An Update on the 'Follow the Fortunes' Doctrine in the Reinsurance Context

Reinsurance, the insurance of insurance companies, arose in the 14th century, the same century that saw the rise of the Ming Dynasty and the decimation of Europe's population by the Black Plague. Despite its 600-year history, however, until recently, judicial decisions on reinsurance disputes were few and far between. Instead, “differences [were] often … settled by handshakes and umpires[.]” Sumitomo Marine & Fire Ins. Co. v. Cologne Reins. Co., 75 N.Y.2d 295, 298, 552 N.E.2d 139, 140 (1990). But with the flood of mass tort and environmental litigation in the last 20 years, there has been a rise in reinsurance litigation. One historic response to deflect protracted reinsurance litigation is the “follow the fortunes” doctrine. When courts and insurers talk about follow the fortunes, they may mean one of two similar concepts: follow the fortunes or “follow the settlements.” While the follow the fortunes doctrine “requires reinsurers to accept a reinsured's good faith decision that a particular loss is covered by the terms of the underlying policy,” the follow the settlements clause “requires reinsurers to abide by a reinsured's good faith decision to settle, rather than litigate, claims on that policy. Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49, 66 (D. Mass. 1998), aff'd, 217 F.3d 33 (1st Cir. 2000), cert. denied, 531 U.S. 1146 (2001). Typically, the follow the fortunes doctrine is implied in the reinsurance contract whereas the follow the settlements clause is a specific provision in the agreement. While these doctrines share the underlying predicate of “good faith,” this article focuses on the follow the fortunes doctrine: the doctrine that requires a reinsurer to indemnify its reinsured whenever the reinsured makes a good faith payment of an insured loss.

In an era when reinsurers frequently underwrote risks by putting their mark on a slip passed around Lloyd's Coffee House, the follow the fortunes doctrine was developed to streamline both the underwriting process and the payment of claims. Basically, the follow the fortunes doctrine states that a reinsurer must indemnify its reinsured ' the cedent ' whenever the reinsured makes a good faith payment of an insured loss. See American Bankers Ins. Co. v. Northwest Nat'l Ins. Co., 198 F.3d 1332, 1335 (11th Cir. 1999) (follow the fortunes requires reinsurers to be “bound by the reinsured's decision to pay the claim and … refrain from second guessing a good faith decision to do so”); North River Ins. Co. v. CIGNA Reinsurance Co., 52 F.3d 1194, 1212-13 (3d Cir. 1995) (follow the fortunes “obligates the reinsurer to indemnify the reinsured for any good faith payment of an insured loss”); Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49, 66 (D. Mass. 1998), aff'd, 217 F.3d 33 (1st Cir. 2000), cert. denied, 531 U.S. 1146 (2001) (follow the fortunes “requires reinsurers to accept a reinsured's good faith decision that a particular loss is covered by the terms of the underlying policy”) As explained by one commentator:

[t]he purpose of the 'follow the fortunes' clause is to preclude wasteful relitigation by a reinsurer of defenses to underlying policy coverage in cases where the ceding insurer has in good faith paid a settlement or judgment which is 'reasonably encompassed within the bounds of the [underlying] policy.' See Barry R. Ostrager and Thomas R. Newman, Handbook on Insurance Coverage Disputes '16.01(a) (10th ed. 2000) (collecting cases).

Without the follow the fortunes doctrine, “reinsureds would be in the impossible position of advancing defenses in coverage contests that could be used against them by reinsurers seeking to deny liability.” North River Ins. Co., 52 F.3d at 1211.

At the end of the day, the follow the fortunes doctrine limits reinsurers to two questions: 1) did the insurer act in bad faith in paying the underlying claim; and 2) did the claim arise from a risk clearly outside the policy as reinsured. Once those questions are answered in the negative, the reinsurer cannot second-guess the reinsured's payment of the loss, and instead, is bound to indemnify the reinsured. Id.

The First Question: Did the Insurer Act in Bad Faith?

Perhaps because it involves more gray area, the first question a reinsurer must answer ' Did the insurer act in bad faith? ' has generated more litigation in the past few years. A recent decision by the U.S. Court of Appeals for the Eighth Circuit, ReliaStar Life Ins. Co. v. IOA Re, Inc., 303 F.3d 874 (8th Cir. 2002), however, narrowly defined bad faith as “'deliberate deception, gross negligence, or recklessness,' or even fraudulent behavior.” Id. at 881.

In ReliaStar, ReliaStar Life Insurance Company, a retrocedent, sued IOA Re, Inc. and Swiss Re Life Canada, its retrocessionaires, after the retrocessionaires failed to pay under their reinsurance contracts. A retrocedent is a reinsurer that has been reinsured by another insurance company called a retrocessionaire. In addition to raising rescission and late notice issues, the retrocessionaires argued that the follow the fortunes doctrine did not apply because ReliaStar had acted in bad faith. Id. at 881-82. As examples of ReliaStar's alleged bad faith, the retrocessionaires claimed that ReliaStar had misrepresented the profitability of its insurance program and failed to obtain adequate claims documentation before it paid underlying claims. Id. at 882. The retrocessionaires then attempted to shift the burden of proof on the bad faith issue to ReliaStar. Specifically, the retrocessionaires argued that ReliaStar had to show it had not acted in bad faith, and the retrocessionaires argued, ReliaStar had not met this burden of proof because it had not shown it “acted in a reasonable, businesslike fashion, and that it submitted legitimate, reinsured losses.” Id. at 881. The Eighth Circuit rejected both the retrocessionaires' efforts to shift the burden of proof and to impose this “reasonable, businesslike fashion” standard on ReliaStar, adopting instead the definition of bad faith formulated by other courts: “'deliberate deception, gross negligence, or recklessness,' or even fraudulent behavior.” Id.

One of the cases the Eighth Circuit relied on extensively in ReliaStar was American Bankers Ins. Co. v. Northwest Nat'l Ins. Co., 198 F.3d 1332 (11th Cir. 1999). Like ReliaStar, the retrocessionaire in American Bankers, Northwestern National Insurance Company, argued that American Bankers Insurance Company of Florida, the retrocedent, acted in bad faith when it allegedly failed to investigate a false claim submitted by Hartford Insurance Company. Id. at 1336. After Hartford treated Dow Corning Corporation's claims as multiple occurrences, it proceeded to treat all of the claims as a single occurrence for purposes of presenting them to American Bankers. Id. Northwestern argued to the trial court that American Bankers should have investigated and determined that Hartford's claims were not covered by the reinsurance contract between Hartford and American Bankers, and therefore, not covered by the reinsurance contract between American Bankers and Northwestern. Id. American Bankers responded that it acted appropriately in evaluating and paying Hartford's claims because, at the time of its decision, there was legitimate debate about whether a large group of similar claims was the result of a single occurrence or multiple occurrences. Id. The trial court granted summary judgment to American Bankers on its indemnification claim. Id. at 1333.

On appeal, the U.S. Court of Appeals for the 11th Circuit turned first to what constituted bad faith in the reinsurance context. In words that would resonate with the ReliaStar court, the 11th Circuit reasoned:

We are persuaded that simple negligence cannot be enough to establish bad faith. Virtually every decision by the ceding insurance company could be second-guessed and litigated under a simple negligence standard. Thus, to equate bad faith with simple negligence would vitiate all of the policy reasons that give rise to the follow the fortunes doctrine. Rather, we agree with the Second Circuit that the proper minimum standard for bad faith should be deliberate deception, gross negligence or recklessness. Id.

Because American Bankers' decision to treat a large group of similar claims as a single occurrence was not grossly negligent, reckless, or deliberately deceptive, the 11th Circuit affirmed the trial court's decision.

Other courts that have grappled with the contours of bad faith in the reinsurance context have come to a similar conclusion. Thus, the Second Circuit and the Third Circuit have both adopted some variation of the gross negligence or recklessness standard to prove bad faith in the reinsurance context. See Unigard Sec. Ins. Co. v. North River Ins. Co., 4 F.3d 1049, 1069 (2d Cir. 1993) (“the proper minimum standard for bad faith should be gross negligence or recklessness”) and North River Ins. Co., 52 F.3d at 1213 (adopting the Second Circuit's gross negligence or recklessness standard).

So what exactly is “gross negligence” or “recklessness”? The Second Circuit in Unigard Sec. Ins. Co. v. North River Ins. Co., spelled out the difference between negligence and gross negligence in the context of a cedent's prompt notice of a loss to its reinsurer.

If a [reinsured] has implemented routine practices and controls to ensure notification to reinsurers but inadvertence causes a lapse, the reinsured has not acted in bad faith. But if a [reinsured] does not implement such practices and controls, then it has willfully disregarded the risk to reinsurers and is guilty of gross negligence. A reinsurer, dependent on its [reinsured] for information, should be able to expect at least this level of protection, and, if a [reinsured] fails to provide it, the reinsurer's late loss notice defense should succeed. Unigard Sec. Ins. Co., 4 F.3d at 1069.

See also Certain Underwriters at Lloyd's London v. Home Ins. Co., 146 N.H. 740, 742, 783 A.2d 238 (2001) (finding “gross negligence” in an insurance company's “1) … failure to maintain proper procedures, guidelines and controls to ensure appropriate notice to [Lloyd's]; and 2) … lack of awareness of its reinsurance policy with [Lloyd's] from 1984 to 1995 resulting from its lack of diligence and faulty procedures.”) Although Unigard focused on whether the cedent's notice of loss was in bad faith, it seems reasonable to assume that a court would look to similar criteria in the follow the fortunes context.

The Second Question: Did the Claim Arise From a Risk Clearly Outside the Policy as Reinsured?

Under most reinsurance agreements, the reinsured's coverage from its reinsurer is designed to be “back to back” with the coverage the reinsured provides to its insured. Thus, the second and more straightforward question generally is whether the loss paid by the reinsured is covered by its policy with the insured in the first place, and then, whether the reinsured's payment is also covered by its policy with the reinsurer. Payments by an insurer who has no legal obligation to pay, but who makes the payment for business reasons, such as avoiding greater expense or accommodating its insured, are called “ex gratia” payments. Ex gratia payments made in bad faith on claims that are clearly outside the policy as reinsured are not covered by the follow the fortunes doctrine. Thus, one New York trial court stated, “it would be an unwarranted and indeed tortured construction of [the follow the fortunes] clause to hold a reinsurer bound … to pay if the prime insurer paid moneys to its insured on a claim completely without the scope of the policy and not in good faith.” Insurance Co. of North America v. United States Fire Ins. Co., 322 N.Y.S.2d 520, 523 (N.Y. Sup. Ct. 1971).

To determine whether a cedent's claim is covered, courts first look at the terms of the underlying policy. In Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49 (D. Mass. 1998), aff'd, 217 F.3d 33 (1st Cir. 2000), cert. denied, 531 U.S. 1146 (2001), a facultative reinsurance dispute, the reinsurer argued that the insurer should not have paid the insured's environmental liabilities since environmental losses were arguably excluded from coverage under the underlying insurance policy. Id. at 57. The court emphasized that a reinsurer must show that the claims settlement “was not even 'arguably' within the scope of the reinsurance coverage” to avoid liability. Id. at 66. Nor can a reinsurer dispute “good faith determinations that a risk was covered by the underlying insurance policy[.]” Id. (citing Christiania Gen. Ins. Corp. v. Great Am. Ins. Co., 979 F.2d 268, 280 (2d Cir. 1993)). Thus, the court explained:

[the reinsurer] has been unable to produce any evidence of bad faith or fraud on [the insurer's] part in its decisions about whether [the insured's] environmental liability was covered by the general liability policy … , in spite of the “owned property” exclusion emphasized by [the reinsured's] counsel[.] … Nor did it produce any such evidence with regard to [the insurer's] assessment that [the insured's] losses were not covered by the difference in conditions policy. … [The reinsurer] called no witnesses from [the insurer's] claims department who might have been able to testify to the bona fides of the claims decisions. Id. at 67.

Consequently, the court concluded that the insurer's payments were not ex gratia, and therefore, the reinsurer was obligated to reimburse the insurer. Id. at 67-68.

One unique feature of the court's opinion in Seven Provinces is its decision to apply the bad faith standard to the reinsured's determination of coverage. Under Seven Provinces, a reinsured's good faith determination that a loss is covered by the underlying policy will obligate the reinsurer to follow its fortunes regardless of whether or not the loss is actually covered by the underlying policy. The reinsurer can still argue that the reinsured's coverage determination was fraudulent, deliberately deceptive, grossly negligent, or reckless, but unless the reinsurer is able to prove bad faith on these terms, it must follow the fortunes of the reinsured. This approach is consistent with other courts that have held that a reinsurer is obligated to cover any settlement or judgment paid by the ceding insurer in “good faith” under the policy that is subject to the reinsurance. See North River Ins. Co., 52 F.3d at 1194; Brannkasse, 996 F.2d at 517; American Marine Ins. Group v. Neptunia Ins. Co., 775 F. Supp. 703, 708-09 (S.D.N.Y. 1991), aff'd, 961 F.2d 372 (2d Cir. 1992); Unigard Security Ins. Co. v. North River Ins. Co., 762 F. Supp. 566, 587 (S.D.N.Y. 1991), aff'd in part, rev'd in part, 4 F.3d 1049 (2d Cir. 1993) (a “reinsurer may not second guess the cedent's good faith decision to pay any claim that is arguably subject to coverage); cf. Weir v. Federal Ins. Co., 811 F.2d 1387, 1395 (10th Cir. 1987) (“The liability of an insurer need not be ironclad in order for it to settle a claim without a subsequent finding that the payment to the insured was voluntary. A payment is not voluntary if it is made with a reasonable or good faith belief in an obligation of personal interest in making that payment.”); see generally OSTRAGER AND NEWMAN, supra '16.01(a). Some courts, however, continue to maintain the position that the follow the fortunes doctrine does not obligate the reinsurer to pay for a loss that is not covered by the underlying policy. See Bellefonte Reins. Co. v. Aetna Cas. Co., 903 F.2d 910 (2d Cir. 1990); American Ins. Co. v. North Am. Co. for Property & Cas. Ins., 697 F.2d 79, 81 (2d Cir. 1982); see generally OSTRAGER AND NEWMAN, supra '16.01(a). While the former approach to the coverage question may frustrate a reinsurer's or retrocessionaire's expectations, it is consistent with the goal of the follow the fortunes doctrine to reduce the costs of reinsurance litigation when the cedent has acted in good faith.

In American Marine Ins. Group v. Neptunia Ins. Co., 775 F. Supp. 703 (S.D.N.Y. 1991), the Southern District of New York looked at the terms of the cedent's policy with its reinsurer to determine whether the cedent's payment was covered by the reinsurance policy after one of the cedent's reinsurers sought a declaratory judgment that it was not liable under its reinsurance contract with the reinsured. Neptunia Ins. Co., 775 F. Supp. at 704. After a heavy storm hit the insured ship between Aruba and Boston, the vessel of the primary insured suffered severe hull damage. Id. Subsequently, the primary insured made a claim for a constructive total loss under the policy. Id. A series of investigations led the primary insurer, Neptunia, to conclude that the insured had not adequately demonstrated that a constructive total loss had occurred. Id. Based on anticipated difficulty with its case against the insured, Neptunia, in consultation with its British reinsurers, settled the claim. Id. Neptunia's American reinsurer, American Marine, claimed that it never agreed to the settlement, despite its alleged consultations with Neptunia, and refused to pay its share under the reinsurance policy because it believed a particular provision in the reinsurance policy barred recovery for compromised total loss. Id. at 705. Neptunia responded that American Marine was obligated to follow its fortunes regardless of whether the clause in question barred recovery for compromised total loss. Id. at 708. Agreeing, the court stated “[the reinsurer American Marine] is obligated to follow [the reinsured Neptunia's] fortunes in this matter.” Id. at 709. The court arrived at this decision because the type of loss was covered by the policy of reinsurance and Neptunia had acted honestly and taken all proper and businesslike steps in making the settlement. Id. at 708.

Similarly, the U.S. District Court for the Southern District of New York recently relied on Seven Provinces to conclude that a facultative reinsurer is required to indemnify the insurer when “the [insurer's] good-faith payment [to its insured] is at least arguably within the scope of the insurance coverage that was reinsured. North River Ins. Co. v. Ace American Reinsurance Co., No. 00 Civ. 7993 (JSR), 2002 U.S. Dist. LEXIS 5536, at *4 (S.D.N.Y. Mar. 29, 2002) (quoting Mentor Ins. Co. v. Brannkasse, 996 F.2d 506, 517 (2d Cir. 1993)). In North River Ins. Co., the reinsurer, Ace, argued that the follow the fortunes doctrine “d[id] not apply at all 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 discernible) that the insurer used in negotiating the settlement with its insured, even if that was not the theory applied in making the actual payments to the insured pursuant to the settlement.” Id. at *6. Quoting Seven Provinces, and using the terms follow the fortunes and follow the settlements interchangeably, the court observed:

The 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 *6-7 (quoting Seven Provinces Ins. Co., 9 F. Supp. at 67-68).

Conclusion

Since the development of reinsurance in the 14th century, reinsurance litigation has been relatively sparse; a legal backwater in the broader, more turbulent current of insurance litigation. As mass tort and environmental litigation have abounded in recent years, reinsurance litigation has entered the mainstream. One attempt to minimize the costs associated with increased reinsurance litigation has been the follow the fortunes doctrine. But whether courts will continue to develop this doctrine in ways that fulfill its fundamental purpose of cost minimization or whether reinsurance litigation will follow the course of insurance litigation at large remains to be seen. Either way, over the next few years, reinsurer and reinsured alike will likely find themselves increasingly in uncharted waters.

Reinsurance, the insurance of insurance companies, arose in the 14th century, the same century that saw the rise of the Ming Dynasty and the decimation of Europe's population by the Black Plague. Despite its 600-year history, however, until recently, judicial decisions on reinsurance disputes were few and far between. Instead, “differences [were] often … settled by handshakes and umpires[.]” Sumitomo Marine & Fire Ins. Co. v. Cologne Reins. Co., 75 N.Y.2d 295, 298, 552 N.E.2d 139, 140 (1990). But with the flood of mass tort and environmental litigation in the last 20 years, there has been a rise in reinsurance litigation. One historic response to deflect protracted reinsurance litigation is the “follow the fortunes” doctrine. When courts and insurers talk about follow the fortunes, they may mean one of two similar concepts: follow the fortunes or “follow the settlements.” While the follow the fortunes doctrine “requires reinsurers to accept a reinsured's good faith decision that a particular loss is covered by the terms of the underlying policy,” the follow the settlements clause “requires reinsurers to abide by a reinsured's good faith decision to settle, rather than litigate, claims on that policy. Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49, 66 (D. Mass. 1998), aff'd , 217 F.3d 33 (1st Cir. 2000), cert. denied , 531 U.S. 1146 (2001). Typically, the follow the fortunes doctrine is implied in the reinsurance contract whereas the follow the settlements clause is a specific provision in the agreement. While these doctrines share the underlying predicate of “good faith,” this article focuses on the follow the fortunes doctrine: the doctrine that requires a reinsurer to indemnify its reinsured whenever the reinsured makes a good faith payment of an insured loss.

In an era when reinsurers frequently underwrote risks by putting their mark on a slip passed around Lloyd's Coffee House, the follow the fortunes doctrine was developed to streamline both the underwriting process and the payment of claims. Basically, the follow the fortunes doctrine states that a reinsurer must indemnify its reinsured ' the cedent ' whenever the reinsured makes a good faith payment of an insured loss. See American Bankers Ins. Co. v. Northwest Nat'l Ins. Co., 198 F.3d 1332, 1335 (11th Cir. 1999) (follow the fortunes requires reinsurers to be “bound by the reinsured's decision to pay the claim and … refrain from second guessing a good faith decision to do so”); North River Ins. Co. v. CIGNA Reinsurance Co. , 52 F.3d 1194, 1212-13 (3d Cir. 1995) (follow the fortunes “obligates the reinsurer to indemnify the reinsured for any good faith payment of an insured loss”); Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49, 66 (D. Mass. 1998), aff'd , 217 F.3d 33 (1st Cir. 2000), cert. denied , 531 U.S. 1146 (2001) (follow the fortunes “requires reinsurers to accept a reinsured's good faith decision that a particular loss is covered by the terms of the underlying policy”) As explained by one commentator:

[t]he purpose of the 'follow the fortunes' clause is to preclude wasteful relitigation by a reinsurer of defenses to underlying policy coverage in cases where the ceding insurer has in good faith paid a settlement or judgment which is 'reasonably encompassed within the bounds of the [underlying] policy.' See Barry R. Ostrager and Thomas R. Newman, Handbook on Insurance Coverage Disputes '16.01(a) (10th ed. 2000) (collecting cases).

Without the follow the fortunes doctrine, “reinsureds would be in the impossible position of advancing defenses in coverage contests that could be used against them by reinsurers seeking to deny liability.” North River Ins. Co., 52 F.3d at 1211.

At the end of the day, the follow the fortunes doctrine limits reinsurers to two questions: 1) did the insurer act in bad faith in paying the underlying claim; and 2) did the claim arise from a risk clearly outside the policy as reinsured. Once those questions are answered in the negative, the reinsurer cannot second-guess the reinsured's payment of the loss, and instead, is bound to indemnify the reinsured. Id.

The First Question: Did the Insurer Act in Bad Faith?

Perhaps because it involves more gray area, the first question a reinsurer must answer ' Did the insurer act in bad faith? ' has generated more litigation in the past few years. A recent decision by the U.S. Court of Appeals for the Eighth Circuit, ReliaStar Life Ins. Co. v. IOA Re, Inc., 303 F.3d 874 (8th Cir. 2002), however, narrowly defined bad faith as “'deliberate deception, gross negligence, or recklessness,' or even fraudulent behavior.” Id. at 881.

In ReliaStar, ReliaStar Life Insurance Company, a retrocedent, sued IOA Re, Inc. and Swiss Re Life Canada, its retrocessionaires, after the retrocessionaires failed to pay under their reinsurance contracts. A retrocedent is a reinsurer that has been reinsured by another insurance company called a retrocessionaire. In addition to raising rescission and late notice issues, the retrocessionaires argued that the follow the fortunes doctrine did not apply because ReliaStar had acted in bad faith. Id. at 881-82. As examples of ReliaStar's alleged bad faith, the retrocessionaires claimed that ReliaStar had misrepresented the profitability of its insurance program and failed to obtain adequate claims documentation before it paid underlying claims. Id. at 882. The retrocessionaires then attempted to shift the burden of proof on the bad faith issue to ReliaStar. Specifically, the retrocessionaires argued that ReliaStar had to show it had not acted in bad faith, and the retrocessionaires argued, ReliaStar had not met this burden of proof because it had not shown it “acted in a reasonable, businesslike fashion, and that it submitted legitimate, reinsured losses.” Id. at 881. The Eighth Circuit rejected both the retrocessionaires' efforts to shift the burden of proof and to impose this “reasonable, businesslike fashion” standard on ReliaStar, adopting instead the definition of bad faith formulated by other courts: “'deliberate deception, gross negligence, or recklessness,' or even fraudulent behavior.” Id.

One of the cases the Eighth Circuit relied on extensively in ReliaStar was American Bankers Ins. Co. v. Northwest Nat'l Ins. Co. , 198 F.3d 1332 (11th Cir. 1999). Like ReliaStar, the retrocessionaire in American Bankers, Northwestern National Insurance Company, argued that American Bankers Insurance Company of Florida, the retrocedent, acted in bad faith when it allegedly failed to investigate a false claim submitted by Hartford Insurance Company. Id. at 1336. After Hartford treated Dow Corning Corporation's claims as multiple occurrences, it proceeded to treat all of the claims as a single occurrence for purposes of presenting them to American Bankers. Id. Northwestern argued to the trial court that American Bankers should have investigated and determined that Hartford's claims were not covered by the reinsurance contract between Hartford and American Bankers, and therefore, not covered by the reinsurance contract between American Bankers and Northwestern. Id. American Bankers responded that it acted appropriately in evaluating and paying Hartford's claims because, at the time of its decision, there was legitimate debate about whether a large group of similar claims was the result of a single occurrence or multiple occurrences. Id. The trial court granted summary judgment to American Bankers on its indemnification claim. Id. at 1333.

On appeal, the U.S. Court of Appeals for the 11th Circuit turned first to what constituted bad faith in the reinsurance context. In words that would resonate with the ReliaStar court, the 11th Circuit reasoned:

We are persuaded that simple negligence cannot be enough to establish bad faith. Virtually every decision by the ceding insurance company could be second-guessed and litigated under a simple negligence standard. Thus, to equate bad faith with simple negligence would vitiate all of the policy reasons that give rise to the follow the fortunes doctrine. Rather, we agree with the Second Circuit that the proper minimum standard for bad faith should be deliberate deception, gross negligence or recklessness. Id.

Because American Bankers' decision to treat a large group of similar claims as a single occurrence was not grossly negligent, reckless, or deliberately deceptive, the 11th Circuit affirmed the trial court's decision.

Other courts that have grappled with the contours of bad faith in the reinsurance context have come to a similar conclusion. Thus, the Second Circuit and the Third Circuit have both adopted some variation of the gross negligence or recklessness standard to prove bad faith in the reinsurance context. See Unigard Sec. Ins. Co. v. North River Ins. Co., 4 F.3d 1049, 1069 (2d Cir. 1993) (“the proper minimum standard for bad faith should be gross negligence or recklessness”) and North River Ins. Co., 52 F.3d at 1213 (adopting the Second Circuit's gross negligence or recklessness standard).

So what exactly is “gross negligence” or “recklessness”? The Second Circuit in Unigard Sec. Ins. Co. v. North River Ins. Co., spelled out the difference between negligence and gross negligence in the context of a cedent's prompt notice of a loss to its reinsurer.

If a [reinsured] has implemented routine practices and controls to ensure notification to reinsurers but inadvertence causes a lapse, the reinsured has not acted in bad faith. But if a [reinsured] does not implement such practices and controls, then it has willfully disregarded the risk to reinsurers and is guilty of gross negligence. A reinsurer, dependent on its [reinsured] for information, should be able to expect at least this level of protection, and, if a [reinsured] fails to provide it, the reinsurer's late loss notice defense should succeed. Unigard Sec. Ins. Co., 4 F.3d at 1069.

See also Certain Underwriters at Lloyd's London v. Home Ins. Co., 146 N.H. 740, 742, 783 A.2d 238 (2001) (finding “gross negligence” in an insurance company's “1) … failure to maintain proper procedures, guidelines and controls to ensure appropriate notice to [Lloyd's]; and 2) … lack of awareness of its reinsurance policy with [Lloyd's] from 1984 to 1995 resulting from its lack of diligence and faulty procedures.”) Although Unigard focused on whether the cedent's notice of loss was in bad faith, it seems reasonable to assume that a court would look to similar criteria in the follow the fortunes context.

The Second Question: Did the Claim Arise From a Risk Clearly Outside the Policy as Reinsured?

Under most reinsurance agreements, the reinsured's coverage from its reinsurer is designed to be “back to back” with the coverage the reinsured provides to its insured. Thus, the second and more straightforward question generally is whether the loss paid by the reinsured is covered by its policy with the insured in the first place, and then, whether the reinsured's payment is also covered by its policy with the reinsurer. Payments by an insurer who has no legal obligation to pay, but who makes the payment for business reasons, such as avoiding greater expense or accommodating its insured, are called “ex gratia” payments. Ex gratia payments made in bad faith on claims that are clearly outside the policy as reinsured are not covered by the follow the fortunes doctrine. Thus, one New York trial court stated, “it would be an unwarranted and indeed tortured construction of [the follow the fortunes] clause to hold a reinsurer bound … to pay if the prime insurer paid moneys to its insured on a claim completely without the scope of the policy and not in good faith.” Insurance Co. of North America v. United States Fire Ins. Co., 322 N.Y.S.2d 520, 523 (N.Y. Sup. Ct. 1971).

To determine whether a cedent's claim is covered, courts first look at the terms of the underlying policy. In Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49 (D. Mass. 1998), aff'd , 217 F.3d 33 (1st Cir. 2000), cert. denied , 531 U.S. 1146 (2001), a facultative reinsurance dispute, the reinsurer argued that the insurer should not have paid the insured's environmental liabilities since environmental losses were arguably excluded from coverage under the underlying insurance policy. Id. at 57. The court emphasized that a reinsurer must show that the claims settlement “was not even 'arguably' within the scope of the reinsurance coverage” to avoid liability. Id. at 66. Nor can a reinsurer dispute “good faith determinations that a risk was covered by the underlying insurance policy[.]” Id. (citing Christiania Gen. Ins. Corp. v. Great Am. Ins. Co., 979 F.2d 268, 280 (2d Cir. 1993)). Thus, the court explained:

[the reinsurer] has been unable to produce any evidence of bad faith or fraud on [the insurer's] part in its decisions about whether [the insured's] environmental liability was covered by the general liability policy … , in spite of the “owned property” exclusion emphasized by [the reinsured's] counsel[.] … Nor did it produce any such evidence with regard to [the insurer's] assessment that [the insured's] losses were not covered by the difference in conditions policy. … [The reinsurer] called no witnesses from [the insurer's] claims department who might have been able to testify to the bona fides of the claims decisions. Id. at 67.

Consequently, the court concluded that the insurer's payments were not ex gratia, and therefore, the reinsurer was obligated to reimburse the insurer. Id. at 67-68.

One unique feature of the court's opinion in Seven Provinces is its decision to apply the bad faith standard to the reinsured's determination of coverage. Under Seven Provinces, a reinsured's good faith determination that a loss is covered by the underlying policy will obligate the reinsurer to follow its fortunes regardless of whether or not the loss is actually covered by the underlying policy. The reinsurer can still argue that the reinsured's coverage determination was fraudulent, deliberately deceptive, grossly negligent, or reckless, but unless the reinsurer is able to prove bad faith on these terms, it must follow the fortunes of the reinsured. This approach is consistent with other courts that have held that a reinsurer is obligated to cover any settlement or judgment paid by the ceding insurer in “good faith” under the policy that is subject to the reinsurance. See North River Ins. Co., 52 F.3d at 1194; Brannkasse, 996 F.2d at 517; American Marine Ins. Group v. Neptunia Ins. Co. , 775 F. Supp. 703, 708-09 (S.D.N.Y. 1991), aff'd , 961 F.2d 372 (2d Cir. 1992); Unigard Security Ins. Co. v. North River Ins. Co. , 762 F. Supp. 566, 587 (S.D.N.Y. 1991), aff'd in part, rev'd in part , 4 F.3d 1049 (2d Cir. 1993) (a “reinsurer may not second guess the cedent's good faith decision to pay any claim that is arguably subject to coverage); cf. Weir v. Federal Ins. Co., 811 F.2d 1387, 1395 (10th Cir. 1987) (“The liability of an insurer need not be ironclad in order for it to settle a claim without a subsequent finding that the payment to the insured was voluntary. A payment is not voluntary if it is made with a reasonable or good faith belief in an obligation of personal interest in making that payment.”); see generally OSTRAGER AND NEWMAN, supra '16.01(a). Some courts, however, continue to maintain the position that the follow the fortunes doctrine does not obligate the reinsurer to pay for a loss that is not covered by the underlying policy. See Bellefonte Reins. Co. v. Aetna Cas. Co., 903 F.2d 910 (2d Cir. 1990); American Ins. Co. v. North Am. Co. for Property & Cas. Ins., 697 F.2d 79, 81 (2d Cir. 1982); see generally OSTRAGER AND NEWMAN, supra '16.01(a). While the former approach to the coverage question may frustrate a reinsurer's or retrocessionaire's expectations, it is consistent with the goal of the follow the fortunes doctrine to reduce the costs of reinsurance litigation when the cedent has acted in good faith.

In American Marine Ins. Group v. Neptunia Ins. Co., 775 F. Supp. 703 (S.D.N.Y. 1991), the Southern District of New York looked at the terms of the cedent's policy with its reinsurer to determine whether the cedent's payment was covered by the reinsurance policy after one of the cedent's reinsurers sought a declaratory judgment that it was not liable under its reinsurance contract with the reinsured. Neptunia Ins. Co., 775 F. Supp. at 704. After a heavy storm hit the insured ship between Aruba and Boston, the vessel of the primary insured suffered severe hull damage. Id. Subsequently, the primary insured made a claim for a constructive total loss under the policy. Id. A series of investigations led the primary insurer, Neptunia, to conclude that the insured had not adequately demonstrated that a constructive total loss had occurred. Id. Based on anticipated difficulty with its case against the insured, Neptunia, in consultation with its British reinsurers, settled the claim. Id. Neptunia's American reinsurer, American Marine, claimed that it never agreed to the settlement, despite its alleged consultations with Neptunia, and refused to pay its share under the reinsurance policy because it believed a particular provision in the reinsurance policy barred recovery for compromised total loss. Id. at 705. Neptunia responded that American Marine was obligated to follow its fortunes regardless of whether the clause in question barred recovery for compromised total loss. Id. at 708. Agreeing, the court stated “[the reinsurer American Marine] is obligated to follow [the reinsured Neptunia's] fortunes in this matter.” Id. at 709. The court arrived at this decision because the type of loss was covered by the policy of reinsurance and Neptunia had acted honestly and taken all proper and businesslike steps in making the settlement. Id. at 708.

Similarly, the U.S. District Court for the Southern District of New York recently relied on Seven Provinces to conclude that a facultative reinsurer is required to indemnify the insurer when “the [insurer's] good-faith payment [to its insured] is at least arguably within the scope of the insurance coverage that was reinsured. North River Ins. Co. v. Ace American Reinsurance Co., No. 00 Civ. 7993 (JSR), 2002 U.S. Dist. LEXIS 5536, at *4 (S.D.N.Y. Mar. 29, 2002) (quoting Mentor Ins. Co. v. Brannkasse, 996 F.2d 506, 517 (2d Cir. 1993)). In North River Ins. Co., the reinsurer, Ace, argued that the follow the fortunes doctrine “d[id] not apply at all 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 discernible) that the insurer used in negotiating the settlement with its insured, even if that was not the theory applied in making the actual payments to the insured pursuant to the settlement.” Id. at *6. Quoting Seven Provinces, and using the terms follow the fortunes and follow the settlements interchangeably, the court observed:

The 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 *6-7 (quoting Seven Provinces Ins. Co., 9 F. Supp. at 67-68).

Conclusion

Since the development of reinsurance in the 14th century, reinsurance litigation has been relatively sparse; a legal backwater in the broader, more turbulent current of insurance litigation. As mass tort and environmental litigation have abounded in recent years, reinsurance litigation has entered the mainstream. One attempt to minimize the costs associated with increased reinsurance litigation has been the follow the fortunes doctrine. But whether courts will continue to develop this doctrine in ways that fulfill its fundamental purpose of cost minimization or whether reinsurance litigation will follow the course of insurance litigation at large remains to be seen. Either way, over the next few years, reinsurer and reinsured alike will likely find themselves increasingly in uncharted waters.