The Follow-the-Fortunes Doctrine

Expressed simply, the follow-the-fortunes doctrine requires a reinsurer to follow and accept a cedent's good-faith settlement and allocation decisions. The insurance industry operates upon the understanding that the doctrine affords a cedent great latitude in making coverage decisions, handling underlying claims, and settling coverage disputes and underlying claims. In recent years, the doctrine has been applied to a cedent's decision of how to allocate a claims settlement to its insurance policies and reinsurance agreements. While some may think it heresy to suggest limitations on the doctrine, in fact limitations are necessary to achieve a level of fairness in the reinsurance relationship and prevent abuse of the doctrine by cedents.

Despite the powerful reach of the follow-the-fortunes doctrine, there are limits to its application. There are three areas where the doctrine may not protect a cedent's claim or allocation determinations:

• Where the terms of the reinsurance contract limit the cedent's ability to make claims settlement or allocation decisions;
• Where a reinsurer can demonstrate that the cedent has been guilty of gross negligence or bad faith in claims handling accompanied by a failure to give notice of the claim to the reinsurer; and
• Where the cedent's allocation of a claim settlement or judgment is unreasonable or has been made in bad faith.

Terms of the Reinsurance Agreement

The follow-the-fortunes doctrine does not override specific language in the reinsurance agreement. The terms of the reinsurance agreement may limit the cedent's ability to cede losses or claims expenses that are covered under its policy, but not the reinsurance agreement. For instance, in Bellefonte Reinsurance Co. v. Aetna Casualty & Surety Co., 903 F.2d 910 (2d Cir. 1990), the court held that the follow-the-fortunes doctrine cannot be used to expand the coverage for costs to amounts expended in excess of the limit of liability in a reinsurance agreement, even though the cedent paid such amounts in connection with it handling of the underlying claims. Interestingly, as industry practitioners are aware, arbitration panels have routinely declined to follow the Bellefonte decision and have awarded costs in excess of reinsurance limits of liability based upon industry custom and practice.

More clearly, where the reinsurance agreement contains an exclusion not contained in the underlying policy, the follow-the-fortunes doctrine will not trump the exclusionary provision and allow for coverage where there is none.

Courts and arbitration panels will also apply definitions of occurrence and trigger of coverage provisions in reinsurance agreements in considering the applicability of the doctrine. The follow-the-fortunes doctrine will not trump reinsurance contract provisions which limit the cedent's ability to allocate losses to reinsurers.

Gross Negligence or Bad Faith

A corollary to the follow-the-fortunes doctrine is that the cedent must take reasonable, businesslike steps in handling a claim. A cedent can forfeit the benefit of the follow-the-fortunes doctrine because of gross negligence or bad faith in the handling of a claim. Bad faith in this context is conduct amounting to deliberate deception, gross negligence or recklessness.

There are few reported court decisions addressing a reinsurer's claim of bad faith or gross negligence in handling a claim. One notable decision is Suter v. General Accident Insurance Co. of America, No. 01-2686, 2006 U.S. Dist. LEXIS 48209 (D.N.J. Jul. 14 2006). The court in Suter denied recovery of a reinsurance claim to the liquidator of Integrity Insurance Company. Integrity was an excess insurer of Pfizer, which asserted coverage for liability for breast implant claims. The court found that Integrity conducted no independent investigation as to whether there was evidence justifying the date of implant trigger. Instead, Integrity relied upon the claims handling and review of the underlying carrier. Integrity's policy was excess to, and followed form to, the underlying carrier. The court found that Integrity was “grossly incompetent under the circumstances ' not to retain competent coverage counsel and to have made an allowance on a claim of this type without obtaining medical information to support it.”

The court in Nationwide Mutual Insurance Co. v. American Reinsurance Co., 961 F.2d 1578 (6th Cir. 1992), denied recovery to a cedent for a reinsurance claim where the cedent's policy excluded the claim in issue.

The cedent's policy excluded employment agency errors and omissions coverage. The cedent failed to assert the exclusion and paid the claim after judgment was entered against the insured. The reinsurer did not receive notice of the claim until after the judgment. Curiously, the court did not discuss the follow the fortunes doctrine even though the court's opinion indicates that the cedent relied upon the doctrine in seeking payment from the reinsurer.

Virtually all arbitrations are subject to confidentiality provisions and one cannot easily determine whether arbitration panels have been receptive to reinsurers' claims of gross negligence or failure to take proper businesslike steps in claims handling. Anecdotal evidence is available. Panels have wide discretion in granting relief and thus, can penalize a cedent for poor claims handling by awarding a significant discount from a billing presented to the reinsurer.

In one case, an arbitration panel granted significant relief to the reinsurer where the cedent denied coverage to a corporate insured that was plainly covered. The insured settled with the claimant and assigned its right against the cedent to the claimant. As a result of the denial of coverage and assignment, under the applicable state law, the cedent could not contest the liability of its insured. However, the insured had no liability to the claimant. The reinsurer was able to demonstrate to the panel the lack of liability. If the cedent had not been grossly negligent in denying coverage, the cedent would have controlled the defense and would have been able to demonstrate that its insured had no liability. Thus, the cedent was compelled to settle the claim for an amount it should not have had to pay. In this case too, notice was not provided to the reinsurer until five years after the denial of coverage and after the cedent's settlement.

In another confidential arbitration where the reinsured alleged grossly negligent claim handling, the cedent failed to respond to the claimant's settlement demand within the range of verdict exposure estimated by defense counsel. The reinsurer was able to show that the cedent ignored harmful evidence against its insured in refusing to make a counter offer. Here too, late notice was a factor because the reinsurer was not notified until 2 ' years after suit was brought against its insured and after the verdict was rendered. The reinsurer was also able to show that it had a track record of associating in claims defense and communicating its recommendations on claims to its cedent.

One common thread in cases alleging gross negligence in claims handling is late notice. If the reinsurer were aware of the claim, it could have communicated any concerns about claims handling to its cedent.

Application of the Doctrine to Allocation Decisions

Once a claim has been settled or reduced to judgment, a cedent must determine how that settlement or judgment should be billed to its reinsurers. This is known as an allocation. Cedents must determine what reinsurance contracts cover a particular settlement. This determination includes decisions as to whether claims can be aggregated, what reinsurance treaty periods apply and what layers of reinsurance apply. As in the case of any settlement billed to reinsurers, the first step is to determine whether the reinsurance contract speaks to the issue of allocation.

Thus, for the follow-the-fortunes doctrine to apply, the allocation must be found by to be within the terms of the reinsurance contract. In Travelers v. Underwriters at Lloyd's, 96 N.Y.2d 583 (2001), the New York Court of Appeals rejected the cedent's follow-the-fortunes argument for its single occurrence cession, as it held that the clause could not supplant other provisions in the treaties that did not support aggregation. The court looked closely at the definition in the treaty of the term “disaster and/or casualty,” which included “all loss resulting from a series of accidents, occurrences and/or causative incidents having a common origin and/or being traceable to the same act, omission, error and/or mistake.” Travelers allocated settlements based on the theory that pollution at several sites had a “common origin” and was “traceable to the same act, omission, error and/or mistake.” Travelers urged the court to adopt a very broad definition of “origin” in addressing whether the allocation was in accordance with the treaty. The court, however, applied the general principle of interpretation of reinsurance agreements that meaning should be given to every sentence, clause and word of an agreement, and determined that Travelers' definition of origin would “excise” the words “series of” from the treaty language, and therefore was untenable. Accordingly, Travelers' single allocation of its settlements was not in accordance with the reinsurance treaties and Lloyd's was not required to “follow the fortunes” of Travelers. The court stated that “To hold that these 'follow the fortunes' clauses supplant the definition of 'disaster and/or casualty' in the reinsurance treaties and allow Travelers to recover under its single allocation theory would effectively negate the phase. The practical result of such an application would be that a reinsurance contract interpreted under New York law that contains a 'follow the fortunes' clause would bind a reinsurer to indemnify a reinsured whenever it paid a claim, regardless of the contractual language defining loss.”

Where a reinsurance contract does not address the issue of allocation, courts have held that an allocation will be upheld where it is reasonable and in good faith under the terms of the policies, settlement and facts. Travelers Cas. & Surety Co. v. Gerling Global Reins. Corp. of Am., 419 F. 3d 181 (2d Cir. 2005); North River Ins. v. ACE American Reins. Co., 361 F. 3d 134, (2d Cir. 2004); Commercial Union Ins. Co. v. Seven Provinces Reins. Co., 9 F. Supp. 2d. 49, aff'd 360 F. 3d 134 (2d. Cir. 2004). Arbitration panels have generally given cedents considerable leeway in allocation decisions, but are likely to be willing to examine the facts more closely than courts.

In North River Insurance Co. v. ACE American Reinsurance Co., 361 F.3d 134 (2d Cir. 2004), the Second Circuit Court of Appeals held that the follow-the-fortunes doctrine extends to a post-settlement allocation decision, even if it is inconsistent with the reinsured's pre-settlement assessment of the risk. Similarly, in Travelers Casualty & Surety Co. v. Gerling Global Reinsurance Corp., 419 F.3d 181 (2d Cir. 2005), the Second Circuit found that an allocation by the cedent that maximizes reinsurance recovery does not necessarily constitute bad faith. In fact, the court stated that “An allocation that increases reinsurance recovery ' when made in the aftermath of a legitimate settlement and when chosen from multiple possible allocations ' would rarely demonstrate bad faith in and of itself.” Travelers left unanswered the question of what constitutes a reasonable settlement, but it indicates that whether an allocation is reasonable must be viewed in light of the context of case law prevailing at the time, and of the position advocated by the parties prior to the allocation.

After Travelers, courts have looked at the particular facts of each case to determine whether a cedent has acted unreasonably or in bad faith. In Allstate Insurance Co. v. American Home Assurance Co., 837 N.Y.S.2d 138 (N.Y. App. Div. 2007), a New York state appellate court found that American Home's allocation on a single occurrence basis was unreasonable. In so holding, the court looked at several factual considerations: 1) that American Home and its insured had consistently espoused a multiple occurrence position; 2) that American Home had ignored a district court ruling that there were multiple occurrences at one of the sites at issue; 3) the allocation analysis was inconsistent; and 4) the determination that the allocation was inconsistent required neither an “intrusive factual inquiry” into the allocation, nor was Allstate “second-guessing” the settlement decision.

Finally, in Granite State Insurance Co. v. ACE American Reinsurance Co., 849 N.Y.S.2d 201 (App. Div. 2007), a New York state appellate court denied summary judgment in favor of the reinsurer, as there were issues of fact regarding whether the cedent had engaged in bad faith by crediting an overpayment on one policy to the policy that was reinsured, even though it had initially disclaimed coverage on that policy.

Conclusion

It is clear that the follow-the-fortunes doctrine remains a powerful tool on behalf of cedents, protecting settlement decisions, amounts of settlements, coverage determinations, and good faith and reasonable allocations. Reinsurers face a heavy burden in challenging the good faith of a post-settlement allocation.

However, important limits exist that can erode the power of the doctrine. In determining whether a settlement or allocation is within the terms of the reinsurance agreement, courts will carefully examine the language and scope of the coverage. A cedent cannot invoke the follow-the-fortunes doctrine where it has failed to take businesslike actions in settling a claim or where it has failed to provide timely notice. The follow-the-fortunes doctrine applies only to actual determinations of coverage. Finally, a reinsurer need not follow the fortunes of the cedent's allocation where it was not made in good faith or was unreasonable.

John M. Nonna, a member of this newsletter's Board of Editors, is a partner at Dewey & LeBoeuf. LLP. He is co-leader of the firm's Insurance and Reinsurance Dispute Resolution Practice and a fellow of the American College of Trial Lawyers. Victoria Melcher is an associate at the firm.

One of the most hallowed principles of reinsurance is the follow-the-fortunes doctrine. With its counterpart, the duty of utmost good faith, the follow-the-fortunes doctrine is a linchpin of the reinsurance industry and the legal rules applied to reinsurance disputes.

This article explores the boundaries of the doctrine. Does it have any limits? Does a cedent have carte blanche to impose its claims decisions and allocations of claims settlements upon a reinsurer without question? Do the answers to the questions depend upon whether the dispute is before a court or an arbitration panel?

The Doctrine

Expressed simply, the follow-the-fortunes doctrine requires a reinsurer to follow and accept a cedent's good-faith settlement and allocation decisions. The insurance industry operates upon the understanding that the doctrine affords a cedent great latitude in making coverage decisions, handling underlying claims, and settling coverage disputes and underlying claims. In recent years, the doctrine has been applied to a cedent's decision of how to allocate a claims settlement to its insurance policies and reinsurance agreements. While some may think it heresy to suggest limitations on the doctrine, in fact limitations are necessary to achieve a level of fairness in the reinsurance relationship and prevent abuse of the doctrine by cedents.

Despite the powerful reach of the follow-the-fortunes doctrine, there are limits to its application. There are three areas where the doctrine may not protect a cedent's claim or allocation determinations:

• Where the terms of the reinsurance contract limit the cedent's ability to make claims settlement or allocation decisions;
• Where a reinsurer can demonstrate that the cedent has been guilty of gross negligence or bad faith in claims handling accompanied by a failure to give notice of the claim to the reinsurer; and
• Where the cedent's allocation of a claim settlement or judgment is unreasonable or has been made in bad faith.

Terms of the Reinsurance Agreement

The follow-the-fortunes doctrine does not override specific language in the reinsurance agreement. The terms of the reinsurance agreement may limit the cedent's ability to cede losses or claims expenses that are covered under its policy, but not the reinsurance agreement. For instance, in Bellefonte Reinsurance Co. v. Aetna Casualty & Surety Co. , 903 F.2d 910 (2d Cir. 1990), the court held that the follow-the-fortunes doctrine cannot be used to expand the coverage for costs to amounts expended in excess of the limit of liability in a reinsurance agreement, even though the cedent paid such amounts in connection with it handling of the underlying claims. Interestingly, as industry practitioners are aware, arbitration panels have routinely declined to follow the Bellefonte decision and have awarded costs in excess of reinsurance limits of liability based upon industry custom and practice.

More clearly, where the reinsurance agreement contains an exclusion not contained in the underlying policy, the follow-the-fortunes doctrine will not trump the exclusionary provision and allow for coverage where there is none.

Courts and arbitration panels will also apply definitions of occurrence and trigger of coverage provisions in reinsurance agreements in considering the applicability of the doctrine. The follow-the-fortunes doctrine will not trump reinsurance contract provisions which limit the cedent's ability to allocate losses to reinsurers.

Gross Negligence or Bad Faith

A corollary to the follow-the-fortunes doctrine is that the cedent must take reasonable, businesslike steps in handling a claim. A cedent can forfeit the benefit of the follow-the-fortunes doctrine because of gross negligence or bad faith in the handling of a claim. Bad faith in this context is conduct amounting to deliberate deception, gross negligence or recklessness.

There are few reported court decisions addressing a reinsurer's claim of bad faith or gross negligence in handling a claim. One notable decision is Suter v. General Accident Insurance Co. of America, No. 01-2686, 2006 U.S. Dist. LEXIS 48209 (D.N.J. Jul. 14 2006). The court in Suter denied recovery of a reinsurance claim to the liquidator of Integrity Insurance Company. Integrity was an excess insurer of Pfizer, which asserted coverage for liability for breast implant claims. The court found that Integrity conducted no independent investigation as to whether there was evidence justifying the date of implant trigger. Instead, Integrity relied upon the claims handling and review of the underlying carrier. Integrity's policy was excess to, and followed form to, the underlying carrier. The court found that Integrity was “grossly incompetent under the circumstances ' not to retain competent coverage counsel and to have made an allowance on a claim of this type without obtaining medical information to support it.”

The court in Nationwide Mutual Insurance Co. v. American Reinsurance Co. , 961 F.2d 1578 (6th Cir. 1992), denied recovery to a cedent for a reinsurance claim where the cedent's policy excluded the claim in issue.

The cedent's policy excluded employment agency errors and omissions coverage. The cedent failed to assert the exclusion and paid the claim after judgment was entered against the insured. The reinsurer did not receive notice of the claim until after the judgment. Curiously, the court did not discuss the follow the fortunes doctrine even though the court's opinion indicates that the cedent relied upon the doctrine in seeking payment from the reinsurer.

Virtually all arbitrations are subject to confidentiality provisions and one cannot easily determine whether arbitration panels have been receptive to reinsurers' claims of gross negligence or failure to take proper businesslike steps in claims handling. Anecdotal evidence is available. Panels have wide discretion in granting relief and thus, can penalize a cedent for poor claims handling by awarding a significant discount from a billing presented to the reinsurer.

In one case, an arbitration panel granted significant relief to the reinsurer where the cedent denied coverage to a corporate insured that was plainly covered. The insured settled with the claimant and assigned its right against the cedent to the claimant. As a result of the denial of coverage and assignment, under the applicable state law, the cedent could not contest the liability of its insured. However, the insured had no liability to the claimant. The reinsurer was able to demonstrate to the panel the lack of liability. If the cedent had not been grossly negligent in denying coverage, the cedent would have controlled the defense and would have been able to demonstrate that its insured had no liability. Thus, the cedent was compelled to settle the claim for an amount it should not have had to pay. In this case too, notice was not provided to the reinsurer until five years after the denial of coverage and after the cedent's settlement.

In another confidential arbitration where the reinsured alleged grossly negligent claim handling, the cedent failed to respond to the claimant's settlement demand within the range of verdict exposure estimated by defense counsel. The reinsurer was able to show that the cedent ignored harmful evidence against its insured in refusing to make a counter offer. Here too, late notice was a factor because the reinsurer was not notified until 2 ' years after suit was brought against its insured and after the verdict was rendered. The reinsurer was also able to show that it had a track record of associating in claims defense and communicating its recommendations on claims to its cedent.

One common thread in cases alleging gross negligence in claims handling is late notice. If the reinsurer were aware of the claim, it could have communicated any concerns about claims handling to its cedent.

Application of the Doctrine to Allocation Decisions

Once a claim has been settled or reduced to judgment, a cedent must determine how that settlement or judgment should be billed to its reinsurers. This is known as an allocation. Cedents must determine what reinsurance contracts cover a particular settlement. This determination includes decisions as to whether claims can be aggregated, what reinsurance treaty periods apply and what layers of reinsurance apply. As in the case of any settlement billed to reinsurers, the first step is to determine whether the reinsurance contract speaks to the issue of allocation.

Thus, for the follow-the-fortunes doctrine to apply, the allocation must be found by to be within the terms of the reinsurance contract. In Travelers v. Underwriters at Lloyd ' s , 96 N.Y.2d 583 (2001), the New York Court of Appeals rejected the cedent's follow-the-fortunes argument for its single occurrence cession, as it held that the clause could not supplant other provisions in the treaties that did not support aggregation. The court looked closely at the definition in the treaty of the term “disaster and/or casualty,” which included “all loss resulting from a series of accidents, occurrences and/or causative incidents having a common origin and/or being traceable to the same act, omission, error and/or mistake.” Travelers allocated settlements based on the theory that pollution at several sites had a “common origin” and was “traceable to the same act, omission, error and/or mistake.” Travelers urged the court to adopt a very broad definition of “origin” in addressing whether the allocation was in accordance with the treaty. The court, however, applied the general principle of interpretation of reinsurance agreements that meaning should be given to every sentence, clause and word of an agreement, and determined that Travelers' definition of origin would “excise” the words “series of” from the treaty language, and therefore was untenable. Accordingly, Travelers' single allocation of its settlements was not in accordance with the reinsurance treaties and Lloyd's was not required to “follow the fortunes” of Travelers. The court stated that “To hold that these 'follow the fortunes' clauses supplant the definition of 'disaster and/or casualty' in the reinsurance treaties and allow Travelers to recover under its single allocation theory would effectively negate the phase. The practical result of such an application would be that a reinsurance contract interpreted under New York law that contains a 'follow the fortunes' clause would bind a reinsurer to indemnify a reinsured whenever it paid a claim, regardless of the contractual language defining loss.”

Where a reinsurance contract does not address the issue of allocation, courts have held that an allocation will be upheld where it is reasonable and in good faith under the terms of the policies, settlement and facts. Travelers Cas. & Surety Co. v. Gerling Global Reins. Corp. of Am. , 419 F. 3d 181 (2d Cir. 2005); North River Ins. v. ACE American Reins. Co. , 361 F. 3d 134, (2d Cir. 2004); Commercial Union Ins. Co. v. Seven Provinces Reins. Co. , 9 F. Supp. 2d. 49, aff'd 360 F. 3d 134 (2d. Cir. 2004). Arbitration panels have generally given cedents considerable leeway in allocation decisions, but are likely to be willing to examine the facts more closely than courts.

In North River Insurance Co. v. ACE American Reinsurance Co. , 361 F.3d 134 (2d Cir. 2004), the Second Circuit Court of Appeals held that the follow-the-fortunes doctrine extends to a post-settlement allocation decision, even if it is inconsistent with the reinsured's pre-settlement assessment of the risk. Similarly, in Travelers Casualty & Surety Co. v. Gerling Global Reinsurance Corp. , 419 F.3d 181 (2d Cir. 2005), the Second Circuit found that an allocation by the cedent that maximizes reinsurance recovery does not necessarily constitute bad faith. In fact, the court stated that “An allocation that increases reinsurance recovery ' when made in the aftermath of a legitimate settlement and when chosen from multiple possible allocations ' would rarely demonstrate bad faith in and of itself.” Travelers left unanswered the question of what constitutes a reasonable settlement, but it indicates that whether an allocation is reasonable must be viewed in light of the context of case law prevailing at the time, and of the position advocated by the parties prior to the allocation.

After Travelers, courts have looked at the particular facts of each case to determine whether a cedent has acted unreasonably or in bad faith. In Allstate Insurance Co. v. American Home Assurance Co. , 837 N.Y.S.2d 138 (N.Y. App. Div. 2007), a New York state appellate court found that American Home's allocation on a single occurrence basis was unreasonable. In so holding, the court looked at several factual considerations: 1) that American Home and its insured had consistently espoused a multiple occurrence position; 2) that American Home had ignored a district court ruling that there were multiple occurrences at one of the sites at issue; 3) the allocation analysis was inconsistent; and 4) the determination that the allocation was inconsistent required neither an “intrusive factual inquiry” into the allocation, nor was Allstate “second-guessing” the settlement decision.

Finally, in Granite State Insurance Co. v. ACE American Reinsurance Co. , 849 N.Y.S.2d 201 (App. Div. 2007), a New York state appellate court denied summary judgment in favor of the reinsurer, as there were issues of fact regarding whether the cedent had engaged in bad faith by crediting an overpayment on one policy to the policy that was reinsured, even though it had initially disclaimed coverage on that policy.

Conclusion

It is clear that the follow-the-fortunes doctrine remains a powerful tool on behalf of cedents, protecting settlement decisions, amounts of settlements, coverage determinations, and good faith and reasonable allocations. Reinsurers face a heavy burden in challenging the good faith of a post-settlement allocation.

However, important limits exist that can erode the power of the doctrine. In determining whether a settlement or allocation is within the terms of the reinsurance agreement, courts will carefully examine the language and scope of the coverage. A cedent cannot invoke the follow-the-fortunes doctrine where it has failed to take businesslike actions in settling a claim or where it has failed to provide timely notice. The follow-the-fortunes doctrine applies only to actual determinations of coverage. Finally, a reinsurer need not follow the fortunes of the cedent's allocation where it was not made in good faith or was unreasonable.

John M. Nonna, a member of this newsletter's Board of Editors, is a partner at Dewey & LeBoeuf. LLP. He is co-leader of the firm's Insurance and Reinsurance Dispute Resolution Practice and a fellow of the American College of Trial Lawyers. Victoria Melcher is an associate at the firm.