Caveat settlor: insurance coverage settlements and the triumph of policy language over precedent.

Author:O'Connor, John F.


For eight decades, courts uniformly followed the Second Circuit's 1928 decision in Zeig v. Massachusetts Bonding & Insurance Co. as it related to insurance coverage settlements. Zeig and its progeny held that a policyholder could settle insurance coverage disputes with its primary and lower-layer insurers for less than their policy limits without forfeiting coverage under non-settling excess policies. The past decade, however, has seen a number of courts reject that result and hold that a policyholder could not pursue excess insurers if it collected less than full limits from its lower-layer insurers. The thesis of this article is that this change in results does not reflect a change in judicial approach. Rather, it reflects a change in policy language that has required courts to reach different results. Excess policy provisions conditioning coverage on the payment of full limits from lower-layer insurers complicate the settlement of complex insurance coverage disputes, and make piecemeal settlements virtually impossible. Nevertheless, this is a predictable and appropriate result where required by the excess insurer's policy language.


    Large businesses often buy insurance coverage in a tower, with a primary insurer responding first to any covered loss, and excess insurers responding in a predetermined order if the loss exceeds the coverage provided by the primary policy. (1) Each excess policy thus has an "attachment point," which is the amount of loss the policyholder must incur before the excess insurer provides coverage. (2) What happens, however, when coverage is disputed and the policyholder settles with a primary or lower-layer excess insurer for less than the insurer's policy limits? To use a simple example, assume a policyholder has a $1 million primary policy and, because of disputes over coverage, settles with that insurer for $500,000. Does the first-layer excess insurer, which has an attachment point of $1 million, cover the portion of the loss in excess of the settlement amount ($500,000), the portion in excess of the primary insurer's policy limit ($1 million), or pay nothing because the primary insurer did not pay its full limit?

    Until a few years ago, the answer to this question was more or less clear. Courts generally held that a policyholder's below-limits settlement functionally exhausted the settled policy, so that excess coverage could be accessed, but that the policyholder was responsible for the gap in coverage caused by its below-limits settlement. (3) So, in the example above, the primary insurer would pay the first $500,000 of the loss by virtue of its settlement payment, the policyholder would be responsible for the $500,000 gap caused by its settlement with the primary insurer for less than the full policy limit, and the excess insurer, subject to its own policy limit, would be responsible for the portion of the loss over $1 million if the claim is covered. (4)

    This rule had three apparent virtues: equity, finality, and fidelity to policy language. The prevailing rule was viewed as equitable, in most cases, because it placed the non-settling insurer in the same litigation position it occupied before there were any settlements; the only difference was that the policyholder paid some amounts that would have been paid by the settling lower-layer insurer. (5) The prevailing rule provided finality because it allowed parties that wanted to stop fighting with each other to do so, again in a way designed to protect the litigation position of non-settling excess insurers. (6) Finally, the prevailing rule was at least arguably true to the excess insurers' policy language, which typically provided that the policy applied upon exhaustion of the lower-layer coverage, but did not explicitly specify who had to make the payments in order for exhaustion to occur. (7)

    The past decade, however, has seen a perceptible shift in the judicial treatment of below-limits settlements between policyholders and their insurers. Several recent decisions have held that excess insurers have no obligation to pay anything on a claim if the policyholder settled with underlying insurers without obtaining a payment of full policy limits. (8)

    The main thesis of this article is that this shift in results is not the result of a shift in judicial philosophy. Courts are not reaching different results because their view of the issue has changed; they are reaching different results because the policy language they are being asked to construe has changed. The cases where courts have held that below-limits settlements render excess coverage inaccessible invariably involve unambiguous policy language that permits no other result. (9) There is an attractive simplicity and efficiency in treating settled policies as exhausted and requiring the policyholder to simply fill any gaps in coverage caused thereby. But there are reasons excess insurers might prefer to contract around such a result, and courts have enforced those contractual provisions as written, even if it complicates a policyholder's efforts to settle with other insurers.

    This is not some arcane issue of little practical relevance. Any time a policyholder has both primary and excess insurance and faces a disputed claim that might exceed its primary insurance coverage, an issue arises as to whether the policyholder can settle with its primary and lower-layer insurers without forfeiting any attempt to pursue coverage from non-settling excess insurers. It makes it virtually impossible to settle large-scale insurance coverage disputes in a piecemeal fashion, and provides substantial leverage to excess insurers that may be able to benefit by holding out on group settlement efforts. But while all of this may be true, the reality is that this is a dilemma of a policyholder's own making.

    If a policyholder purchases excess insurance with provisions unambiguously premising coverage on payment of full limits by all underlying insurers, the policyholder has no one to blame but itself when settlements become complicated. Moreover, while the settlement playing field might tilt, in some cases, in favor of excess insurers, this is just an adjustment of a playing field that long had been tilted in favor of policyholders and lower-layer insurers, as the gap-filling rule that had long prevailed came to be used in ways that prejudiced the litigation positions of non-settling excess insurers.

    Part II of this article will explain why below-limits insurance coverage settlements are commonplace in complex insurance coverage disputes and provide some examples as to why below-limits settlements occur. Part III of this article will trace the development of rules concerning the effect of a policyholder's settlement with lower-layer insurers on their pursuit of coverage from excess insurers. Part III.A will address the development of the "gap-filling" rule, whereby a policyholder could settle with a lower-layer insurer for less than full policy limits, and then proceed against any excess insurers so long as the policyholder covered any gap in insurance caused by its settlement. This rule has its genesis in a 1928 Second Circuit case, and was more or less universally followed until the second half of the last decade.

    Part III.B will explore decisions from the late 2000s to the present challenging the orthodoxy of the gap-filling rule. As these modern decisions make clear, they are based on changing language in excess insurance policies, and do not represent a wholesale rejection of the gap-filling rule. Indeed, the gap-filling rule continues to be applied by courts in cases where the excess insurance policy's language permits it. Finally, Part III.C will examine the effect of the change in judicial treatment of below-limits settlements. The lesson of the evolution of this case law is the fundamental lesson of contract law in general. Words matter. While conditioning excess coverage on payment of full limits by lower-layer insurers can make settlement of complex insurance disputes more difficult, courts have enforced such clauses and required policyholders to live with the contract terms to which they have agreed.


    Why would a rational policyholder settle with an insurer for less than the insurer's policy limit if the total loss exceeds that limit? The answer is that policyholders settle for less than policy limits for the same reasons that parties in litigation settle their lawsuits every day: uncertainty as to liability and uncertainty as to damages. (10) Consider a few examples.

    A building owner might have her building damaged or destroyed in a hurricane and turn to her first-party (11) property insurer to cover the loss. (12) Many property insurance policies, however, provide coverage for wind damage but exclude coverage for water damage. (13) If there is a dispute as to whether the property damage was caused by wind or by flooding, a rational policyholder and a rational insurer might decide that all-or-nothing litigation is undesirable and that they should mitigate their risk by settling for some percentage of policy limits. (14) The same phenomenon can occur in the third-party (15) context. Different states have reached different results as to whether the "sudden and accidental" pollution exclusion common in 1970s general liability policies excludes coverage for losses caused by the gradual discharge of pollutants. (16) If there was uncertainty as to how this issue would be resolved under applicable law, a policyholder might compromise its claim for insurance coverage in return for the insurer's payment of less than policy limits, thereby eliminating the risk of losing in court and receiving nothing. (17)

    Even where the existence of coverage is clear, a policyholder and insurer might dispute the amount of available coverage. Many insurance policies limit coverage to a specified amount per occurrence, (18) and sometimes...

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