(Article from Insurance Law Alert, July/August 2026)
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Holding
The California Supreme Court held that an insured need not establish or plead prior exhaustion of all underlying insurance to pursue relief against an excess insurer. For declaratory relief, however, the insured must adequately allege covered losses sufficient to create a “reasonable likelihood” that the excess policy’s attachment point will be reached. For bad faith, the insured must allege facts showing that the excess policy will attach or would have attached but for the insurer’s alleged misconduct, and that the misconduct has impaired the insured’s recovery of policy benefits. Fox Paine & Co., LLC v. Twin City Fire Ins. Co., 2026 Cal. LEXIS 3943 (Cal. July 27, 2026).
Background
This dispute arose from litigation between co-founders of investment firm Fox Paine & Company, LLC (“FPC”). FPC and related insureds were covered under a $50 million insurance program consisting of a $10 million primary policy and four $10 million “follow form” excess policies. Each excess policy conditioned payment on exhaustion of the underlying insurance.
After a business dispute between FPC’s principals generated extensive litigation, the primary insurer paid its $10 million limit to one group of insureds, and two excess insurers later paid an additional $9 million in settlement. The plaintiffs, who were a different group of insureds and received none of the payments, subsequently sought coverage for their own litigation-related losses. They alleged that the excess insurers’ failure to pay them policy benefits and other conduct by excess insurers that allegedly favored another group of insureds violated the implied covenant of good faith and fair dealing. The plaintiffs alleged that they had incurred more than $43 million in covered loss and recoverable interest arising from the underlying litigation, and they sued the excess insurers for breach of contract, declaratory relief, bad faith, and aiding and abetting breaches of fiduciary duties.
The trial court concluded that the plaintiffs adequately alleged exhaustion of the $10 million primary policy based on the primary insurer’s payment of its full limit to the competing group of insureds and therefore allowed the plaintiffs’ claims against the first excess layer to proceed. The trial court dismissed the claims against the higher excess layers, however, because only approximately $6 million of the $10 million first-excess limit had been paid and, accordingly, the insurance underlying those higher layers had not been exhausted. The Court of Appeal affirmed, holding that the higher-layer insurers could not be liable for breach of contract because their policies had not yet attached, that the plaintiffs had not adequately alleged an actual controversy supporting declaratory relief because they had not sufficiently alleged covered losses reaching the higher excess layers, and that their inability to allege exhaustion was fatal to their bad faith claims. The plaintiffs sought review of the latter two rulings.
Decision
The California Supreme Court reversed. As to declaratory relief, the court rejected a categorical rule requiring exhaustion of all underlying insurance before an insured may obtain a declaration concerning coverage under an excess policy. Although declaratory relief requires an “actual controversy” rather than a dispute dependent on hypothetical future events, the court explained that the existence of future contingencies does not necessarily make a coverage dispute too speculative for adjudication and that courts should instead consider the practical likelihood that those contingencies will occur. Applying those principles, the court held that the fact that underlying insurance has not yet been exhausted does not, by itself, preclude an actual controversy concerning an excess insurer’s future coverage obligations. The court further reasoned that requiring sequential exhaustion of each underlying layer before permitting declaratory relief could force insureds to pursue multiple lawsuits against successive excess insurers and create a risk of inconsistent rulings.
The court emphasized, however, that an insured must adequately allege covered losses sufficient to reach an excess policy’s attachment point. If the amount of losses covered is uncertain, the allegations must establish a “reasonable likelihood” that the policy’s attachment point will be reached; a mere theoretical possibility is insufficient. The court also concluded that the plaintiffs’ allegation of more than $43 million in “covered Loss and recoverable interest” improperly combined covered loss with prejudgment interest, which does not count toward exhaustion. The court therefore remanded for consideration of whether the complaint adequately alleged a covered loss, excluding interest, sufficient to create a reasonable likelihood that the higher-layer policies would be reached.
As to bad faith, the court held that prior exhaustion is not required to state a claim against an excess insurer for breach of the implied covenant of good faith and fair dealing. The court held that the implied covenant exists from the inception of the policy and that it may be breached even before the insurer’s contractual payment obligation has matured. The court further held that an insured may state a bad faith claim by alleging facts that, taken as true, show that “the excess policy will attach—or that it would attach, if not for the excess insurer’s bad-faith conduct—and that the insurer’s misconduct has impaired the insured’s recovery of benefits owed to it under the policy.” The court therefore rejected the Court of Appeal’s conclusion that the plaintiffs’ failure to allege exhaustion was, by itself, fatal to their bad faith claims.
Comments
The court observed that numerous courts, including the Second Circuit in E.R. Squibb & Sons, Inc. v. Lloyd’s & Companies, 241 F.3d 154 (2d Cir. 2001), have already applied a “reasonable likelihood” standard in determining whether an insured may pursue declaratory relief against an excess insurer before exhaustion. The court therefore concluded that adopting that standard would not disrupt insurers’ settled expectations or destabilize the excess insurance market. The decision does not alter exhaustion requirements as conditions to payment.