Reinsurance disputes: death of the handshake.

• Author: Brady, Michael J.

PRIOR to the 1980s, there were few reinsurance disputes, and almost all were resolved informally. In those good old days, when the handshake was king, the insurance and reinsurance communities comprised a small gentleman's club in which the participants often knew each other personally. Transactions were relatively straightforward--usually involving only two parties--and business relationships were of long standing. Although reinsurance agreements were skeletal and often formally documented long after they were bound, there was an accepted code of conduct between insurers and their reinsurers embodied in the precepts of "an honorable undertaking," "utmost good faith" and "follow the fortunes."

The few disputes that did arise usually were settled by business people who were concerned more about long-term relationships than short-term outcomes. Ceding companies generally saw reinsurers as partners entitled to a profit. If a reinsurer was called on to pay a questionable loss today, it was understood that the reinsurer would recover the loss by charging higher rates tomorrow.

NEW DAWN HAS UNFOLDED

But the last decade has witnessed a dramatic change. The number of reinsurance disputes has grown at an exponential rate, and more and more they are being resolved formally by litigation or arbitration, rather than by business people.

This change results from a variety of factors. The club, for one, is no longer small. There are many new players. They frequently do not know each other well. Business relationships may be episodic. Many decisions are driven by a short-term profit objective rather than a partnership tradition.

The financial magnitude of disputes now often are enormous. Not only are the dollars at stake in individual cases large, but reinsurers are concerned that their payment of an individual claim may create a precedent obligating them to pay many others. In addition, they are concerned that their retrocessionnaires may resist supporting them on claims they do pay.

Finally, the types of disputes between reinsurers and their ceding companies also have changed. Traditionally, liability reinsurers contemplated large, third-party injury accidents that occurred at defined points in time--such as explosions and collisions. Instead, reinsurers are now being called on to pay for costly and volatile coverage and bad faith disputes between insurers and their insureds, and to participate in "global" settlements involving many insurers and many years of potentially applicable coverage. Standard reinsurance arrangements were not designed with these types of problems in mind.

As a result, reinsurance disputes have both multiplied and become more contentious. Moreover, since many reinsurance arrangements--especially reinsurance treaties--require binding arbitration, on many key issues there is scant legal precedent to guide disputants. Great attention therefore is given to the few available published opinions.

Care should be taken, however, in evaluating these precedents. Most of them arise under facultative certificates rather than the broader business relationships that exist under treaties. The results in many cases turn on unique contract provisions, and a number of the key decisions both in the United States and England seem to favor technical arguments over industry custom and broader public policy considerations.

THREE AREAS OF DISPUTE

Although the law is changing rapidly on many reinsurance-related issues, three major areas are particularly noteworthy:

* Should a reinsurer be liable for declaratory judgment expenses when its cedent contests coverage with its insured?

* When can a reinsurer object to liability based on the cedent's handling of claims?

* How should multi-policy-year "global" settlements and policy buy-backs be apportioned between a ceding company and its reinsurer?

* Some recent cases are instructive on these issues.

LIABILITY FOR DECLARATORY JUDGMENT EXPENSES

1. Background

   Until the 1980s, declaratory judgment actions in which insurers contest coverage with their insureds were fairly infrequent, and when they did arise, they generally were litigated in a relatively inexpensive and straightforward manner. In the last decade, however, the number, costs and complexity of declaratory judgment actions have multiplied.

   The main contributor has been environmental property damage and toxic tort litigation, in which declaratory judgment expenses often total millions of dollars. This phenomenon, moreover, has extended into other areas of coverage law as well, including complex litigation, for example, in which coverage is sought under advertising injury or personal injury coverages.

   The carriers that have incurred declaratory judgment expenses now seek contribution from their reinsurers. And although millions of dollars are at stake, to date there is no modern case law directly on point.

2. Affiliated FM

   An important declaratory judgment test case is pending in Massachusetts--Affiliated FM Insurance Co. v. Constitution Reinsurance Corp.(1) An Equal Employment Opportunity Commission claim was brought against Campbell Soup Co., which was Affiliated's insured. Affiliated contested coverage in a declaratory judgment action that it eventually won. Having avoided paying any loss under its policy, Affiliated then requested Constitution Re to bear 15 percent of the costs of the declaratory judgment action. Affiliated insured Campbell under three successive one-year excess umbrella liability policies. Constitution Re assumed 15 percent of Affiliated's $10 million limit, and received 15 percent of the total premium paid to Affiliated. In addition, Constitution Re paid Affiliated a 22.5 percent ceding concession, presumably to compensate it for acquisition and other expenses.

   Constitution Re declined to pay the declaratory judgment expenses requested by Affiliated. Its position was tried to a Massachusetts state court judge, who ruled that Constitution Re was correct. The Massachusetts Supreme Judicial Court elected to review the case without benefit of intermediate appellate review, because it was an important matter of first impression. In January 1994, it reversed and remanded, ordering the trial court to consider industry custom and practice, with two of the six judges dissenting that the reinsurer was not liable for declaratory judgment expenses.

   Here is a comparative outline of the arguments presented by the cedent (Affiliated) and its reinsurer (Constitution Re).

   1. Reinsurer's Arguments

      Neither settlement nor loss adjustment expense. The reinsurer promised to pay only loss settlements and investigation and settlement expenses; declaratory judgment expenses are neither. A reinsured's "investigation" expenses are for "investigating on behalf of the insured," not for "litigating against" the insured.

      Follow the fortunes. This doctrine does not expand the scope of policy coverage. Follow the fortunes binds the reinsurer to good faith settlement of matters that are within coverage, not matters that are outside the terms of coverage.

      Business expense. Declaratory judgment expenses are unreinsured "business expenses." The ceding commission compensates the ceding carrier for these expenses, and the ceding carrier bears sole responsibility for any litigation expenses required to clarify its policy language.

      Limited by underlying policy obligations. The reinsurer's obligations "shall be subject . . . to all terms and conditions of the company's policy"--that is, the underlying reinsured policy. Declaratory judgment expenses do not flow from fulfilling obligations imposed by the reinsured policy, but instead are incurred in resisting obligations asserted under the reinsured policy.

      Contractual conditions should be strictly construed. Contractual limitations in reinsurance agreements should be strictly construed in the same manner as conditions in other negotiated business arrangements are enforced.(2)

      Sophisticated parties. Reinsurers and insurers are sophisticated. The facultative certificate should not be construed against the drafting reinsurance company. Had the reinsurer intended to include declaratory judgment expenses, the parties could have so provided.

      Contract unambiguous. No evidence of industry custom and practice is needed.

      Equity. Declaratory judgment actions benefit a cedent's entire book of business by clarifying terms used in the cedent's policies. A facultative reinsurer, which reinsures only a specific risk, should not be asked to bear the cost of declaratory judgment actions that bear on the cedent's entire book. Moreover, fears of potential abuse by reinsurers are overstated. Reinsurers that unreasonably insist on the commencement of declaratory judgment actions could be held to participate in the costs of defense.

   2. Cedent's Arguments

      Equity. By vigorously resisting questionable coverage, ceding companies are protecting the interests of reinsurers, who should not get a "free ride."(3)

      Investigation expenses. Declaratory judgment expenses can be "investigation expenses." Declaratory judgment actions often involve identifying and evaluating issues relevant to the underlying claim. These are covered investigation expenses.

      Loss adjustment expenses. Declaratory judgment expenses are allocated loss adjustment expenses arising directly from the claims adjustment process.

      Follow the fortunes. A reinsurer is bound to follow the reinsured's fortunes if the reinsured's actions are instituted in good faith. Moreover, a cedent often must institute a declaratory judgment action in order to avoid extra-contractual exposure. The cedent's actions, therefore, are part of the defense and adjustment of the underlying claim.

      Ambiguity. When reinsurance contracts or certificates have been drafted by the reinsurer, ambiguities should be construed in favor of the reinsured. The facultative certificate at issue in Affiliated was on a form widely used in the reinsurance business.

      Custom and practice. Industry...