One of the hottest topics in liability insurance is the conversation around horizontal versus vertical exhaustion of limits. Landlords and construction companies are particularly affected by where their jurisdiction rules on this debate, but all business owners need to be educated on the subject.
The battleground centers around the fact that most primary liability insurers do not offer occurrence limits higher than $1M. Thus, almost every business owner carries an excess liability (or umbrella liability) policy to provide the additional limits they need in order to adequately protect their business. So what happens when multiple parties are held liable for a single claim? One insured’s policy must pay out first, but when their primary policy limits are exhausted do we move on to that party’s excess policy or to the second party’s primary policy? Herein lies the horizontal vs vertical exhaustion debate.
Luckily we are here to answer these questions and break down how different types of policyholders are affected.
The rule of horizontal exhaustion states that, in the event of a claim, all primary policy limits must be exhausted before any excess policy may respond.
Let’s imagine a landlord carries primary and excess liability policies for their commercial property. They also require that each tenant carries the same level of liability for their respective spaces and names the landlord as an additional insured with primary and noncontributory language – a good risk transfer practice.
A customer of one of these tenants sustains an injury and is seeking a $3M recovery. The tenant’s primary policy is responsible for paying out the claim first because of the risk transfer that the landlord requires. However, that policy only covers $1M per occurrence. Under the horizontal rule of exhaustion, the landlord’s primary policy would pay the next part of the claim. Only when all primary policies are exhausted would an excess policy contribute to the claim. So in this example, both the tenant and landlord’s primary liability policies would contribute their full limit of $1M (plus their respective deductibles/retentions) towards the claim. The tenant’s excess policy would only be responsible for the portion that is left.
A horizontal ruling favors policyholders like tenants and subcontractors because they see less claims to their excess insurance policies. This leads to a cleaner loss history which gives tenants and subcontractors a better chance at maintaining a reasonable premium year after year.
Meanwhile, landlords and general contractors are seeing their primary policies being affected by greater loss activity. As a result, they may experience increases in rates and receive non-renewal notices from their carrier due to loss history.
Some ways that landlords and general contractors can try to protect themselves from being affected by horizontal exhaustion is by demanding higher primary limits from the parties that are providing additional insured status to them (i.e. tenants, subcontractors). The shortcoming is that most primary insurance carriers do not offer occurrence limits higher than $1M and tenants/subcontractors may have a hard time finding a policy that will meet their contractual requirements. Insurers are still adjusting to this issue and we may see that more primary insurers start to offer higher occurrence limits in the future.
Jurisdictions that rule in favor of horizontal exhaustion include New York, Illinois, California, and Florida.
Courts that rule in favor of vertical exhaustion state that an insured may seek coverage from an excess policy before another primary policy provided the primary policy directly beneath the excess policy has been exhausted.
If we apply vertical exhaustion to our landlord example, the tenant’s excess policy will pay towards the claim before the landlord’s primary policy. Depending on the excess limits carried by the tenant, this may prevent the landlord’s insurance from being affected at all leading to a clean loss history for the landlord.
Courts that rule in favor of vertical exhaustion benefit policyholders like landlords and GCs at the expense of tenants and subcontractors. These jurisdictions include New Jersey, Wisconsin, and Washington.
It is important for policyholders to know where their jurisdiction stands and include the proper risk transfer approach when going into contract with third parties.
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