An Analytic Gap : The Perils of Relentless Enforcement of Payment-By-Underlying-Insurer-Only Language in Excess Insurance Policies

Excess liability insurance, as the phrase implies, sits atop primary insurance or a lower layer of excess insurance and is required to cover only claims that are above the policy\u27s underlying limit and reach the attachment point of the excess policy in question. Historically, the law was largely indifferent to whether the underlying limit was exhausted by full payment from the underlying insurer or by other means such as payment by the policyholder due to an underlying insurer\u27s insolvency or because the policyholder and underlying insurer had compromised a coverage dispute for less than 100 percent coverage by the underlying insurer, with the policyholder filling the gap of the remaining underlying limit in order to reach the attachment point of an excess policy. This was the legacy of the 1928 Zeig v. Massachusetts Bonding Co. case, a short but influential Augustus Hand decision. Over time, excess insurers began adding language to their policies that stated the entire underlying limit should be paid solely by an underlying insurer in order to trigger coverage. Courts have generally enforced such language and the American Law Institute\u27s draft Restatement of the Law of Liability Insurance has endorsed this approach. But both the ALI and courts enforcing anti-Zeig payment-only-by-underlying-insurer clauses have failed to fully appreciate the pernicious impact of literal application of these provisions, which are often in the nature of boilerplate language that is not specifically negotiated or appreciated by policyholders. Routine application of anti-Zeig clauses runs counter to traditional contract concepts as well as to the overall socioeconomic objectives of insurance and sound risk management. Several alternative approaches would better serve the risk management objectives of excess liability insurance. One modest alternative would be to enforce payment-only-by-underlying-insurer clauses only if they are the product of specific negotiation and understanding of the parties. Another would be to treat these clauses like anti-assignment clauses, which are not enforced when a policyholder assigns insurance rights after a loss because the rationale for the clause has evaporated since the assignment involves no increase of risk to the insurer. In similar fashion, an excess insurer appears in many cases to have no valid interest in the source of satisfaction of an underlying limit. A third and preferred approach-one fairest to excess insurers fearing that attachment will be achieved through suspect settlements designed to access towers of excess insurance without sufficient vetting of claims-would be to treat payment-only-by-underlying-insurer clauses in a manner akin to notice provisions, where late notice by the policyholder bars coverage only if the insurer can demonstrate substantial prejudice