Common reinsurance issues: follow the fortunes, late notice and rescission.

• Author: Hummer, Paul M.

Law is evolving in each of these areas, while courts seek to balance cedents' expectations with reinsurers' contract rights

THERE are three legal issues that are common to many reinsurance disputes--follow the fortunes, late notice, and rescission. The law in each of these areas, while still evolving, attempts to balance the cedent's expectation that it will be reimbursed with the reinsurer's right to rely on the terms of the reinsurance agreement and on the good faith and diligence of the cedent in both the underwriting and claims handling process.

FOLLOW THE FORTUNES

1. Use

   Many reinsurance agreements contain a follow the fortunes clause, which provides that all settlements pursuant to the underlying insurance are binding on the reinsurer.(1) Even when a follow the fortunes provision is not expressly included in the agreement, courts have implied such a condition.(2) Courts also have applied the doctrine to both facultative and treaty reinsurance.(3)

   Notwithstanding this widespread recognition of the doctrine, decisional law on its parameters is still developing. A federal district court in New York refused to vacate an opinion on the issue, even though requested by the parties who had reached a settlement following the decision, noting "that the important public interest in the development of decisional law definitively outweighs the settlement interests of the parties here."(4)

2. Purpose

   The follow the fortunes doctrine is generally understood to mean, as stated in National American Insurance Co. v. Certaint Underwriters at Lloyd's London, that a reinsurer "may not challenge the reinsured's good faith and studied decision to pay on a claim that is arguably subject to the coverage of a valid insurance policy."(5) The Third Circuit declared in North River Insurance Co. v. Cigna Reinsurane Co. that the doctrine prevents "reinsurers from second guessing good-faith settlements and obtaining de novo review of judgments of the reinsured's liability to its insured."(6) The North River court also stated that the follow the fortunes doctrines is broader than the obligations imposed by a "following forms" clause, which obligates the reinsurer only to cover risks insured under the reinsured policy, adding that it obligates a reinsurer to indemnify "all payments made in good faith that are reasonably within the scope of the policy's coverage."

   The decision whether a payment is reasonably within the scope of coverage is made by the cedent. In discussing the scope of a cedent's obligation to its reinsurer, the federal district court in Aetna Casualty & Surety Co. v. Home Insurance Co. stated:

   The reasoning that undergirds the "follow the settlements" doctrine does not require that a ceding company pursue every defense in litigation against the insured, however close a call the particular policy defense might be. Quite the contrary: subject to the ceding company's duty of utmost good faith, and the requirement that investigations such as the one conducted by [the cedent] be reasonable and businesslike, the doctrine leaves it to the ceding company to make the settlement decision in the first instance, which settlement is then binding upon the reinsurers.(7) The rationale for the doctrine is that allowing reinsurers to relitigate coverage issues would put cedents in the untenable position of having coverage defenses that they might initially have advanced in defense of an insured's claim used against them by reinsurers seeking to disclaim liability for a subsequent settlement of the claim. The North River court observed, "Without '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."(8)

3. Limits

   Notwithstanding the broad scope of the doctrine, courts generally have been careful not to allow the doctrine to overwhelm the remainder of the reinsurance agreement. For example, in Bellefonte Reinsurance Co. Aetna Casualty & Surety Co., the Second Circuit rejected a cedent's argument that the follow the fortunes doctrine obligated its reinsurers to pay more than the limits of liability specified in the reinsurance agreement, noting that the cedent's argument "would strip the limitation clause and other conditions of all meaning; the reinsurer would be obliged merely to reimburse the insurer for any and all funds paid."(9)

   The Third Circuit in North River expressed the limits of the doctrine:

   "Follow the fortunes" clauses prevent reinsurers from second guessing good-faith settlements and obtaining de novo review of judgments of the reinsured's liability to its insured. But while a "follow the fortunes" clause limits a reinsurer's defenses, it does not make a reinsurer liable for risks beyond what was agreed upon in the reinsurance certificate. In that regard, the reinsurer retains the right to question whether the reinsured's liability stems from an unreinsured loss. A loss would be unreinsured if it was not contemplated by the original insurance policy or if it was expressly excluded by terms of the certificate of reinsurance.(10) The follow the fortunes doctrine is limited by a cedent's duty of utmost good faith. There are, however, few reported decisions exploring the limits of the duty of good faith in this context. In North River, the Third Circuit held that the duty of good faith "requires the reinsured to align its interests with those of the reinsurer," but that to avoid an obligation to "follow" a settlement on the grounds that it was not made in good faith, a reinsurer must establish that the settlement was the result of "gross negligence or recklessness" on the part of the cedent and that the reinsurer suffered "economic prejudice" as a result. The court went on to rule that "bad faith requires an extraordinary showing of a disingenuous or dishonest failure to carry out a contract." The reinsurer bears the burden of proving that the cedent acted in bad faith.(11)

4. Scope of Judicial Review

   Courts have limited the scope of judicial review of a reinsurer's argument that it is not bound by a cedent's settlement of a claim. In Aetna Casualty & Insurance Co. v. DR Insurance Co., the federal district court described the standard of review as a "court need only address whether an insured's request for payment from its reinsurer is made in good faith, is arguably within its policy, and does not exceed the reinsurer's liability cap."(12) The Third Circuit described the standard as a "deferential review of a determination of the insurer's liability to the insured."(13)

   Nonetheless, reviewing courts have struggled to draw the line between paying deference to a cedent's good faith determination of coverage and preserving a reinsurer's right to avoid paying for losses that were not reinsured. North River involved a claim by the cedent to recover from a reinsurer defense costs paid by the cedent to the insured. The Third Circuit recognized that the dispute between the cedent and its reinsurer raised competing principles:

   On the one hand, in order to preserve "follow the fortunes" doctrine, courts may not conduct de novo review of a judgment imposing liability on the insurer. On the other, to protect the contractual intent of the parties, courts must reexamine the judgment to determine whether the liability represents a risk not contemplated by the terms of the underlying policy as reinsured.(14) The court outlined what it termed a "deferential" standard of review of the cedent's coverage determination, but it held that "we do not believe that asking whether the risk was unreinsured is tantamount to de novo review." The court then went on to examine in great detail whether the defense costs were covered under the reinsured policy. Ultimately solving its dilemma by imposing on the reinsurer the burden to establish that the relevant state law "unambiguously provides that the policies do not pay defense costs," the court reversed a summary judgment in favor of the reinsurer after finding that the reinsurer could not sustain its burden to establish that the requested defense costs were "clearly outside the policy as reinsured."

   LATE NOTICE

1. Purpose

   Many reinsurance agreements contain provisions requiring cedents to give "immediate notice" or notice "as soon as practicable" upon knowledge of an occurrence "likely to give rise to a claim" under the reinsurance agreement.(15) Courts have recognized that the notice clause serves a number of different purposes, including enabling a reinsurer to set appropriate reserves and associate in the defense of claims.(16)

   In Unigard Security Insurance Co. v. North River Insurance Co., the Second Circuit...