Will Reinsurers Still 'Follow-the- Settlements'?

Allocations Generally Subject to the 'Follow-the-Settlements' Doctrine

Most reinsurance disputes are arbitrated, and there is generally little case law regarding reinsurance allocation. One of the most widely discussed cases in the last several years, however, is Commercial Union Insurance Co. v. Seven Provinces Insurance Co., Ltd., 9 F. Supp. 2d 49 (D. Mass. 1998). In Seven Provinces, the plaintiff insurer was a successor in interest to a cedent who had issued several insurance policies to its insured, a manufacturing company. The cedent had purchased facultative reinsurance coverage for one of the underlying policies, a general liability policy. The insured sought coverage for claims arising from pollution at several manufacturing sites. The plaintiff settled these claims with its insured and allocated a certain portion of the settlement to the reinsured policy, and a certain amount of that allocation was billed to Seven Provinces, the defendant reinsurer.

The reinsurer, in part, challenged the cedent's allocation of $843,000 of the $2.2 million settlement to a particular site and to the policy that covered it, arguing that alternative allocations between the insured's sites and the policies that covered them would have been more reasonable. The district court examined the allocation method used by the cedent and rejected the reinsurer's argument. The court determined that Commercial Union had applied an allocation method that was reasonable, made in good faith and consistent with the underlying settlement.

The court ruled that the reinsurer was bound by the cedent's allocation under the “follow-the-settlements” doctrine. The court rejected the reinsurer's argument that the “follow-the-settlements” doctrine does not apply to a cedent's allocation of a loss. The reinsurer attempted to avoid the effect of the doctrine by arguing that it was challenging the good faith of the allocation, not the settlement. The court ruled that:

“[the reinsurer's] attempt to distinguish settlement from allocation would undermine the entire “follow-the-settlements” doctrine. In practical terms, the determination of which among several policies covers which particular loss among many is not much different from the more general decision that the losses are covered by the policies. … Review of either type of decision has an equal likelihood of undermining settlement and fostering litigation. … When several reinsurers are involved, there would be a risk of successive litigations, in which each reinsurer offered an alternative allocation model that would reduce its own liability.” Id. at 67-68.

The Seven Provinces decision was affirmed on appeal by the First Circuit, in a decision that did not review the district court's rulings regarding allocation and the follow-the-settlements doctrine. See Commercial Union Ins. Co. v. Seven Provinces Ins. Co., Ltd., 217 F.3d 33 (1st Cir. 2000).

The U.S. District Court for the Southern District of New York recently cited Seven Provinces with approval in North River Insurance Co. v. ACE American Reinsurance Co., 2002 U.S. Dist. LEXIS 5536 (S.D.N.Y. March 29, 2002). In that case, the court rejected a reinsurer's attempt to avoid the cession of loss payments to its facultative certificates. The reinsurer argued that the follow-the-fortunes doctrine either did not apply to the issue of how an insurer chooses to allocate its settlement payment among various policies “or must at least be consistent with the theory of allocation (if discernable) that the insurer used in negotiating the settlement with its insured, even if that was not the theory applied in making the actual payment to the insured pursuant to the settlement.” ACE American, 2002 U.S. Dist. LEXIS 5536 at *5-6. Unlike the Seven Provinces court, the court in ACE American did not engage in a searching analysis of the reasons underlying the cedent's allocation. The court ruled that a cedent should be allowed to choose a good faith allocation among multiple policies and insurers, which the reinsurer must follow. Id. at *6. The court determined that allowing reinsurers to second-guess a cedent's good faith allocation would make settlement impossible and reinsurance itself problematic. Id.

In National Union Fire Insurance Co. v. Travelers Indemnity Co., 210 F. Supp. 2d 479 (S.D.N.Y. 2002), the court showed deference to the follow-the-settlements doctrine and denied a reinsurer's cross-motion for summary judgment concerning whether a loss was covered under a facultative reinsurance certificate. The certificate contained a follow-the-settlements clause providing that the reinsurer's liability should follow the insurer's in accordance with the terms and conditions of the policy reinsured. National Union, 210 F. Supp. 2d at 483. The reinsurer argued that the loss did not fall within the scope of a Boiler and Machinery (“B&M”) endorsement included in the property insurance policy at issue. Id. The court parsed and considered the operative terms in the B&M endorsement and determined that the loss was indeed covered under the B&M endorsement and that the reinsurer was, therefore, required to indemnify the cedent. See Id. at 486-90.

The Court of Appeals for the Eighth Circuit also suggested that the follow-the-settlements doctrine will be enforced unless it is expressly excluded from the contract or where there is sufficient evidence that the cedent's allocation was reckless or made in bad faith. In ReliaStar Life Insurance. Co. v. IOA Re, Inc., 303 F.3d 874 (8th Cir. 2002), a case that did not address a question of whether a cedent properly allocated the loss to the reinsurers, the court affirmed a judgment in favor of the retrocedent of a “snowbird” short-term medical coverage program insuring Canadians traveling out of their home provinces. The retrocedent reinsured the underlying cedent's short-term medical insurance business and retroceded those risks to the retrocessionaire. Losses occurred and the retrocedent billed the retrocessionaires. ReliaStar, 303 F.3d at 877. The retrocessionaires argued that that the follow-the-fortunes doctrine did not apply because the retrocessional contract incorporated the terms of the underlying insurance contracts, and those contracts contained particular notice, settlement, and “proof of coverage” requirements. Id. at 880. The court ruled that there was no evidence that the mere reference to the terms of the underlying coverage was intended to preempt the follow-the-fortunes doctrine. Id. at 881. The court rejected the argument that the parties entered into any express agreement to “preempt the application of the customary follow-the-fortunes doctrine.” Id.

No Deference to 'Follow-the-Settlements' Doctrine

Several federal courts have taken a more narrow view toward application of the follow-the-settlements/follow-the-fortunes doctrine in decisions that did not involve allocation issues.

In North River Insurance Co. v. Employers Reinsurance Corp., 2002 U.S. Dist. LEXIS 11711 (S.D. Ohio June 3, 2002), the court held that a reinsurer was not required to indemnify a cedent under the follow-the-settlements doctrine where the facultative certificate did not expressly provide for indemnification of settlements not covered under the terms of the primary policy. The action arose from the settlement of claims submitted by the insured under an excess general liability policy in which there was a dispute as to whether the claim was in fact covered under the policy. Employers Reinsurance Corp., 2002 U.S. Dist. LEXIS 11711 at *2. The cedent contended that the reinsurer was subject to the follow-the-settlements doctrine, which required it to honor the cedent's settlements so long as they were not fraudulent, collusive, or made in bad faith. Id. The reinsurance agreement did not expressly provide for liability in cases of disputed coverage, however. Id. at *8-9. The cedent contended that there is a custom and practice in the reinsurance industry to read a follow-the-settlements clause into every facultative reinsurance certificate. Id. at *13. The court ruled, however, that the parties did not intend for the reinsurer to be obligated to indemnify the cedent for settlements of claims not covered by its policy. Id. at *23. The court found that the cedent failed to prove that it was the custom and practice for reinsurers to honor a reinsured's good faith settlement of claims involving disputed coverage. Id. at *23-24.

The U.S. District Court for the District of Kansas has also declined to apply the follow-the-settlements doctrine, in a dispute as to which provision of an underlying policy covered a settlement agreement between the insured and a third person. See Employers Reinsurance Corp. v. Newcap Ins. Co., Ltd., 209 F. Supp. 2d 1184 (D. Kan. 2002). In this case, the cedent requested that the court, based on the follow-the-settlements doctrine, adopt a “deferential” view of the facts and only determine whether the cedent had made a good faith determination that the underlying claim fell under a commercial general liability coverage part of the policy as opposed to a hospital professional liability part of the policy. Newcap, 209 F. Supp. 2d at 1190. The court declined to apply the follow-the-settlements doctrine, finding that neither the language of the settlement agreement nor the language of a funding agreement by which the cedent would fund the settlement indicated that the parties ever decided the issue of which provision covered the settlement. Id. at 1191. Because this action sought to answer that particular issue, the court determined that the follow-the-settlements doctrine was inapplicable in this case. Id.

Cedents Must Be Mindful of Specific Provisions of Reinsurance Treaties

In a very recent case, a federal court ruled that the follow-the-fortunes doctrine is not intended to supplant other provisions of reinsurance treaties. Commercial Union Insurance Co. v. Swiss Reinsurance America Corp., 2003 U.S. Dist. LEXIS 4974 (D. Mass. March 31, 2003), involved a dispute involving the extent of the reinsurer's obligation under three facultative reinsurance certificates. Under the reinsurance certificates, the reinsurer provided coverage on a quota share basis and agreed to accept a fixed percentage of the cedent's covered losses up to the reinsurance limits specified in the certificates. The certificates also contained “follow form” provisions stating that the liability of the reinsurer would follow the liability of the cedent on the underlying policies, unless otherwise specified by an endorsement. Swiss Re, 2003 U.S. Dist. LEXIS 4974 at *7. The reinsurance certificates contained no similar endorsements. Id.

The reinsurance dispute arose following the settlement of environmental claims between the cedent and its insured. The parties entered into a settlement during the coverage litigation whereby the cedent agreed to pay $70 million over 7 years in exchange for a full release of its obligations. Id. at *17. The reinsurer paid only a portion of the amount tendered to it when the cedent sought indemnification. The reinsurer argued that the cedent's billing was inappropriate because it was based on annualizing the claims instead of the single, per occurrence limits stated in the certificates and thereby exceeded the reinsurer's bargained-for liability. Id. at *19-23. The reinsurer contended that even if the annualization of claims was proper under the underlying agreement between the cedent and the insured, the “follow form” language should not supersede the limitation of liability stated in the certificates. Id. at *22-23. The cedent argued that the “follow form” provision of the reinsurance certificates must prevail over the stated limits of liability. Id. at 32.

The court ruled that the reinsurer was only obligated to “follow the fortunes” of the cedent's settlement with the insured up to the per occurrence limit specified in the reinsurance certificates. Id. at *48. The court determined that the clear language of the reinsurance certificates set forth the limits of the reinsurer's liability and did not consider the annualization of claims. Id. at *35-36. The court ruled that even without the existence of separate endorsements, the certificates unambiguously identified all the important terms of the parties' agreement and that annualized limits should not be read into multiyear reinsurance policies without an express statement that policy coverage is to be calculated on an annual basis. Id. at *44-45.

Moreover, the court refused to allow the “follow form” provision to supplant the express terms of the limitation of liability and thereby effectively rewrite the reinsurance agreement. Id. at *44. The court noted that the Seven Provinces decisions affirmed that “the follow-the-fortunes doctrine creates a powerful presumption that settlements made by a reinsured will be sustained, barring evidence of bad faith, collusion, or fraud.” Id. The court ruled, however, that those holdings did not address the threshold question in the Swiss Re case, namely “whether the follow forms provisions in the [reinsurance certificates] may be read to require the reinsurer to pay for claims that exceed the stated limitation of coverage.” Id. The court determined that where there is a conflict between specific, bargained-for terms and form language, the former must prevail. Id. at 47-48.

Conclusion

Case law has generally held that reasonable, good faith allocations of settlement payments to reinsured policies, consistent with the way the cedent addressed the underlying claims, are encompassed within the reinsurers' obligation to follow-the-settlements. Allocations, however, cannot override the terms of the reinsurance contracts if the contract requires a different allocation. Absent language in the reinsurance contract requiring a different allocation, a cedent's reasonable, good faith allocation carries a strong presumption that it falls within the reinsurer's obligation to follow-the-settlements.

In the insurance arena, allocations of claims amounts are frequently the subject of litigation among policyholders and insurers. Courts seek to fashion allocation formulas based upon a number of factors including policy language, legal principles and equitable considerations. In the reinsurance context, allocation questions are generally resolved in arbitration. A number of courts, however, have recently addressed the allocation of claims settlements in the reinsurance context. The issue in reinsurance is whether the reinsurer is bound by the cedents' allocation of a loss or settlement amount to the cedents' policies at issue in the underlying claim. Reinsurers are generally bound to “follow-the-fortunes” or “follow-the-settlements” of a cedent provided the cedent has acted reasonably and in good faith and in accordance with the terms of the reinsurance contracts. Aetna Cas. & Sur. Co. v. Home Ins. Co., 882 F. Supp. 1328, 1346 (S.D.N.Y. 1995). This article surveys recent case law that has addressed the question of whether the “follow-the-settlements” or “follow-the-fortunes” doctrine applies to allocation of claims payments or settlements to reinsured policies.

The 'Follow-the-Settlements' Doctrine

The “follow-the-settlements” or “follow-the-fortunes” doctrine requires a reinsurer to cover settlements made by the reinsured, as long as they are not fraudulent, collusive, or made in bad faith. Aetna Cas. & Sur., 882 F. Supp. at 1346. The doctrine obligates the reinsurer to indemnify a cedent for good faith payment of claims that arguably fall within the scope of the underlying policy that was reinsured. Mentor Ins. Co. (U.K.) Ltd. v. Brankasse, 996 F.2d 506, 517 (2d Cir. 1993). The term “follow-the-fortunes” describes the reinsurer's obligation to follow the ceding insurer's underwriting fortunes, whereas “follow-the-settlements” refers to the duty to follow the actions of the cedent adjusting and settling claims. Aetna Cas. & Sur., 882 F. Supp. at 1346 n.9. However, most commentators and courts use the two terms interchangeably.

Allocations Generally Subject to the 'Follow-the-Settlements' Doctrine

Most reinsurance disputes are arbitrated, and there is generally little case law regarding reinsurance allocation. One of the most widely discussed cases in the last several years, however, is Commercial Union Insurance Co. v. Seven Provinces Insurance Co., Ltd., 9 F. Supp. 2d 49 (D. Mass. 1998). In Seven Provinces, the plaintiff insurer was a successor in interest to a cedent who had issued several insurance policies to its insured, a manufacturing company. The cedent had purchased facultative reinsurance coverage for one of the underlying policies, a general liability policy. The insured sought coverage for claims arising from pollution at several manufacturing sites. The plaintiff settled these claims with its insured and allocated a certain portion of the settlement to the reinsured policy, and a certain amount of that allocation was billed to Seven Provinces, the defendant reinsurer.

The reinsurer, in part, challenged the cedent's allocation of $843,000 of the $2.2 million settlement to a particular site and to the policy that covered it, arguing that alternative allocations between the insured's sites and the policies that covered them would have been more reasonable. The district court examined the allocation method used by the cedent and rejected the reinsurer's argument. The court determined that Commercial Union had applied an allocation method that was reasonable, made in good faith and consistent with the underlying settlement.

The court ruled that the reinsurer was bound by the cedent's allocation under the “follow-the-settlements” doctrine. The court rejected the reinsurer's argument that the “follow-the-settlements” doctrine does not apply to a cedent's allocation of a loss. The reinsurer attempted to avoid the effect of the doctrine by arguing that it was challenging the good faith of the allocation, not the settlement. The court ruled that:

“[the reinsurer's] attempt to distinguish settlement from allocation would undermine the entire “follow-the-settlements” doctrine. In practical terms, the determination of which among several policies covers which particular loss among many is not much different from the more general decision that the losses are covered by the policies. … Review of either type of decision has an equal likelihood of undermining settlement and fostering litigation. … When several reinsurers are involved, there would be a risk of successive litigations, in which each reinsurer offered an alternative allocation model that would reduce its own liability.” Id. at 67-68.

The Seven Provinces decision was affirmed on appeal by the First Circuit, in a decision that did not review the district court's rulings regarding allocation and the follow-the-settlements doctrine. See Commercial Union Ins. Co. v. Seven Provinces Ins. Co., Ltd., 217 F.3d 33 (1st Cir. 2000).

The U.S. District Court for the Southern District of New York recently cited Seven Provinces with approval in North River Insurance Co. v. ACE American Reinsurance Co., 2002 U.S. Dist. LEXIS 5536 (S.D.N.Y. March 29, 2002). In that case, the court rejected a reinsurer's attempt to avoid the cession of loss payments to its facultative certificates. The reinsurer argued that the follow-the-fortunes doctrine either did not apply to the issue of how an insurer chooses to allocate its settlement payment among various policies “or must at least be consistent with the theory of allocation (if discernable) that the insurer used in negotiating the settlement with its insured, even if that was not the theory applied in making the actual payment to the insured pursuant to the settlement.” ACE American, 2002 U.S. Dist. LEXIS 5536 at *5-6. Unlike the Seven Provinces court, the court in ACE American did not engage in a searching analysis of the reasons underlying the cedent's allocation. The court ruled that a cedent should be allowed to choose a good faith allocation among multiple policies and insurers, which the reinsurer must follow. Id. at *6. The court determined that allowing reinsurers to second-guess a cedent's good faith allocation would make settlement impossible and reinsurance itself problematic. Id.

In National Union Fire Insurance Co. v. Travelers Indemnity Co., 210 F. Supp. 2d 479 (S.D.N.Y. 2002), the court showed deference to the follow-the-settlements doctrine and denied a reinsurer's cross-motion for summary judgment concerning whether a loss was covered under a facultative reinsurance certificate. The certificate contained a follow-the-settlements clause providing that the reinsurer's liability should follow the insurer's in accordance with the terms and conditions of the policy reinsured. National Union, 210 F. Supp. 2d at 483. The reinsurer argued that the loss did not fall within the scope of a Boiler and Machinery (“B&M”) endorsement included in the property insurance policy at issue. Id. The court parsed and considered the operative terms in the B&M endorsement and determined that the loss was indeed covered under the B&M endorsement and that the reinsurer was, therefore, required to indemnify the cedent. See Id. at 486-90.

The Court of Appeals for the Eighth Circuit also suggested that the follow-the-settlements doctrine will be enforced unless it is expressly excluded from the contract or where there is sufficient evidence that the cedent's allocation was reckless or made in bad faith. In ReliaStar Life Insurance. Co. v. IOA Re, Inc., 303 F.3d 874 (8th Cir. 2002), a case that did not address a question of whether a cedent properly allocated the loss to the reinsurers, the court affirmed a judgment in favor of the retrocedent of a “snowbird” short-term medical coverage program insuring Canadians traveling out of their home provinces. The retrocedent reinsured the underlying cedent's short-term medical insurance business and retroceded those risks to the retrocessionaire. Losses occurred and the retrocedent billed the retrocessionaires. ReliaStar, 303 F.3d at 877. The retrocessionaires argued that that the follow-the-fortunes doctrine did not apply because the retrocessional contract incorporated the terms of the underlying insurance contracts, and those contracts contained particular notice, settlement, and “proof of coverage” requirements. Id. at 880. The court ruled that there was no evidence that the mere reference to the terms of the underlying coverage was intended to preempt the follow-the-fortunes doctrine. Id. at 881. The court rejected the argument that the parties entered into any express agreement to “preempt the application of the customary follow-the-fortunes doctrine.” Id.

No Deference to 'Follow-the-Settlements' Doctrine

Several federal courts have taken a more narrow view toward application of the follow-the-settlements/follow-the-fortunes doctrine in decisions that did not involve allocation issues.

In North River Insurance Co. v. Employers Reinsurance Corp., 2002 U.S. Dist. LEXIS 11711 (S.D. Ohio June 3, 2002), the court held that a reinsurer was not required to indemnify a cedent under the follow-the-settlements doctrine where the facultative certificate did not expressly provide for indemnification of settlements not covered under the terms of the primary policy. The action arose from the settlement of claims submitted by the insured under an excess general liability policy in which there was a dispute as to whether the claim was in fact covered under the policy. Employers Reinsurance Corp., 2002 U.S. Dist. LEXIS 11711 at *2. The cedent contended that the reinsurer was subject to the follow-the-settlements doctrine, which required it to honor the cedent's settlements so long as they were not fraudulent, collusive, or made in bad faith. Id. The reinsurance agreement did not expressly provide for liability in cases of disputed coverage, however. Id. at *8-9. The cedent contended that there is a custom and practice in the reinsurance industry to read a follow-the-settlements clause into every facultative reinsurance certificate. Id. at *13. The court ruled, however, that the parties did not intend for the reinsurer to be obligated to indemnify the cedent for settlements of claims not covered by its policy. Id. at *23. The court found that the cedent failed to prove that it was the custom and practice for reinsurers to honor a reinsured's good faith settlement of claims involving disputed coverage. Id. at *23-24.

The U.S. District Court for the District of Kansas has also declined to apply the follow-the-settlements doctrine, in a dispute as to which provision of an underlying policy covered a settlement agreement between the insured and a third person. See Employers Reinsurance Corp. v. Newcap Ins. Co., Ltd., 209 F. Supp. 2d 1184 (D. Kan. 2002). In this case, the cedent requested that the court, based on the follow-the-settlements doctrine, adopt a “deferential” view of the facts and only determine whether the cedent had made a good faith determination that the underlying claim fell under a commercial general liability coverage part of the policy as opposed to a hospital professional liability part of the policy. Newcap, 209 F. Supp. 2d at 1190. The court declined to apply the follow-the-settlements doctrine, finding that neither the language of the settlement agreement nor the language of a funding agreement by which the cedent would fund the settlement indicated that the parties ever decided the issue of which provision covered the settlement. Id. at 1191. Because this action sought to answer that particular issue, the court determined that the follow-the-settlements doctrine was inapplicable in this case. Id.

Cedents Must Be Mindful of Specific Provisions of Reinsurance Treaties

In a very recent case, a federal court ruled that the follow-the-fortunes doctrine is not intended to supplant other provisions of reinsurance treaties. Commercial Union Insurance Co. v. Swiss Reinsurance America Corp., 2003 U.S. Dist. LEXIS 4974 (D. Mass. March 31, 2003), involved a dispute involving the extent of the reinsurer's obligation under three facultative reinsurance certificates. Under the reinsurance certificates, the reinsurer provided coverage on a quota share basis and agreed to accept a fixed percentage of the cedent's covered losses up to the reinsurance limits specified in the certificates. The certificates also contained “follow form” provisions stating that the liability of the reinsurer would follow the liability of the cedent on the underlying policies, unless otherwise specified by an endorsement. Swiss Re, 2003 U.S. Dist. LEXIS 4974 at *7. The reinsurance certificates contained no similar endorsements. Id.

The reinsurance dispute arose following the settlement of environmental claims between the cedent and its insured. The parties entered into a settlement during the coverage litigation whereby the cedent agreed to pay $70 million over 7 years in exchange for a full release of its obligations. Id. at *17. The reinsurer paid only a portion of the amount tendered to it when the cedent sought indemnification. The reinsurer argued that the cedent's billing was inappropriate because it was based on annualizing the claims instead of the single, per occurrence limits stated in the certificates and thereby exceeded the reinsurer's bargained-for liability. Id. at *19-23. The reinsurer contended that even if the annualization of claims was proper under the underlying agreement between the cedent and the insured, the “follow form” language should not supersede the limitation of liability stated in the certificates. Id. at *22-23. The cedent argued that the “follow form” provision of the reinsurance certificates must prevail over the stated limits of liability. Id. at 32.

The court ruled that the reinsurer was only obligated to “follow the fortunes” of the cedent's settlement with the insured up to the per occurrence limit specified in the reinsurance certificates. Id. at *48. The court determined that the clear language of the reinsurance certificates set forth the limits of the reinsurer's liability and did not consider the annualization of claims. Id. at *35-36. The court ruled that even without the existence of separate endorsements, the certificates unambiguously identified all the important terms of the parties' agreement and that annualized limits should not be read into multiyear reinsurance policies without an express statement that policy coverage is to be calculated on an annual basis. Id. at *44-45.

Moreover, the court refused to allow the “follow form” provision to supplant the express terms of the limitation of liability and thereby effectively rewrite the reinsurance agreement. Id. at *44. The court noted that the Seven Provinces decisions affirmed that “the follow-the-fortunes doctrine creates a powerful presumption that settlements made by a reinsured will be sustained, barring evidence of bad faith, collusion, or fraud.” Id. The court ruled, however, that those holdings did not address the threshold question in the Swiss Re case, namely “whether the follow forms provisions in the [reinsurance certificates] may be read to require the reinsurer to pay for claims that exceed the stated limitation of coverage.” Id. The court determined that where there is a conflict between specific, bargained-for terms and form language, the former must prevail. Id. at 47-48.

Conclusion

Case law has generally held that reasonable, good faith allocations of settlement payments to reinsured policies, consistent with the way the cedent addressed the underlying claims, are encompassed within the reinsurers' obligation to follow-the-settlements. Allocations, however, cannot override the terms of the reinsurance contracts if the contract requires a different allocation. Absent language in the reinsurance contract requiring a different allocation, a cedent's reasonable, good faith allocation carries a strong presumption that it falls within the reinsurer's obligation to follow-the-settlements.