In our January 2006 article, we discussed two theories of allocating ongoing losses over multiple policy periods: the "all sums" approach and the pro rata method. Courts use horizontal and vertical exhaustion theories of allocation when an insured carries primary and excess policies over several years covering the same risk. Courts apply these allocation theories when the injury or property damage occurs continuously over multiple policy periods and is otherwise incapable of allocation.
The theory of horizontal exhaustion "requires the insured to exhaust all primary policy limits before invoking excess coverage." Kajima Constr. Servs., Inc. v. St. Paul Fire & Marine Ins. Co., 856 N.E.2d 452, 456 (Ill. App. 2006). Vertical exhaustion "allows an insured to seek coverage from an excess insurer as long as the insurance policies immediately beneath that excess policy, as identified in the excess policy's declaration page, have been exhausted, regardless of whether other primary insurance may apply." Id. at 457 (citations omitted).
Courts applying the horizontal exhaustion theory do so based upon the "other insurance" language typically found in excess policies. U.S. Gypsum Co. v. Admiral Ins. Co., 643 N.E.2d 1226 (Ill. App. 1994), illustrates the horizontal exhaustion theory. In this case, U.S. Gypsum manufactured asbestos containing building materials. The underlying plaintiffs sought compensation for damages caused to their buildings and other properties by these materials.
U.S. Gypsum sought coverage from its insurers for the period of time from the 1930s through 1984. The court determined that a continuous trigger applied because the property damage occurred over a period of time and could not be linked or confined to one policy period. The court also determined that there was only once occurrence for the purpose of the per occurrence deductible. Finally, the court addressed whether U.S. Gypsum had to exhaust all primary coverage prior to reaching any excess policy.
The plain language of the excess policies stated:
[i]f other valid and collectible insurance with any other insurer is available to the insured covering a loss also covered by this Policy, other than insurance that is in excess of insurance afforded by this Policy, the insurance afforded by this Policy shall be in excess of and shall not contribute with such other insurance.
U.S. Gypsum at 1261. This language made them "excess to all triggered primary policies, regardless of whether they extend over multiple policy periods or only one." Id. Construing identical language in favor of horizontal exhaustion, the court in California Ins. Co. v. Stimson Lumber Co., 2005 WL 627624, 4 (D. Or. 2005), explained that "the only reasonable interpretation of 'underlying' as it is used in the policies refers to any insurance policy that is lower on the coverage chart."
Further, to adopt vertical exhaustion would allow the insured:
to effectively manipulate the source of its recovery, avoiding difficulties encountered as the result of its purchase of fronting insurance and the liquidation of some of its insurers ... [and] pursue coverage from certain excess insurers at the exclusion of others. Such a practice would blur the distinction between primary and excess insurance, and would allow certain primary insurers to escape unscathed when they would otherwise bear the initial burden of providing indemnification. Likewise, certain co-excess insurers could avoid contributing to the indemnification of the insured when they would otherwise be responsible for any amount up to the limit of the policy it issued.
U.S. Gypsum at 1262.
Unlike horizontal exhaustion which courts generally derive from the plain language of the policy, vertical exhaustion appears to involve public policy considerations. Only one jurisdiction has apparently adopted the theory of vertical exhaustion wholesale: New Jersey. In three different insurance coverage cases, each involving an otherwise unallocable loss, New Jersey adopted a continuous trigger, pro rata allocation and vertical exhaustion. Owens-Illinois, Inc. v. United Ins. Co., 650 A.2d 974 (N.J. 1994), is an asbestos property damage case, Carter-Wallace, Inc. v. Admiral Ins. Co., 712 A.2d 1116 (N.J. 1998), is an environmental contamination/EPA cleanup case, and more recently, Benjamin Moore & Co. v. Aetna Cas. & Sur. Co., 843 A.2d 1094 (N.J. 2004), is a lead paint exposure case.
In this analysis, courts address the extent to which each triggered policy shall provide indemnity. Unlike courts applying horizontal exhaustion, the courts do not rely upon policy language: "'[o]ther insurance' clauses in standard CGL policies were not intended to resolve that question." Owens-Illinois at 995. In adopting vertical exhaustion, one court explained that "it is entirely consistent with our belief that 'any allocation should be in proportion to the degree of the risks transferred or retained during the years of exposure'." Carter-Wallace, Inc. v. Admiral Ins. Co., 712 A.2d 1116 (N.J. 1998) (citation omitted).
The Owens-Illinois court explained:
the rules that we adopt will attempt to relate the theory of a continuous trigger causing indivisible injury to the degree of risk transferred or retained in each of the years of repeated exposure to injurious conditions. In the absence of a satisfactory measure of allocation ... we believe that straight annual progression is not an appropriate measure of allocation. The degree of risk transferred or retained in the early years of an enterprise like O-I's obviously was not at all comparable to that sought to be insured in later years. Hence, any allocation should be in proportion to the degree of the risks transferred or retained during the years of exposure. We believe that measure of allocation is more consistent with the economic realities of risk retention or risk transfer. That later insurers might need to respond to pre-policy occurrences is not unfair.
Owens-Illinois at 993. These occurrence policies, "provide coverage for pre-policy occurrences (acts) which cause injury or damage during the policy period." Owens-Illinois at 993 (citation omitted).
In this case, the year-by-year increase in policy limits must have reflected an increasing awareness of the escalating nature of the risks sought to be transferred ... therefore, a better formula ... is [one] that ... allocated the losses among the carriers on the basis of the extent of the risk assumed, i.e., proration on the basis of policy limits, multiplied by years of coverage.
Id.Owens-Illinois did not specifically address exhaustion, noting that:
many complexities encumber [this] solution ... for example, determining how primary and excess coverage is to be taken into account or the order in which policies are triggered. ... [But] the parties did not focus on those issues.
Owens-Illinois at 994.
Carter-Wallace focuses on those issues. The trial court required horizontal exhaustion prior to reaching the second layer excess policy. The appellate court reversed, finding that horizontal exhaustion was not only not required, but Owens-Illinois prohibited horizontal exhaustion. In addressing the issue, the Supreme Court of New Jersey found the policy language and traditional rules of contract interpretation:
unhelpful in settling on the proper method of allocating responsibility. [Consequently, the court] was guided by our concern for the efficient use of resources to address the problem of environmental disease and by the simple demands of justice.
Carter-Wallace at 1121 (citation omitted).
In Carter-Wallace the second layer excess insurer, Commercial Union, proposed a method of horizontal exhaustion by layer which subordinated:
its coverage responsibility to all primary and first-level excess policies in effect during the entire 17-year trigger period ... [which resulted] in Commercial Union indemnifying no portion of Carter-Wallace's costs."
Id. at 1122. In turn, Carter-Wallace submitted an allocation method rejecting horizontal exhaustion. The court accepted neither.
In rejecting Commercial Union's reliance on policy language that required exhaustion of the underlying limits of coverage before liability attached, the court explained that:
[f]airly read, that provision requires the vertical depletion of the relevant policies in effect during the time of the excess policy's coverage; we are unpersuaded that this clause somehow applies to future policies that had not yet been written or signed at the time this second-layer policy was issued.
Carter-Wallace at 1123. The Supreme Court of New Jersey rejected Carter-Wallace's approach because it:
collapses the damages incurred over the entire 17-year trigger into Commercial Union's policy period resembling the all sums method which was specifically rejected in favor of pro rata allocation. Id.
Instead, the court amplified the method adopted in Chemical Leaman Tank Lines, Inc. v. Aetna Cas. & Surety Co., 978 F. Supp. 589 (D. N.J. 1997), which:
rejected the theory of horizontal exhaustion by layer and directed apportionment of damages among policy years without reference to the layering of policies in the triggered years.
Carter-Wallace at 1123. In so doing, the court noted "that within any given year, each layer of excess coverage must be depleted before the next level is pierced." Id. at 1123-4. After applying the New Jersey pro-rata by years and limits allocation method and reaching a figure for each triggered year, that figure is then"
vertically allocated [through] each policy in effect for that year, beginning with the primary policy and proceeding upward through each succeeding excess layer. Id.
The Carter-Wallace court explained that this method promotes cost-efficiency by spreading costs, "simple justice" by "respecting the distinction between primary and excess insurance while not permitting excess insurers to unfairly avoid coverage in long-term, continuous trigger cases" and introduced a degree of certainty and predictability. Carter-Wallace at 1124. Finally, despite dismissing the policy language, the court "perceive[d] that this solution is consistent with the contract language" because the second-layer excess policy will not be reached "unless and until the primary and first-level excess policies in effect for a given year have been expended." Id.
Benjamin Moore addresses one final question in the context of vertical exhaustion: application of the deductible. Benjamin Moore explains that "once the amount of loss allocable to the policy period is determined," using the method described above, "it is to be treated exactly as any actual loss during that period would be treated in accordance with the policy provisions, including limits and exclusions." Benjamin Moore at 1105. Recognizing that "[d]eductibles constitute a bargained-for aspect of the insurance contract that affects the premiums the insured pays," Benjamin Moore makes it clear that in New Jersey's vertical exhaustion scheme, the insured must satisfy the full deductible for each triggered policy prior to triggering the next layer's indemnity obligation. Benjamin Moore at 1106.
A Combination Approach
In a case just decided in May, Padilla Constr. Co. v. Transportation Ins. Co., 58 Cal. Rptr. 3d 807 (Cal. App. 2007), the Fourth District Court of Appeals in California recognized that California applies horizontal exhaustion but allowed for the possibility of a combination approach.
As applied in California, the rule of horizontal exhaustion means that "an excess or secondary policy does not cover a loss, nor does the duty to defend the insured arise, until all of the primary insurance has been exhausted." Padilla at 809, n.1 (citations omitted, emphasis in original). The court went on to explain, however, that:
a rule of drop-down "vertical exhaustion" is possible in California when a provision in an excess policy states specifically that is it is excess over a "specifically described policy and will cover a claim when that specific primary policy is exhausted." Id. (citation omitted).
The Padilla decision addressed the problems with the rule of horizontal exhaustion and the continuous injury trigger adopted in California in a construction defect claim. The court considered whether an excess insurer has a duty to drop down and defend when the action alleges that the insured caused continuing property damage that existed prior to the policy period (answering no, because other insurance is available for the defense for the pre-policy period of time because a primary insurer whose policy is triggered must defend the complaint in its entirety) and the meaning of "other insurance available" in an excess policy where the policy has an SIR (again, answering no, because that would lead to the absurd result of an excess insurer having a defense obligation before the primary insurer has to defend the claim).
The allocation theory a court will apply depends on a number of considerations and the decisional law of each jurisdiction. Often, because the policy language differs, courts apply allocation methods to determine indemnity obligations. While these two articles have attempted to introduce some of the issues about allocation, each state's policy considerations will typically determine which policies are triggered and the extent of the indemnification obligations.
Contributing author Rebecca C. Appelbaum is a senior associate practicing in the area of third-party coverage at the firm of Butler Pappas Weihmuller Katz Craig, LLP.
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