Here’s a fairly common circumstance in large commercial liability claims.  A policyholder settles with the carrier in Layer 1 for less than its limits, leaving a gap between Layer 1 and the next layer up.  Does the carrier in Layer 2 then have an obligation to contribute to settlement with the underlying plaintiff?  

Example:  I recently had a circumstance in which Carrier A and Carrier B each had a $7.5M quota share of a $15M excess layer.  The client settled with each carrier for $5M (total $10M).  The settlement amount of $10M with these two carriers left a $5M gap before reaching the next layer of coverage, occupied by Carrier C.  Carrier C argued that its coverage wasn’t triggered, and that it had no obligation to contribute to settlement with the underlying plaintiff, because the limits beneath its coverage hadn’t been properly exhausted.  

Carrier C’s exhaustion language read:  “The Insurer shall pay the Insured…for Loss by reason of exhaustion by payments of all applicable underlying limits by either the Underlying Insurers…or the Insured.”  (Emphasis added.)  

Under this policy language, it seems pretty clear that if the policyholder covers the gap in Layer 1, then the coverage in Layer 2 is triggered. But it’s also possible that a policyholder might not even be required to cover the gap in order to get to Layer 2.  .  (In the matter I’m talking about, the issue is currently being negotiated.  Hopefully the carrier will see the light.)  

The venerable one-page decision in Zeig v. Massachusetts Bonding, 23 F.2d 665 (2d Cir. 1928) is still good law on this issue.  The Zeig Court wrote:  “[The excess carrier] had no rational interest in whether the insured collected the full amount 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. To require an absolute collection of the primary insurance to its full limit would in many, if not most, cases involve delay, promote litigation, and prevent an adjustment of disputes which is both convenient and commendable.”  (So, under Zeig, it wouldn’t even be necessary for the policyholder to pay the $5M gap.) 

In JP Morgan v, Indian Harbor, 2011 NY Slip Op. 51055 (N.Y. Sup. Ct. N.Y. County May 31, 2011), which was decided under Illinois law, the Court distinguished Zeig and held that there was no exhaustion unless and until the underlying carrier actually paid the full extent of its policy limits – but in that case, the policy required the underlying excess insurers to have “admitted liability” and “paid the full amount of their respective liability” before the next layer’s liability attached. 

Another recent decision, Maximus v. Twin City, No. 1:11cv1231 (LMB/TRJ), slip op. (E.D. Va. March 12, 2012), includes a very good discussion of case law on this issue.  The Court wrote:  “The Axis Policy’s exhaustion provision is ambiguous in that it does not clearly require all underlying insurance carriers themselves to pay the full amounts of their policy limits in order to trigger the Axis Policy’s coverage and does not clearly provide that settling for less than the policy limit, even if the insured fills the gap, fails to satisfy the exhaustion requirement.” (Emphasis added.)

As you can see from the decisions cited above, there is no standardized policy language on this issue.  But if you’re in settlement discussions that may trigger several layers of coverage, it’s critical to review the exhaustion language of all excess policies before concluding the settlement.  Otherwise, you may leave a large self-insured gap, with no ability to trigger the upper layers.