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by Elizabeth (Betsy) Doyle

A fundamental principle of excess insurance is that an excess insurer's obligation to pay a covered loss does not arise until the underlying insurance has been exhausted. The California Supreme Court's decision in Fox Paine & Co. v. Twin City Fire Insurance Co., S287404 (July 27, 2026) leaves that rule intact but reshapes the pleading analysis. Under Fox Paine, it may be more difficult for an untriggered excess insurer to obtain dismissal of declaratory relief and bad faith claims based solely on the absence of exhaustion if the complaint plausibly alleges: (1) a reasonable likelihood that exhaustion will occur and (2) pre-exhaustion conduct by the excess insurer that could support a bad faith claim. The Fox Paine decision takes a more nuanced approach than courts have previously applied.

Going forward, interested parties will want to keep tabs on two issues.  The first is the Court’s ruling that “additional considerations” may warrant application of a more lenient standard for declaratory relief, requiring only that a plaintiff plead a “reasonable likelihood” of attachment, rather than actual exhaustion.  The second is the Court’s emphasis on the covenant of good faith beginning at the inception of the insurance contract and not merely once the obligation to pay benefits arises. Although the Court declined to decide whether the Fox plaintiffs did, in fact, allege unreasonable pre-exhaustion conduct by the excess insurers amounting to bad faith, leaving that question for remand, the Fox Paine decision hints at a broadened pleading standard — that it is enough to allege that insurer misconduct may have impaired recovery of policy benefits before the duty to pay benefits arose — and a potential paradigm shift in coverage litigation in California. 

Background

Private equity firm Fox Paine & Co. and related parties were insured under a professional liability insurance program consisting of a $10 million primary policy and four successive $10 million excess layers. A year-long dispute among Fox Paine's principals gave rise to extensive litigation. The primary insurer exhausted its $10 million policy limits by paying one group of insureds. The Fox plaintiffs subsequently sought coverage for their own litigation-related losses and filed suit against the excess insurers, asserting claims for declaratory relief under the excess policies and breach of the implied covenant of good faith and fair dealing.

The trial court held that the obligations of the higher-layer excess insurers could not arise until the underlying policies were exhausted and that the claims against the excess insurers were unripe while the plaintiffs' claims against the first-layer excess insurer remained unresolved. The First District Court of Appeal affirmed.

The Decision

Declaratory Judgment: “Reasonable Likelihood” of Exhaustion

The California Supreme Court reversed the lower courts’ rulings in a unanimous decision. The Court ruled that “the absence of exhaustion is not fatal” to claims for declaratory relief under Civil Code Section 1060. It reasoned that “additional considerations” may warrant application of a more lenient standard requiring only a “reasonable likelihood” of attachment.

After weighing the hardships, as required to complete the "actual controversy" analysis, the Court concluded that requiring exhaustion of underlying limits before permitting an action for declaratory relief would impose an undue hardship by forcing insureds to engage in piecemeal litigation, "scaling the tower of excess insurance policy-by-policy."  The Court found that this hardship outweighed the excess insurers' inconvenience of remaining in litigation that might ultimately prove unnecessary because any such burden could be managed by the trial court.

The Court remanded the issued back to the Court of Appeal to reevaluate the Fox plaintiffs’ actual controversy allegations, including whether they must allege a covered loss reaching the excess attachment points, or whether “other considerations” justify application of the “reasonable likelihood” standard for pleading exhaustion, and whether the Fox plaintiffs’ allegations in this case meet the applicable standard. 

Breach of the Implied Covenant of Good Faith and Fair Dealing

Although the Fox plaintiffs did not dispute lack of actual exhaustion of the underlying policies, they alleged that the excess insurers engaged in bad faith conduct by favoring rival claimants and insureds, and concealing coverage decisions and settlements.

Instead of applying the typical “no coverage = no bad faith” equation, the Court took a more nuanced approach, based on general contract law and the “long-standing rule that neither party will do anything which will injure the right of the other to receive the benefits of the agreement.”  Reasoning that the covenant of good faith begins at the inception of the insurance contract, and not merely when the obligation to pay benefits arises, a plaintiff may adequately plead a cause of action for bad faith against an excess insurer by alleging facts showing that coverage under a policy will attach and that the excess insurer’s misconduct has “impaired the insured’s recovery of benefits owed to it under the policy.” 

Significantly, the Court remanded the issue to the Court of Appeal to determine whether, after applying the proper standard, the Fox plaintiffs’ allegations were in fact sufficient to state a viable cause of action against the excess insurers for breach of the implied covenant of good faith and fair dealing before the obligation to pay benefits arose. The Court expressly declined to decide whether, "in unusual circumstances involving consequential harm to an insured," a bad faith claim may proceed even in the absence of coverage under the insurance policy, as argued by the Fox plaintiffs. 

Takeaways

Fox Paine serves as a reminder that, while a high layer excess insurer may be “up in the nosebleeds” on the coverage chart, it may still have pre-exhaustion claims handling exposure. 

Stakeholders are wise to monitor the case to see how the Court of Appeal rules regarding the more lenient “reasonable likelihood” of attachment and the impact of an insurer’s pre-exhaustion conduct on the predicate breach of contract needed to trigger liability for breach of implied covenant of good faith and fair dealing. Of course, we will also keep an interested eye on it as well.