California Supreme Court Adopts Vertical Exhaustion Rule for Excess Policies

On April 6, 2020, the California Supreme Court issued its long-awaited decision in Montrose Chemical Corporation Of California V. Superior Court, Case No. S244737, 2020 WL 1671560 (Cal. Apr. 6, 2020). The issue before the Court was whether an insured may seek coverage from its excess policies under a rule of vertical exhaustion rather than horizontal exhaustion in a continuous trigger or “long-tail” case (i.e., cases involving bodily injury or property damage that takes place over multiple years). The Court held that vertical exhaustion applies and that an insured “is entitled to access otherwise available coverage under any excess policy once it has exhausted directly underlying excess policies for the same policy period. An insurer called on to provide indemnification may, however, seek reimbursement from other insurers that would have been liable to provide coverage under excess policies issued for any period in which the injury occurred.” Id. at *1.

The insured, Montrose, was sued for environmental contamination allegedly caused by its manufacturing operation over a period of more than thirty years. Montrose entered into partial consent decrees in which it agreed to pay for environmental cleanup and represented that it had paid more than $100 million to meet its obligations. After all of its primary policies were exhausted, Montrose sought coverage from its excess insurers. Montrose argued that the rule of “vertical exhaustion” or “elective stacking” applied and that it was entitled to access any excess policy issued in any policy year so long as the underlying policies for that same policy year have been exhausted. The excess insurers disagreed and sought a ruling that the excess insurers owed no duty to pay until Montrose had “horizontally exhausted” all of the excess policies at lower attachment points in all triggered policy years.

The Court agreed with Montrose and adopted the rule of vertical exhaustion for excess policies. After analyzing the excess insurers’ policy language and the objectively reasonable expectations of the parties, the Court concluded that “California law permits the insured to seek indemnification under any excess policy once [the insured] has exhausted the underlying excess policies in the same policy period. [The insured] is not required to exhaust excess insurance at lower levels for all periods triggered by continuous injury before obtaining coverage from higher level excess insurance in any period." Id. at 11. In so ruling, the Court explicitly stated that the vertical exhaustion rule for excess policies “does not alter the usual rules of equitable contribution between insurers” and that an excess insurer required to provide excess coverage for a long-tail injury could seek contribution from other insurers that issued policies during the relevant period. Id. at *10.

Significantly, the Court made clear that its vertical exhaustion ruling was limited to excess policies. It acknowledged that California courts have applied the rule of horizontal exhaustion to primary policies and specifically cited the Court of Appeal’s decision in Community Redevelopment Agency v. Aetna Casualty & Surety Co. (1996) 50 Cal.App.4th 329, 340 wherein the Court held: “Under the principle of horizontal exhaustion, all of the primary policies must exhaust before any excess will have coverage exposure.” Id. at *10-*11. However, because the parties in Montrose had stipulated that all primary policies had been exhausted, the issue of whether horizontal or vertical exhaustion applied to primary coverage was not at issue and the Montrose Court specifically advised that it was not addressing “when or whether an insured may access excess policies before all primary insurance covering all relevant policy periods has been exhausted.” Id. at fn. 4. Rather, the Court left the issue open, stating “[r]egardless of whether Community Redevelopment was correct to apply a rule of horizontal exhaustion “in the context of a dispute between a primary and excess insurer (as was the case there), the Montrose Court was “unpersuaded” that horizontal exhaustion should apply to excess policies. Id. at *10-*11. The Montrose Court then reiterated the limited extent of its holding: “In sum, we conclude that in a case involving continuous injury, where all primary insurance has been exhausted, the policy language at issue here permits the insured to access any excess policy for indemnification during a triggered policy period once the directly underlying excess insurance has been exhausted. Id. at *11.

This decision will have a significant impact on excess insurers in long tail (asbestos, pollution, construction defects) cases. Insureds will now be permitted to select a policy year and seek vertical exhaustion of that year’s tower of coverage. Excess insurers will no longer be able to argue that they owe no obligation until all underlying excess insurance in all policy periods is exhausted and it is now unclear whether excess insurers can argue that all primary insurance must be exhausted before their policy is triggered. As a result, excess insurers should expect and be prepared for demands made to them whenever their directly underlying primary or excess insurer exhausts its coverage or tenders its limits towards settlement. Because this may require that an excess insurer participate in a settlement and seek reimbursement from other insurers, it is critical that issues of the existence and applicability of "other insurance" be clarified as early as possible.