The parties filed cross-motions for summary adjudication as to whether Continental’s policies attached immediately upon exhaustion of the specified retention for the policy period (vertical exhaustion), or only upon exhaustion of all retentions across all policy periods (horizontal exhaustion). The trial court held that vertical exhaustion applied, and Continental agreed to pay its policy limits of $12 million. The trial court further awarded the state prejudgment interest on that $12 million at 7 percent, totaling $13,914,082.09. Continental appealed, contending that the mandatory prejudgment interest award was erroneous, in part, because the start date for calculating interest was based on the trial court’s decision that Continental’s coverage attached immediately upon exhaustion of the specified retention for the specified policy period (the vertical exhaustion ruling).

On appeal, Continental argued that the “other insurance” clauses in its policies supported horizontal exhaustion, and that California precedent mandated the application of horizontal exhaustion. The practical effect of applying horizontal exhaustion would have been that no excess policy would attach until the state’s self-insured retention, and the amounts of all lower-lying policies and retentions, spanning every applicable policy period, had been exhausted. The Court of Appeals rejected both arguments and affirmed the trial court’s ruling applying vertical exhaustion.

Addressing Continental’s argument regarding policy language, the court held that other insurance clauses “are intended to apply in contribution actions between insurers, not in coverage litigation between insurer and insured.” Moreover, it noted that if Continental’s interpretation of other insurance clauses was adopted, then “a court could not determine the amount any insurer owes without first determining what every insurer owes.” (Emphasis in original.) This would undermine the valid interests of policyholders in obtaining timely indemnity for their claims.

The court further rejected Continental’s argument that California precedent mandated horizontal exhaustion. The court distinguished Community Redevelopment Agency v. Aetna Casualty & Surety Company, 50 Cal. App. 4th 329 (Cal. App. 1996), which had mandated horizontal exhaustion of primary policies in continuous loss cases, because “the applicable policies were not neatly divided into a primary and an excess level.” As such, no policy was “written” as excess to any given policy, even where the state had subsequently purchased some insurance to cover the retained limit. The court reasoned that while Community Redevelopment held that excess insurers should not pay defense costs before all primary insurance was exhausted, the same would not be true of two insurers whose coverage was written excess of a retention. This is because in the latter case, the insurer had not bargained for the insured to purchase primary insurance before issuing coverage, and the insurance was not designed to be excess of a primary policy.

Accordingly, the Court of Appeals held that Montgomery Ward & Company v. Imperial Casualty, 81 Cal. App. 4th 356 (2000), was more directly on point. In Montgomery Ward, the Court of Appeals held that where a policy states that it is excess to a specifically described policy, or specifically described retention, the policy terms themselves rebut the presumption of horizontal exhaustion. Thus, because Continental’s policy language expressly required only the exhaustion of the specified retentions, rather than all retentions in all policy periods, Continental’s duty to indemnify arose immediately upon the exhaustion of that specified retention, regardless of whether the insured chose to purchase insurance within its retained limit.

Notably, the Court of Appeal specifically rejected, without addressing in detail, the reasoning of Montrose Chemical Corporation v. Superior Court, B272387 (Cal. App. 2nd Dist. Aug. 31, 2017), which a different panel of the Court of Appeal decided earlier this summer. In that case, the court held that where a loss triggers policies across multiple policy periods, a policyholder must demonstrate exhaustion of all triggered underlying policies before any excess policy will be called upon to pay a claim (horizontal exhaustion), unless the excess policy has specific language that would require a different result. See Montrose and Multiple Policy Periods: Policyholders in California may have to demonstrate exhaustion of all triggered underlying policies before any excess policy is required to pay a claim. The Montrose court relied, in part, on “other insurance” clauses in the applicable policies, in contrast to the treatment given to them by the court in State of California.

The conflicting decisions, as well as conflicting approaches to exhaustion in other jurisdictions, increase the likelihood of review by the California Supreme Court. Until this split of authority is resolved, however, State of California v. Continental provides policyholders with important ammunition to avoid a horizontal exhaustion ruling. Accordingly, policyholders should closely analyze the specific terms of their excess insurance policies to determine whether those policies include language limiting the scope of “underlying insurance” to specific policies or policy terms.

Client Alert 2017-242