Understand the nuances of horizontal versus vertical exhaustion of insurance.

Like many things in this world, claims arising out of defective construction have become more contentious and complex. Specifically, one area in which this has occurred is with construction defect claims that involve property damage occurring over an extended period of time and stretching over the periods of multiple liability insurance policies. Under these circumstances, it is often difficult to obtain the agreement of the involved insurers as to which policies apply and to what extent.

A Claim Scenario
Construction insureds usually purchase a combination of commercial general liability (CGL) insurance and excess insurance to cover exposures. The typical CGL policy provides a $1 million per-occurrence limit but, more importantly, provides the insured with a defense of lawsuits arising out of such claims. At the same time, an excess policy provides a higher limit, such as $10 million over the CGL policy, at a much lower premium. Together, this typical construction insured would have a total limit of $11 million available to pay a large claim in that year—or so one would think. Image of courthouse

Consider a simple example where Watertight, a general contractor, constructs an office building that has leaked for various reasons after completion, and  the damage occurs over a three-year period during which its CGL coverage is provided by the same insurer and all of its excess insurance is provided by another. However, each CGL policy is subject to a $250 thousand self-insured retention to be paid by Watertight. The claim goes to litigation, and the undisputed cost of repairing the property damage is $3 million. How should it be allocated among these policies?
Horizontal Allocation
Under the law of some states, the courts might apply a “multiple trigger,” determining that the occurrence of water intrusion triggers all CGL policies. Therefore, it would seem that Watertight is protected by plenty of insurance in all three years, and the case can be settled. However, the issue is not as simple as the availability of $11 million in insurance to pay the claim in each of the three years. For example, the excess insurer is likely to argue for “horizontal exhaustion” of all applicable underlying insurance. Under this method of insurance application, all primary policies that apply to a loss must be exhausted (have paid their limit) before an excess policy is triggered. Often, the premise is that the premium for an excess policy is much less than for the underlying policies, with the expectation that it will be less likely to be called upon to pay a claim.  

If the rule of horizontal exhaustion was applied to Watertight, all of the CGL policies would be required to contribute to the loss up to their limits. In other words, those policies contribute $1M each, funding the entire loss. Unfortunately, each of those policies is subject to a $250 thousand self-insured retention, and Watertight itself will be required to fund $750 thousand, the CGL insurer $2.25 million and the excess carrier nothing. It is doubtful that this is the scenario contemplated by Watertight, its broker and the CGL insurer.

Vertical Exhaustion
On the other hand, the courts of some other states apply a “vertical exhaustion” model. This approach allows insureds with multiple insurers over a long-term exposure to select the most favorable policy, in terms of the highest limits or the lowest deductible, for indemnification. The argument for the selection approach is that it reduces legal costs and streamlines the settlement process. It also focuses on provisions of the policy that obligate the insurer to pay those sums up to the full limit of the policy until exhausted. Once the primary CGL policy is exhausted, the excess policy above it applies. Applied to the Watertight claim, the loss would be allocated as follows: Watertight pays a $250 thousand self-insured retainer, the CGL pays $750 thousand and the excess pays $2 million. This allocation is likely to be more in accord with the expectation of the insured contractor.

Complicating Factors
Of course the claim scenario described above is highly simplified, and many construction insureds may move from insurer to insurer when they place their coverage. The presence of multiple insurers in the primary CGL or the excess layers can fuel the incentive to spread the claim among multiple policy periods to other insurers. In addition, an insured may not be subject to a self-insured retention on all of its policies, increasing the incentive to allocate a claim to the policy period or periods that are not subject to the retention.

While predictability is a key element of the risk management program of any construction insured, disputes over allocation between policy periods and layers of coverage are extremely difficult to predict, let alone resolve. A contributing factor to the lack of predictability is that these issues are frequently not raised until late in the game, usually when mediation is impending or settlement negotiations otherwise begin in earnest. Often, the focus is on defense of the claim by the CGL insurer, and an excess insurer may not be provided with all available information as to the liability and damages associated with the claim against the insured. Even if it is, more opaque issues relating to the triggering of applicable policies and allocation among them are not usually addressed in any reservation of rights letter received from the excess insurer until later settlement stages. 

Predictability of results on allocation issues is clouded by general uncertainty under state laws. Most states have yet to consider and rule on these issues, and so far there is no consistency as to whether they apply a horizontal or vertical allocation, although it appears that a majority of states have applied a horizontal approach. In addition, some of the states that have applied a horizontal allocation have also determined that the insured is obligated for any self-insured retention or deductible under the triggered policies. A minority of courts have limited the insured’s obligation to fund to a single self-insured retention despite the number of policies triggered. As can be seen, it is difficult to generalize about the state of the law on these issues.

Keep in Mind
General points to take away from any discussion on this subject are difficult to conceptualize, but it is particularly important to focus on policy language, state-specific legal knowledge and negotiation.

Policy Language — An excess insurance policy usually includes an “other insurance” provision that states that the policy is not only excess of the scheduled underlying policy directly below it but also of “any other valid and collectible insurance” available to the insured. That language would include other CGL policies. Modification of these provisions can be sought but may be difficult to obtain. On the other hand, some insurers have endorsed CGL policies issued over multiple years to the same insured to provide that only a single policy limit will apply where the same occurrence triggers consecutive policies issued to the insured. Some courts have refused to apply these limitations, particularly under a horizontal scheme of allocation. Thus, even if policy modifications regarding these issues are made, results in the courts are unpredictable.

Knowledge and Negotiation — While the law is unclear and varies from state to state, it is a great advantage to be aware of these issues in the states where the insured does business. Because of the fact that the law is unsettled, these issues most often get negotiated and resolved. A policyholder should ensure that the professionals with whom he or she  entrusts risk management, whether brokers or even attorneys, are acquainted with these issues. Trigger and allocation are malleable issues, and most insurers are hesitant to have them decided upon in the courthouse because many large insurers write both CGL and excess policies. As such, application of a particular theory, while possibly of benefit on an excess layer, may not be on a CGL layer, and vice versa. While lack of clarity in the law can be frustrating, it nevertheless promotes negotiation, and hopefully settlement, of complex claims.