Calif. Justices’ Options In Insurance Exhaustion Case
By Aiden Spencer (January 16, 2025) 
The California Supreme Court recently agreed to review Fox Paine & Co. LLC v. Twin City Fire Insurance Co., a September 2024 appellate court decision finding that an insured must establish exhaustion of underlying policies before filing suit against excess insurers.[1] Fox Paine’s opening brief is due on Feb. 10.
California courts, as well as courts throughout the country, have grappled with this issue, questioning what constitutes exhaustion sufficient to trigger excess policies. Broadly speaking, jurisdictions generally fall within one of two camps: those that favor public policy considerations, and those that adhere to the plain language of the excess policies.
This article outlines the two camps, and then discusses which the California justices are likely to select in Fox Paine.
Zeig Rule
Most jurisdictions have long followed the rule established in Zeig v. Massachusetts Bonding & Insurance Co., a U.S. Court of Appeals for the Second Circuit decision from 1928. The Zeig rule emphasizes the importance of public policy and allows an insured to settle with a primary insurer for less than its policy limits without forfeiting coverage from an excess insurer, so long as that excess insurer is only required to pay the portion of the loss that exceeds the primary limits of liability.[2]
The insured may absorb the difference between the settlement amount and primary policy limit to then trigger coverage under the excess policy.
The potentially problematic aspect of the Zeig approach lies in the court’s analysis of policy language or complete disregard of its meaning or purpose. Prior to ruling on public policy grounds, courts should first find ambiguity in the policy language.
This process, however, is vulnerable to inconsistency. As an example, multiple courts have been met with identical policy language and reached varied conclusions.[3] And even more concerning are those jurisdictions that apply Zeig regardless of the specific policy language provided in excess policies.[4]
Qualcomm Rule
Other jurisdictions find exhaustion of underlying coverage to be a condition precedent to accessing excess policies.
A growing number of jurisdictions have departed from Zeig, choosing to follow the rule established in Qualcomm Inc. v. Certain Underwriters at Lloyd’s, London, a 2008 decision from the California Court of Appeal, Fourth Appellate District.[5] The Qualcomm rule requires the actual exhaustion of underlying policies before an insured may seek coverage under its excess policies, electing to prioritize unambiguous policy language over public policy principles.
Although, like other jurisdictions, these courts may favor and encourage settlement, they also abide by the belief that the excess policy’s plain language should apply and supersede such principles.
Qualcomm expressly states that a rationale favoring the efficient settlement of disputes between an insurer and their insured cannot supplant plain and unambiguous policy language. If the relevant policy language is clear and explicit, such language should govern and serve to resolve the dispute, alleviating the excess insurer of any coverage obligation absent full payment by the primary insurer.
The Qualcomm rule is not, however, without its potential pitfalls with respect to policy interpretation and inconsistency among the courts. Even if a court finds contractual language unambiguous on its face, extrinsic evidence may serve to expose a latent ambiguity, revealing more than one possible meaning.
As the California Supreme Court observed in its 2004 decision in Wolf v. Superior Court, when a court interprets a contract based on its own conclusion that the contractual language has a plain meaning and refuses to admit any extrinsic evidence contradicting its interpretation, the court “determines the meaning of the instrument in accordance with the ‘ … extrinsic evidence of the judge’s own linguistic education and experience.'”[6]
Moreover, two judges could be met with identical policy language, both find it unambiguous, and still arrive at different meanings and potentially impose opposing resolutions.
Restatement
Although the Restatement of the Law of Liability Insurance, Section 39, articulates the principles of Zeig, it stops short of overruling the importance of policy interpretation prioritized by Qualcomm. The comments clarify the majority rule, suggesting that primary and excess coverage functions best when excess insurers know that their policies will not be “called on to pay judgments, settlements, or defense costs until the underlying limits have been paid out, or will with certainty be paid out, by someone.”
However, the Restatement later nods to Qualcomm jurisdictions by identifying Section 39 as the default rule, but also leaving room for tailored policy language that prohibits a finding of exhaustion absent actual payment in full.
Legal Background of Fox Paine
Returning to Fox Paine, California prioritizes plain policy language over public policy, notwithstanding its favorable outlook and consideration of public policy principles such as settlement. Fox Paine may serve as the California Supreme Court’s opportunity to firmly establish precedent with respect to a strict adherence to excess policies’ exhaustion provisions when the language is clear and explicit.
Prior to Qualcomm, California state courts and the U.S. Court of Appeals for the Ninth Circuit weighed in on the issue, publishing conflicting opinions concerning exhaustion requirements.
Absent an opinion from the state’s highest court, in 1994, the Ninth Circuit issued an opinion favorable to the excess insurers in Iolab Corp. v. Seaboard Surety Co., requiring the legal obligations of the primary insurers to be determined, and the excess policies triggered, before an insured can sue the excess insurers for breach of contract.[7]
Subsequent district court decisions within the Ninth Circuit followed Iolab, with one choosing to disregard the opinion in favor of a decision issued by California’s Sixth Appellate District in favor of the insured. In Title Fremont Reorganizing Corp. v. Federal Insurance Co.,[8] decided in 2010, the U.S. District Court for the Central District of California agreed with Iolab, but ultimately followed the Sixth Appellate District’s 2000 decision, Ludgate Insurance Co. v. Lockheed Martin Corp.,[9] and ruled in favor of the insured.
The Central District of California’s reasoning centered around a federal court’s duty to apply state law when sitting in diversity. Citing the Ninth Circuit’s 2008 opinion in U.S. v. Taylor, the district court noted that, “[i]n the absence of a ruling by the high state court, the federal court should follow the decision of an intermediate state appellate court[] ‘unless it is convinced by other persuasive data that the highest court of the state would decide otherwise.'”[10]
Thus, while conceding within the opinion that Ludgate was not persuasive and extensively discussing Iolab, noting that a claim against an excess insurer cannot stand until the liability of the primary insurer has been established, the district court elected to follow Ludgate to the extent the opinion was inconsistent with Iolab.
It is worth noting, however, that the Central District of California first considered the language of the excess policy’s exhaustion provision in Title Fremont Reorganizing. The provision states that the excess insurer’s liability arises “if such loss is properly payable [under the primary policy], or would be, except for exhaustion of the Underlying insurance.”
The Central District of California court found that this exhaustion provision covers two different scenarios, with the first being where the losses exceed the primary policy’s limits and are properly payable. Under that scenario, there is no strict exhaustion requirement that the primary policy limits must be paid prior to the excess policy attaching, which the court also discussed in support of its holding in favor of the insured. Thus, the court arguably did its due diligence in considering policy language, finding no ambiguity in its meaning.
California Supreme Court’s Likely Ruling
Notably, the insured in Fox Paine relied upon Ludgate in its appellate briefing to suggest that its declaratory relief claims should move forward because an “actual justiciable controversy exists” between the parties sufficient to allow the Fox Paine claims against the excess insurers to move forward.
Fox Paine specifically quoted Ludgate in opposition to the excess insurers’ demurrers, arguing that exhaustion is merely an “issue of proof and entitlement to recovery, not of pleading.” Fox Paine suggested that Ludgate differentiates between facts relating to the legal rights and duties of the parties — which the court deemed legally sufficient to prove an actual controversy exists — and those relating to exhaustion, which establish an insured’s right and entitlement to recovery.
In response, the Court of Appeal rejected Fox Paine’s argument, dismissed this portion of Ludgate as “pure dictum,” and instead held that an insured’s failure to establish exhaustion is fatal to declaratory relief claims against excess insurers.
Overall, it seems unlikely that the California Supreme Court will uproot the Qualcomm rule considering its commitment to adhere to the plain language provided in excess policies, giving effect to the mutual intent of the parties. Rather, the uncertainties lie more so with the lifespan of the Zeig rule as the majority view.
Nonetheless, with courts’ growing tendency to interpret policies in a pro-policyholder manner, the emphasis on judicial economy and efficiency to the benefit of the insured, and the preeminence of public policy principles as a bench marker for justice, the Zeig rule will likely remain the default rule rather than the exception.
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Aiden Spencer is an associate at Langsam Stevens Silver & Hollaender LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Fox Paine & Co., LLC v. Twin City Fire Ins. Co., 2024 Cal.App.5th 1034 (Sept. 5, 2024).[2] Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928).
[3] Bradley, Beth, Fagelson, Marilyn, Brownell, Margo, and Gassman, Gary. Can You Climb the Excess Tower and Enjoy the View From Up There? American College of Coverage Counsel, p. 17 fn. 3 (Sept. 22-24, 2021) (comparing Martin Res. Mgmt. Corp. v. AXIS Ins. Co., 803 F.3d 766, 770 (5th Cir. 2015 (applying Texas law) with Maximus, Inc. v. Twin City Fire Ins. Co., 856 F. Supp. 2d 797, 802 (E.D. Va. 2012)).
[4] See, e.g., Minnesota (Drake v. Ryan, 514 N.W.2d 785 (Minn. 1994); New Mexico (Rummel v. Lexington Ins. Co., 123 N.M. 752, 763 (1997); and Florida (Reliance Ins. Co. v. Transamerica Ins. Co., 826 So. 2d 998, 999-1000 (Jan. 10, 2001).
[5] Qualcomm Inc. v. Certain Underwriters at Lloyd’s, London, 161 Cal.App.4th 184, 199 (2008).
[6] Wolf v. Superior Court, 114 Cal. App.4th 1343, 1356 (2004), (quoting Pacific Gas & Elec. Co. v. G. W. Thomas Drayage & Rigging Co., 69 Cal.2d 33 (1968)).
[7] Iolab Corp. v. Seaboard Sur. Co., 15 F.3d 1500 (Jan. 28, 1994).
[8] Title Fremont Reorganizing Corp. v. Federal Insurance Co., 2010 U.,S. Dist. LEXIS 14675 * (Feb. 1, 2010).
[9] Ludgate Insurance Co. v. Lockheed Martin Corp., 82 Cal. App. 4th 592, 98 Cal. Rptr. 2d 277 (Ct. App. 2000). [10] U.S. v. Taylor, 529 F.3d 1232, 1237 (9th Cir. 2008).