely incurs liabilities sufficient to exhaust underlying coverage—but does not actually pay them—it could not trigger its excess coverage.  In Ali, the policyholders argued “that their liability must reach the attachment point in order to trigger excess coverage,” while the excess insurers argued that “excess liability coverage is triggered only when liability payments reach the attachment point” of the excess policies.  Id., p. 2.  The court did specifically address whether a policyholder can effectively exhaust underlying insurance by paying amounts sufficient to exhaust underlying coverage, but the decision leaves open the possibility that payment by the policyholder would be sufficient.

Ali involves the now-defunct Commodore International Limited, the maker of the computer of the same name.  When Commodore filed for bankruptcy, claims were asserted against certain of its former directors, and the claims were tendered to Commodore’s D&O insurers.  Certain of its excess insurers were insolvent.  Certain other excess insurers contested coverage on the basis that the underlying policies had not been exhausted by actual payment.

The insurers and the directors filed competing motions for summary judgment.  The trial court first ruled that the excess insurers did not have to drop down—that is, lower their attachment point—to cover the shares of the insolvent underlying insurers; this ruling was not appealed by the directors.  The trial court then denied summary judgment to the directors on the exhaustion issue, holding that “the excess coverage is not triggered until the underlying insurance is exhausted ‘solely as a result of payment of losses thereunder,’” and therefore “the excess coverage will not be triggered solely by the aggregation of [the Directors’] covered losses.”  Fed. Ins. Co. v. Estate of Gould, No. 10 Civ. 1160 (RJS), 2011 WL 4552381, (S.D.N.Y. Sept. 28, 2011) at *7.  Instead, the trial court held, “the Excess Policies expressly state that coverage does not attach until there is payment of the underlying losses.”  Id.

On appeal, the Second Circuit affirmed the trial court’s decision regarding exhaustion.  In finding that the trial court “did not err” in denying summary judgment to the directors, the Second Circuit, discussing the exhaustion language in the policies, stated:

In other words, the excess insurers here had good reason to require actual payment up to the attachment points of the relevant policies, thus deterring the possibility of settlement manipulation. In this context, the plain meaning of the phrase “payment of losses” refers to the actual payment of losses suffered by the Directors—not the mere accrual of losses in the form of liability.

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The plain language of the relevant excess insurance policies requires the “payment of losses”—not merely the accrual of liability—in order to reach the relevant attachment points and trigger the excess coverage.

Ali v. Federal Ins. Co., p. 15. (The Second Circuit also noted that an excess insurer could not avoid coverage because an underlying insurer is insolvent, and therefore its policy limits could not be exhausted.  Ali, p. 12 n.15.)

On first read, this somewhat awkward language—which draws a seemingly artificial distinction between “accruing liability” and “paying losses”—could be interpreted as articulating a rule that a policy can be triggered only if the underlying insurers have paid their limits in full.  However, while the Second Circuit went to some length to attempt to distinguish Zeig, it also avoided specifically stating that payment by the Directors of the full amount of the underlying limits in settlements or judgments—rather than payment by the underlying insurers—would be insufficient to trigger the excess policies.  Perhaps this is because the Second Circuit recognized that, in such circumstances, the risk of collusive settlements it refers to in the opinion would not be present, but the Second Circuit provides scant discussion—and no detailed reasoning—for its differentiation between these two scenarios.

So where does this leave New York law on the exhaustion issue (at least as enunciated by New York federal courts)?  It appears that, depending on the language of the excess policy, an insured cannot exhaust underlying coverage (thus triggering an excess policy) merely by incurring liabilities sufficient to exhaust underlying coverage (e.g., simply by agreeing to a settlement in excess of the amount of underlying coverage).  However, an insured apparently can exhaust underlying coverage by actually paying amounts sufficient to exhaust the underlying coverage.

It is plainly the correct rule that a policyholder should be able to trigger an excess policy if it has paid losses sufficient to reach the attachment point of an excess policy.  Many policies make that completely clear, for example by stating that the excess policy attaches if the amount of the underlying limits is paid either by the policyholder or by the underlying insurers.  Such a rule avoids a situation where a lower-level insurer that takes an incorrect coverage position, or asserts a coverage defense unique to its policy (for example, late notice), provides excess insurers above it an excuse to avoid paying covered claims merely because the underlying policies have not been “exhausted by payment.”

Nevertheless, it is not certain, in the wake of the Ali decision, whether the Second Circuit or other courts in New York will recognize the inequity of allowing an excess insurer to avoid coverage in such circumstances.  The distinction drawn in the Ali case between a policyholder “incurring liabilities” and “paying damages” seems an artificial one, since in neither case will the underlying insurance necessarily have been exhausted through payment by the underlying insurers.  This distinction seems particularly ill-fitting in many contexts because a number of common policy forms require an insurer to pay losses “on behalf of” a policyholder, so the policyholder will never actually pay damages.

Insurers may seize on the Ali decision to argue that they are not required to pay claims unless underlying coverage is exhausted through payment by the underlying insurers.  However, because the Ali decision does not state such a rule—indeed, it strongly suggests a contrary rule—the debate over this issue is likely to continue until a New York court squarely addresses the point.