Follow The Fortunes: But Not For Ex Gratia Payments

In Lexington Insurance Co. v. Prudential Reinsurance Company of America, No. 95-4083 (Mass. Super., Suffolk Co. 1997), the Massachusetts Superior Court demonstrated that there are limits to the "follow the fortunes" reinsurance doctrine when a reinsured provides coverage for an insured's willful acts. Suffolk County Superior Court Justice Peter M. Lauriat's June 24, 1997 opinion in that case held that a reinsurer was not required to reimburse a comprehensive general liability insurer for its voluntary settlement with an insured accused of conversion, because that insurer's provision of coverage for its insured's willful act constituted an ex gratia payment.

In that case, the Union Bank of California was insured under a CGL policy by Lexington Insurance Company. Lexington in turn reinsured a portion of this risk with Prudential Reinsurance Company of America, now known as Everest Reinsurance Corporation. Union Bank was sued by numerous parties for fraudulent misrepresentation and a host of other claims related to a line of credit the bank had issued to an automobile dealership. It was alleged that the Union Bank had acted fraudulently in an attempt to pass on to other entities losses associated with this credit line.

Lexington's counsel eventually reached the conclusion that coverage could be found for Union Bank under a provision in the Lexington policy that covered "wrongful conversion." As a result, Lexington paid Union Bank four million dollars in satisfaction of all liability of Union Bank's claims against Lexington. Lexington then commenced an action against Everest seeking to collect the reinsurer's share of the liability and expenses. Both Lexington and Everest filed motions for summary judgment.

In assessing the reinsurer's liability, the court noted that as a general rule the "follow the fortunes" doctrine of reinsurance requires a reinsurer to provide coverage when the reinsured suffers losses as a result of litigation or settlement. Thus, the court said, the insured and reinsured generally share the same fate and the reinsurer must accept, for the most part, the misfortunes that give rise to claims under the original risk. The court added, however, that this doctrine is inapplicable where the payment by the cedant was clearly and unambiguously outside the scope of its policy. Such a payment is considered ex gratia and does not bind the reinsurer.

The reinsurer's obligations were analyzed under California law because the Union Bank policy was domiciled in that state. Everest argued that it was not required to reimburse Lexington because Lexington was under no obligation to pay its insured pursuant to California Insurance Code § 533. This provision states that "[a]n insurer is not liable for a loss caused by the wilful act of the insured." Cal. Ins. Code § 533 (West 1998). The court noted that § 533 is a part of every California insurance contract, and has the operative effect of an exclusionary or exculpatory clause. It was determined by the court that § 533 would be applicable so long as the insured's conversion was deemed willful. The court concluded that conversion requires willfulness under California law, citing Collin v. American Empire Ins. Co., Inc., 26 Cal. Rptr. 2d 391, 404 (1994), where it was succinctly stated:

"[T]he essence of 'conversion' is the exercise of domination over the property of another, [and] virtually every court to consider the question has agreed that 'conversion' cannot occur accidentally."

Lexington, relying upon Clemmer v. Hartford Insurance Co., 151 Cal. Rptr. 285, 297 (1978), contended that in order for § 533 to be applicable the insured's act must not only be willful but must also be done with a "preconceived design to inflict injury." The court found that recent California decisions had moved away from the "preconceived design" standard and that the standard was inapplicable where the insured's wrongful act was inherently harmful. In addition, the court noted that the types of acts Union Band had allegedly committed, such as fraudulent concealment, had previously been found to trigger the application of § 533, citing Employers Insurance of Wausau v. Musick, Peeler & Garrett, 871 F. Supp. 381, 386, modified on other grounds, 948 F. Supp. 942 (S.D. Cal. 1994). Moreover, the court concluded that the application of California Insurance Code § 533 in this instance was in accord with general principles of insurance as CGL policies generally cover accidents and not intentional occurrences.

Although Lexington's decision to settle with its insured was found to have been made in good faith, Lexington's determination that it was obligated to pay its insured under the policy was legally incorrect. In determining that the insured was covered because it had committed wrongful conversion, Lexington had established that the insured's actions were by their very nature intentional. As a result, California Insurance Code § 533 excluded coverage for the insured's willful act. Thus the court ruled that Lexington's settlement with its insured was clearly outside the parameters of the Lexington policy and constituted an ex gratia payment. Accordingly, summary judgment was entered in favor of the reinsurer.

The implications of this opinion are clear. As an initial matter, a CGL insurer that provides coverage for the willful acts of its insured in California does so at its own peril. More importantly, the opinion demonstrates once again that reinsurers are required to follow the fortunes of their reinsureds only so far. Where, as here, the reinsured makes a payment that is outside the scope of its policy, the reinsurer will not be required to reimburse its reinsured for such an ex gratia payment.