Updating reinsurance law developments: the gloves are beginning to come off.

• Author: Monin, Lawrence O.

ALTHOUGH reinsurance has existed for centuries, the body of reinsurance law is immature because until fairly recently virtually all disputes between ceding companies and their reinsurers were resolved amicably by business people within the context of preserving and extending long-term business relationships. Reinsurance was a business of honorable undertakings in which the handshake was king. In recent years, however, the handshake has been dying. More and more reinsurance disputes are being resolved either in court or in litigated arbitrations.

The reasons for this increased litigiousness are several, including principally that

* the business is no longer conducted by a small and friendly club, as many more market participants exist now than 30 years ago;

* the ability to resolve disputes within the context of long-term business relationships has decreased substantially as many market participants are now "running off" books of business and others have alternative reinsurance options; and

* the amounts in dispute, which primarily arise from environmental damage and toxic tort litigation, are often so large that friendly compromises can't be reached.

With this increase in reinsurance disputes, the relevant law has undergone significant development. What makes following these developments especially interesting is that the body of reinsurance law is national and international in scope, rather than state based, like most areas of law. Moreover, because the law is so immature, cases at even the trial level or in non-precedent setting arbitrations are followed and given significance.

WHAT'S HAPPENING

The new developments are in three key areas - process disputes; substantive legal disputes; and transaction-intensive disputes.

1. Process Disputes

   Many reinsurance agreements require disputes to be resolved by binding arbitration. In recent years, considerable developments have occurred in the law of arbitration, both within reinsurance and in other contexts. Since arbitrations themselves have become litigious and costly, and since the decisions of arbitrators are generally not subject to later review, considerable debate has arisen as to what process is preferable - arbitration or litigation.

2. Substantive Legal Issues

   There are two burning substantive legal issues.

   1. Declaratory Judgment Expenses

      Can an insurer that spends large amounts of money contesting coverage with its insured later share these coverage litigation costs with its reinsurers as an allocated loss adjustment expense?

   2. Reinsurance for Environmental

      Cleanup and Toxic Tort Settlements

      In recent years, insurers have begun settling with insureds who have been charged with polluting the environment or injuring people with toxic products. From a reinsurance point of view, the problem in that these are generally "global" settlements in which the insurance company ends all disputes it has with its insured under all policies for all years for all allegations of environmental or toxic injury. Many questions are raised as settling insurers try to pass portions of these settlements on to their reinsurers. These include questions as to the number of insured occurrences, whether reinsurers should pay for policy buybacks, whether reinsurers should pay for what may be perceived as business or economic settlements, and how much of these settlements should be allocated to each policy year.

3. Transaction-intensive Disputes

   For the most part, resolutions of transaction-focused disputes have been put on back burners. But as questions over the process and underlying legal issues are resolved, increased attention will be given to the underlying facts that precipitated these reinsurance collection disputes. The underlying disputes are of two main types.

   1. Poor ("Bad Faith") Claims Handling

      If, as a result of apparent poor claims handling, a ceding company must pay a very large judgment, should its reinsurers be forced to "follow its fortunes"?

   2. Fraudulent Business Dealings

      A number of major disputes have arisen, and the reinsurers have attempted to rescind or otherwise avoid responsibility for participation in reinsurance programs on the ground that they were fraudulently induced to reinsure or that the underlying program was mismanaged.

      PROCESS DISPUTES

      Almost three-quarters of reported reinsurance disputes have focused on the process itself. These disputes have involved a variety of subjects, including whether state law can invalidate a pre-dispute arbitration agreement, what issues can be encompassed by an arbitration, what remedies can be imposed by the arbitrators, on what grounds can arbitrators be disqualified, and whether arbitrators are required to follow earlier precedents.

      These issues, of course, are all preliminary to getting down to the substance of the underlying disputes. In fact, many of the reported decisions almost appear to be silly, as almost every position imaginable has been asserted. For example, when a party-appointed arbitrator withdrew after being challenged, the opposing party that had successfully challenged the arbitrator had the chutzpah to assert that it should be permitted to appoint his replacement. Of course, the court rejected this contention.(1) In such cases, a great deal of effort has been expended while the parties argue about the process and jockey for position around the negotiating table.

      During the past year, the U.S. Supreme Court issued three rulings of great significance to arbitrations in general - Allied-Bruce Terminix Cos. v. Dobson,(2) Mastrobuono v. Shearson Lehman Hutton Inc.(3) and First Options of Chicago v. Kaplan.(4) These decisions should lay to rest many of the disputes over the "process" and, it is to be hoped, help disputants move on to the underlying contentions.

1. Allied-Bruce

   In a 6-3 decision authored by Justice Breyer, the Supreme Court followed and elaborated on its 1984 decision in Southland Corp. v. Keating.(5)

   The Alabama Supreme Court had applied an Alabama statute to invalidate a pre-dispute arbitration clause contained in a homeowners "termite inspection" contract. In applying the state statute, the Alabama court concluded that the Federal Arbitration Act (FAA) was inapplicable since the termite inspection contract did not involve sufficient interstate commerce to trigger the FAA's applicability.

   The Supreme Court reversed, reaffirming Southland, which held that the FAA established a federal body of substantive law that preempts state law and applies to disputes before both the federal courts and the state courts. The Court went on to explain the interstate commerce linkage necessary to trigger the applicability of the FAA. By its terms, the FAA applies to written arbitration agreements "involving commerce." The Court ruled that this meant commerce "in fact" - the connection with interstate commerce need not. have been contemplated by the parties - and the Court equated the FAA's term "involving commerce" to the term "affecting commerce" used in the federal Constitution's commerce clause.

   Thus, the Court held, the FAA extends to the full reach of the commerce clause. For example, the Court noted that no question was raised in this case as to the involvement with interstate commerce since the termite treating and house repairing material used by Allied-Bruce came from outside Alabama.

   Although dissenting, Justice O'Connor stated that for stare decisis reasons she would follow this ruling in the future. Her dissent was on the ground that she did not believe Congress, when it enacted the FAA in 1925, intended for it to extend beyond the federal courts. In agreeing to follow this decision in the future, she has effectively created a 7-2 majority behind it.

2. Mastrobuono

   At about the same time, the Court handed down a second major arbitration ruling, this 8-1 decision being written by Justice Stevens.

   The Mastrobuonos, Illinois residents, entered into a standard securities management...