Over the years, we have written and discussed during our seminars the fact that no insurance generates more litigation in New York State than liability policies obtained for parties in the construction industry. This phenomenon is due to the “absolute liability”^[1] that exists under New York State Labor Law applicable to owners and general contractors. The nearly assured liability at the top of the construction project hierarchy generates litigation for those down the chain on issues of the primacy of insurance coverage. Thus, the questions become which insurer or insurers will provide defense and indemnification coverage on both a primary and excess basis and, most importantly, when. In this issue of The E&O Report, we provide an overview of an exceptionally complicated, highly litigated and often misunderstood body of insurance law that relates to the “Horizontal vs. Vertical Exhaustion” of liability insurance coverage.

Broadly speaking, these issues arise between and among insurers whose polices at both the primary and excess levels are implicated in a claim, when those insurers disagree over who should pay and also the order of any payment. Resolving such disputes depends on understanding the relationship between primary and excess insurers and the point coverage from the excess insurance policy is triggered when there are multiple parties, contracts and layers of insurance coverage.

“Vertical Exhaustion” allows an insured with multiple primary and excess policies covering a common risk to seek coverage from an excess insurer as long as the insurance policies immediately beneath that policy have been exhausted, regardless of whether other primary insurance may apply – in other words, an owner or general contractor seeking coverage as an additional insured can exhaust the subcontractor's coverage through all excess layers before triggering its own policy(ies).

“Horizontal Exhaustion” requires an insured with multiple primary and excess policies covering a common risk to exhaust all primary policy limits before invoking excess coverage. As a result, that same owner or general contractor's own primary policy would be triggered either concurrent with the subcontractor's policy or immediately after it, regardless of whether the subcontractor had purchased excess or umbrella coverage. Obviously, the excess insurers seek to invoke the application of all primary insurance before admitting that their excess policy is triggered.

When looking at this issue, it is important to understand the court’s aggressive role in this analysis. We all know that parties to construction contracts either use AIA standardized construction agreements or carefully craft their own to address, among other issues, whose policies are primary, excess and when they are triggered. Common sense tells us that the party’s agreement on these issues should control. However, New York courts say otherwise. The courts have held that none of the construction agreements, as well as the terms and provisions on primacy or trigger of coverage, apply to the insurers or their policies. The reason: the insurers are not parties to those construction agreements and, therefore, they cannot be bound by their terms. So, the courts have created a body of law on exhaustion based on the subject policies' language and social considerations having little to do with the construction agreements.

New York courts do not use the actual terms “vertical” or “horizontal” exhaustion, but refer to these issues as “priority of coverage” and rely on the “Other Insurance” clauses contained in policies to resolve priority issues.

Several years ago, the state Court of Appeals issued a significant decision^[2] that many thought was going to make subcontractors' insurance policies primary and non-contributory by law (i.e. applying a vertical exhaustion rule), in accordance with typical language in construction agreements. However, as the courts later held^[3], this decision was based on, and thus limited to, the policy language that stated additional insured coverage would be excess, unless the insured “ha[d] agreed in a written contract for this insurance to apply on a primary or contributory basis.”

Under the older ISO forms (pre-1997), the "other insurance" clause did not have language making the insured's own policy excess over policies on which the insured is named as an additional insured. As a result, when the insured was named as an additional insured on another's insurance policy, the two policies would generally become co-primary – in other words, they would share in the primary coverage, typically on a pro rata basis.

For example, a subcontractor has $500,000 primary and $1 million excess insurance. The general contractor has $1 million primary and $1 million excess umbrella coverage. The subcontractor’s and general contractors policies' "Other Insurance" clauses "cancel each other out," making both co-primary and, therefore, the policies say they share on a pro rata basis based upon their percentage share of the total available coverage.  In this example, the subcontractor's carrier would pay one-third of any loss, while the general contractor's carrier would pay two-thirds of any loss.

Apparently in an effort to allow the policies to trigger more in line with what one would expect to be included in a construction contract, ISO amended its commercial general liability form in 1997 to include language in the "Other Insurance" provision, stating that the policy is excess over "[a]ny other primary insurance available to you covering liability for damages arising out of the premises or operations for which you have been added as an additional in­sured by attachment of an endorsement." This eliminated the problem addressed above – under that example, the subcontractor's primary policy would trigger first and would have to be exhausted before the general contractor's policy would be triggered. But what happens to the excess policy?

Using that same example, if the subcontractor also maintained $1,000,000 in excess insurance coverage, we enter the arena where "vertical" and "horizontal" exhaustion become relevant. Assuming a post-1997 ISO endorsement on the primary policy and standard follow-form language on the excess policy, the subcontractor's primary policy would trigger first. Under "vertical" exhaustion, the subcontractor's excess policy would be exhausted before the general contractor's primary policy is triggered, since the general contractor is an additional insured on the subcontractor's primary policy and the excess policy is follow-form. In other words, the general contractor gets the benefit of what was likely intended under the construction contract. Under "horizontal" exhaustion, the general contractor's primary policy (being a primary policy and not a "true excess" policy) would trigger after the subcontractor's primary policy, leaving the subcontractor's excess policy to trigger last. The distinction looks like this:

Note that there are some insurers who, in some of their policies, include an endorsement stating that their policy is excess over all other collectible insurance. So, for example, you could end up with a situation where the policy on which an entity is added as additional insured contains that language, the additional insured's own policy contains the CG 00 01 10 01 (or something after the 1997 version) and they cancel each other out. Or worse, the policy with the additional insured endorsement says it is excess over all other policies and the additional insured's own policy states that it is primary.

We understand that it is impractical for insurance agents and brokers to obtain and review construction agreements from insureds. In fact, this is something that we have strongly advised agents and brokers not to do. Doing so drastically increases the duty an agent or broker assumes and thus creates increased errors and omissions exposure. We would suggest that if your insured requests coverage on a primary and non-contributory basis (i.e. that the additional insured's own coverage would not trigger the additional insured coverage is exhausted), your response should be to ensure that there is an endorsement on the policy providing coverage on this basis. If the insured refers to its contract and insists that the agency or brokerage obtain insurance in compliance with the contract, you should consider submitting a copy of the contract to the insurer along with the application and advise the underwriter that the insured is requesting coverage in compliance with the insurance requirements contained in the contract.

Providing insurance for construction projects is important business for many New York insurance agencies and brokerages. Although insurance for contractors presents many unique risks and issues that may not exist with regard to other insureds, the prudent insurance agency or brokerage should do its best to understand the various nuances associated with this type of insurance coverage, such as the horizontal versus vertical exhaustion of coverage discussed in this issue of The E&O Report. Doing so will not only help provide better service and protection to the insured but it will also help protect the agency or brokerage from potential E&O issues arising in connection with the insurance procurement.