It is well-settled that commercial umbrella insurance does not attach (i.e., the point at which the umbrella insurer coverage begins) unless and until the underlying insurance limit has been exhausted. But what, exactly, constitutes exhaustion of the underlying insurance?
Does exhaustion of the underlying insurance require the underlying insurer to pay its full limit to the claimant—in cash—before the commercial umbrella is obligated to pay damages? Or is the underlying insurance exhausted when the insured's obligation to pay damages is fixed at amounts that exceed the underlying insurance limit, regardless of the amounts actually paid by the underlying insurer? Absent express policy wording to the contrary, the latter applies.
Exhaustion of the underlying, as noted above, follows the so-called Zeig rule. The Zeig rule is based on the case of Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d. Cir. 1928). This seminal case,1 even though it was a first-party matter, stands for the proposition that primary insurance may be exhausted without full cash payment by the underlying insurer. Nonetheless, the excess insurer is responsible only for the portion of damages that exceed the underlying limit. Following, Circuit Judge Augustus Hand summarizes in Zeig.
The plaintiff should be allowed to prove the amount of the loss, and, if that loss was greater than the amount of the expressed limits of the primary [underlying] insurance, he was entitled to recover to the extent of the policy….
Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d. Circuit 1928) at 666.
The Zeig rule is generally applicable to today's typical commercial umbrella policy wording. But it is important not to lose sight of the fact that many commercial umbrella insurers draft their own policy forms, and such wording may not be typical and may vary dramatically among insurers.
Typical Exhaustion Wording
For example, the Insurance Services Office, Inc. (ISO), Commercial Liability Umbrella (CU 00 01 04 13), states the following.
11. Loss Payable
Liability under this Coverage Part does not apply to a given claim unless and until:
a. The insured or insured's "underlying insurer" has become obligated to pay the "retained limit";2 and
b. The obligation of the insured to pay the "ultimate net loss" in excess of the "retained limit" has been determined by a final settlement or judgment or written agreement among the insured, claimant and us.3
The ISO commercial umbrella does not include any requirement that the underlying insurer actually pay the underlying limit (much less pay the limit in cash)—only that either the insured or the insurer is obligated to pay by final settlement or judgment (or a written agreement with the insured, claimant, and umbrella insurer) amounts that exceed the underlying limit.
Absent express wording to the contrary, modern courts, here explaining how it applies, still follow the Zeig rule. Note that the court's explanation is consistent with today's ISO commercial umbrella policy exhaustion wording.
This does not mean that underlying insurers must actually pay before excess policies are triggered. It means that their obligation to do so must be finally determined.
Federal Ins. Co. v. Srivastava, 2 F.3d. 98, 103, n. 5 (5th Cir. 1993).
Fittingly, the American Law Institute's recent Restatement of the Law, Liability Insurance (RLLI), describes the Zeig rule as the "exhaustion default rule" for excess insurance.4 The RLLI has the following comments.
This function of the exhaustion requirement is satisfied as long as someone, typically either the underlying insurer or the insured itself, is required pay an amount equal to the policy limits in settlements or judgments. Second, the default-rule approach followed in this Section promotes settlement by permitting the underlying insurer and the insured to compromise without the insured losing access to its excess insurance. This is especially important in situations in which there is some dispute about coverage.5
Rejection of the Zeig Rule
On the other hand, courts have rejected the Zeig rule and have required the underlying insurer to pay the full policy limit if the policy wording so requires. Consider the following exhaustion wording.
Underwriter shall be liable only after the insurers under each of the Underlying policies have paid … the full amount of the Underlying Limit of Liability.
This wording was analyzed by the California Court of Appeal, Fourth Appellate Division. The court decided that the underlying insurer was required to pay the full underlying limit of $20 million in order to exhaust the underlying [primary] limit and trigger the excess policy.
In our view, the phrase "have paid … the full amount of [$20 million]," particularly when read in the context of the entire excess policy and its function as arising upon exhaustion of the primary insurance, cannot have any other reasonable meaning than actual payment of no less than the $20 million underlying limit.
Qualcomm, Inc. v. Certain Underwriters at Lloyd's, London, 73 Cal. Rptr. 3d 770 (Cal. Ct. App. 2008) at 778.
The Qualcomm court specifically rejected the Zeig rule because of the plain meaning of the terms of the excess policy.
The RLLI describes the Zeig rule merely as the default rule because the Zeig rule does not apply when the excess insurer's policy wording proscribes a different approach to exhaustion.
If the policyholder and excess insurers determine that … tying exhaustion to the payment by the underlying insurers of the full policy limits … the parties can alter the default rule … Some liability insurance policies already contain such language in their exhaustion clauses, and court have typically enforced those terms….6
Insurer A's Exhaustion Wording
Keeping in mind that insurers can and do change the policy wording to avoid the Zeig rule, consider the following wording from hypothetical Insurer A's commercial umbrella policy.
Coverage hereunder will attach only after the full amount of the applicable underlying limits have been exhausted through payment in legal currency of a covered loss by the underlying insurer(s) under all applicable underlying insurance….
Aside from foreclosing the possibility of paying in digital currency, such as Bitcoin, requiring the payment by the underlying insurer in legal currency has one overriding purpose—the umbrella insurer has no intention of paying unless and until the underlying limit has actually been paid in cash by the underlying insurer.
Similar to Qualcomm, the above wording would very likely negate the Zeig doctrine.
Importance of Exhaustion Wording
How important is the difference in the exhaustion wording of the ISO commercial umbrella when compared to that of Insurer A? In other words, is this a distinction without a difference? Is this a highly unusual situation of little consequence or minimal significance for umbrella insurance coverage?
Because commercial umbrella policies necessarily involve millions of dollars in damages, any time a commercial umbrella insurer may be able to avoid making any payment, the purpose of purchasing the policy is hindered. Simply stated, uninsured claims in the millions of dollars are usually highly significant.
Claim Situations: Underlying Exhausted without Full Cash Payment
Here are two rather common examples in which the exhaustion wording may make the difference between full payment or no payment by the commercial umbrella insurer.
A Disputed Claim
Any claim in which the underlying commercial general liability policy (CGL) and umbrella insurer both initially deny coverage and refuse to defend may lead to trouble with the exhaustion of the underlying and attachment of the umbrella.
Consider the CGL pollution exclusion, one of the most litigated coverage matters throughout the country. Our policyholder has been sued for property damage that the CGL insurer declares was caused by a pollutant. The umbrella insurer ($5 million limit) follows the terms of the underlying CGL ($1 million underlying limit) and takes the same coverage position—and both refuse to defend.
A trial is conducted in which the policyholder engages its own legal counsel to defend but to no avail. A judgment is entered against our policyholder for damages of $4 million—that judgment is appealed but upheld. The insured is obligated to pay $4 million by a final judgment.
The policyholder, without the financial wherewithal to pay full amount of the damages, brings suit against both its CGL and umbrella insurer for wrongly denying coverage. Before adjudication of the coverage matter, the policyholder compromises with the CGL insurer and settles for the CGL insurer's payment of $900,000. Of course, the policyholder will be responsible for the remaining $100,000 payment on the judgment. Policyholders are often put into this position in a coverage dispute—this type of settlement is sometimes referred to as a below-limits settlement.
After the settlement with the CGL insurer, the court grants the policyholder's motion that the cause of the property damage was not a pollutant and finds the umbrella policy applies to the property damage claim.
Assuming typical ISO Commercial Umbrella exhaustion wording (or similar wording) and based on the application of the Zeig rule,7 the umbrella insurer would be obligated to pay $3 million damages excess of the required $1 million underlying CGL limit. It matters not that the CGL insurer paid only $900,000—the obligation of the insured to pay $4 million (and thus excess of the CGL $1 million limit) was determined by a final judgment.
If instead the umbrella used Insurer A's exhaustion wording, it is likely that the umbrella insurer would not be required to pay any amount. Because the CGL insurer did not pay the full underlying limit, Insurer A's obligation never attached. Even though the insured would be ultimately responsible to pay the $100,000 in damages, this does not satisfy the exhaustion wording as the limit has not yet been paid in legal currency—and even if the insured was able to fund the $100,000 payment to the claimant, it was not a payment by the underlying insurer.
There should be no doubt that Insurer A's exhaustion wording, which results in uninsured damages of $3 million, would be considered substantial by just about any measure.
Insolvent Underlying Insurer
Any claim involving an insolvent underlying insurer will raise the threat of the umbrella insurer escaping all payments—if the umbrella includes a requirement that the underlying limits must be exhausted by payment by the underlying insurer in legal currency.
While it has become a standard provision that an umbrella insurer will not drop down and replace an insolvent underlying insurer, such provisions also state the insolvency "will not relieve us of our obligations under this Coverage Part. This insurance will apply as if the 'underlying insurance' were in full effect."8
If the umbrella policy includes typical ISO commercial umbrella exhaustion wording as quoted above, the insurer would likely be obligated to pay excess of the insolvent insurer's underlying limit, regardless of whether the underlying insurer was unable to pay the full underlying limit. While Zeig does not directly address insolvency,9 the principles of the doctrine remain.
We are aware of the fact that there are decisions holding that the words "exhausted by payment of claims" require collection of [payment by] the primary policies as a condition precedent to the right to recover excess insurance. We see nothing in the clause before us to require a construction so burdensome to the insured, and accordingly we must reject such an interpretation.
Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d. Cir. 1928) at 666.
But, if we apply the exhaustion wording of Insurer A, those "obligations" apply only in the event that the underlying limit is exhausted by payment by the underlying insurer in legal currency. The umbrella insurer may plausibly argue that at no time did its obligation to pay arise. Even if a guaranty fund steps in for an admitted underlying insurer and pays its limit (for our purposes, let's say the guaranty fund limit is $300,000 each occurrence), the underlying insurer will never make a cash payment of the full underlying limit. Simply stated, if the underlying insurer becomes insolvent, the umbrella insurer may be able to escape any obligation to pay damages by its requirement that the underlying limit be exhausted by the payment by the underlying insurer in legal currency.
Of course, a straightforward solution is for the umbrella insurer to make an express exception for insolvency as respects the payment by the underlying insurer.10 However, no such exception or even recognition of the coverage issue is recognized by Insurer A.
The reasoning of the Zeig rule is well-explained by the Seventh Circuit Court of Appeals, applying Indiana law.
Rather than agree to a lower payout by a CGL provider as part of a settlement, an insured with an excess policy would be forced to fully litigate each and every one of its CGL policy claims before seeking recourse from its umbrella insurer. Unless the clear language of the contract counsels otherwise, Indiana public policy favors an interpretation that encourages—not discourages—settlement.
Moreover, this construction of the policy neither has a punitive effect on Cincinnati nor does it alter its underwriting considerations. Beazer is not asking Cincinnati to drop down and pay the remainder of the CGL limits after its settlement with the CGL insurers.
Trinity Homes LLC v. Ohio Cas. Ins. Co., 629 F.3d 653, 659 (7th Cir. 2010).
Perhaps most critically, applying the Zeig rule will prevent forfeiture of an entire excess policy or excess policies when, as in the examples above, the underlying coverage may be in dispute or the underlying insurer may be insolvent. The Third Circuit Court of Appeals, applying Pennsylvania law, made the following observation.
Courts have adopted this rule because it encourages settlement and allows the insured to obtain the benefit of its bargain with the excess insurer." [Emphasis added.]
Therefore, it is difficult to overstate the importance of determining what, exactly, constitutes exhaustion of the underlying policies in order for the commercial umbrella policy to attach. The RLLI offered this opinion as to the importance of a clear understanding of the exhaustion wording found in an umbrella or any excess policy.
In light of the importance of such language, an insurance broker's duty of reasonable care may require that the broker advise a customer of the presence of such a term [exhaustion wording] and the consequences thereof and present an alternative excess-insurance program that does not contain such a term [the exhaustion wording].11
While I would strongly suggest RLLI's opinion as to the level of an insurance broker's duty of reasonable care is not at all typical and, in fact, would be imposed only in rare circumstances, the opinion does reflect the importance of understanding the consequences of various approaches to exhaustion wording taken by insurers. In particular, it is important to recognize that Insurer A's exhaustion wording in our example may indeed result in an unforeseen forfeiture of an excess policy and possibly forfeiture of an entire "tower" of excess coverage.
"The Zeig court adopted the rule that an insurer whose policy applies excess of underlying policies is not necessarily freed from liability where the policyholder has settled with the underlying carriers for less than their policy limit. Instead, the excess insurer's policy is triggered, but only to the extent the policyholder's loss exceeds the actual policy limits of the underlying policies, with the policyholder being liable for any gap in coverage caused by the below-limits settlements. The vast majority of courts considering below-limit settlements have adopted the Second Circuit's analysis in Zeig." Insurance Coverage Settlements and the Rights of Excess Insurers, p. 51.
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