California Supreme Court Holds Horizontal Exhaustion Not Needed – Vertical Exhaustion Rules
On April 6, 2020, the California Supreme Court issued its decision in Montrose Chemical Corp. of California v. Superior Court, No. S244737. It ruled that in the continuing loss context, California law permits a policyholder to seek indemnification under any excess policy once it has exhausted the underlying excess policies in the same policy period. The policyholder is not required to horizontally exhaust excess insurance at lower levels for all periods triggered before obtaining coverage from higher level excess insurance in any period.
The Montrose coverage litigation is decades old and concerns liability coverage for long-tail environmental losses. The specific coverage issue decided by the Court was whether various provisions requiring “other insurance” to be taken into account before coverage under an excess liability policy attaches requires a policyholder to horizontally exhaust all underlying policies before accessing the excess policy. The Court noted that this requirement appeared in various locations among the policies at issue, including in the definitions of “loss” and “retained limit,” and in the “Loss Payable” or “Limits” provisions. The Court grouped all such references together, regardless of the nature of the provision, and referred to them as “other insurance” clauses.
Montrose argued the various references to “other insurance” apply only to claims between insurers and do not require the policyholder to exhaust all triggered coverage horizontally before pursuing coverage vertically in a policy period of its choice. The insurers cited long-standing California precedent holding that horizontal exhaustion is the general rule, absent express policy language requiring exhaustion only of the scheduled underlying insurance before the excess policy would respond.
The Court adopted Montrose’s interpretation. It reasoned that vertical exhaustion is consistent with its decisions in Aerojet-General Corp. v. Transport Indemnity Co., 17 Cal.4th 38, 57 (1997) (adopting the “all sums” rule) and State of California v. Continental Insurance Co., 55 Cal.4th 186, 195-96 (2012) (policyholder may recover the full limits from every triggered policy for continuous property damage, so long as some of the damage occurred while each policy was in effect).
The Court rejected the insurers’ argument that Dart Industries, Inc. v. Commercial Union Insurance Co., 28 Cal.4th 1059 (2002), supported horizontal exhaustion. It found that decision explained that “other insurance” clauses were “designed to prevent multiple recoveries when more than one policy provided coverage for a particular loss,” but did not dictate a particular exhaustion rule. (Opinion at 18 (citing Dart at 1079).)
The Court acknowledged that if the “other insurance” clauses were read in isolation, they may support horizontal exhaustion. It noted with significance the fact that the policies regularly included a schedule of underlying insurance for the same policy period and that, under the insurers’ interpretation, such schedules might only represent a small fraction of the insurance policies that must be exhausted. The Court found the insurers’ interpretation less plausible when the “other insurance” clauses are read together with all provisions in the policies, and consideration is given to their “historic role of governing allocation between overlapping concurrent policies.” (Opinion at 22-23.)
To bolster its decision, the Court ruled that “[t]o the extent any of the language of these policies remains ambiguous, we resolve these ambiguities to protect ‘the objectively expectations of the insured.’” It found the parties’ reasonable expectations favors a rule of vertical exhaustion. (Opinion at 23.)
Finally, the Court distinguished Community Redevelopment Agency v. Aetna Casualty & Surety Co., 50 Cal.App.4th 329 (1996), which has been long-cited for application of the horizontal exhaustion rule in California. It noted that decision involved a dispute between a primary and excess insurer and not the policyholder. The Court further found the limited issue addressed by Community Redevelopment was whether an excess insurer had to drop down and defend the insured before all available primary coverage exhausted. With expressly disapproving Community Redevelopment, the Court held it “offers no real lessons for resolving the question now before us.” (Opinion at 27.)
The California Supreme Court departed from long-standing California precedent that has been followed by numerous trial courts, in holding that, for continuous injury claims, a policyholder may access coverage vertically after exhausting underlying limits in the same policy period. It rejected the rule of horizontal exhaustion, despite the presence of provisions requiring all “other insurance” to be taken into account before excess policies may attach.