Industry Custom and practice versus judicial fiat: Something's gotta give.
By Eugene Wollan, ESQ.
There is a conflict in the reinsurance business, and neither side is budging. The dispute? Whether expenses are within or in addition to the limits of a facultative reinsurance contract. Industry custom and practice says "in addition"; the Second Circuit says "within." Players in the reinsurance business need to know which voice is louder.
When an irresistible force such as you
Meets an old immovable object like me,
You can bet, as sure as you live,
Something's gotta give,
Something's gotta give,
Something's gotta give. (1)
What happens when an irresistible force meets an immovable object? In the words of the immortal poet (and lyricist) Johnny Mercer, "Something's gotta give." But which something?
The reinsurance business has recently generated a less lyrical version of the question. One of the special characteristics of reinsurance has always been its heavy emphasis on tradition or, to tap a familiar phrase, "industry custom and practice." Call "industry custom and practice" the immovable object, and call directly contrary case law the irresistible force. Not even Johnny Mercer can tell us with certainty which of them will prevail in the long run. But if I were a betting man, "I'd put about $75 on the irresistible force.
Within or In Addition
The current tension between industry practice and judicial fiat arises out of the debate over whether expenses are within or in addition to the limits of a facultative reinsurance contract. Every facultative certificate, for rather obvious reasons, sets forth a limit of the reinsurer's liability. Most certificates also embody language, in one form or another, requiring the reinsurer to pay its share of "expense," meaning loss adjustment expense, legal fees, and the like. (We will pass over the hot topic of whether it includes declaratory judgment expenses, as that subject calls for a column of its own and, no matter what view I hold, expressing it will make me enemies.) Finally, most certificates also incorporate some formulation of the follow-the-fortunes or follow-the-settlements principle, which would probably be read into the contract even if it is not articulated.
The understanding in the reinsurance world since time immemorial has been that the reinsurer's share of expense is not charged against its limit of liability--in other words, the expense is in addition to the limit. Then along came Bellefonte Reinsurance Co. v. Aetna, 903 F.2d 910 (2nd Cir. 1990).
The Second Circuit held that the limit of liability applied overall.
Bellefonte was decided in 1990 by the U.S. Court of Appeals for the Second Circuit. It held that expense was within--i.e., subject to--the limit. The cedant in that case relied heavily on the phrase in the certificate calling for the reinsurer to pay its proportion of the liability "in addition" to its share of expense. But the Second Circuit was not persuaded and held that the limit of liability applied overall, capping what the reinsurer must pay the cedant. Industry practice continued undeterred, however.
Next came Unigard Security Ins. Co. v. North River Ins. Co., 4 F.3d 1049 (2d. Cir. 1993), decided by the same court in 1993. The court reaffirmed the Bellefonte rule--and even displayed a bit of petulance that the lower court (which it reversed) had gone the other way, especially so soon after Bellefonte.
Still, the immovable object of custom and practice remained unaffected. In at least one unreported arbitration involving precisely the same certificate form as in Bellefonte and Unigard, the panel unanimously went down the line for custom and practice--the Second Circuit be damned. How many more such situations there have been, this writer knoweth not?
Strike Three, You're--Wrong
July 1997 brought us another court decision that not only relies on Bellefonte and Unigard, but seemingly expands their application beyond the specific form of the certificate. The case is Allendale Mutual Insurance Company v. Excess Insurance Company, Ltd., No. 95 CIV. 10970, 1997 WL 379683 (S.D.N.Y. July 8, 1997), and it was decided by Judge Scheindlein in the Southern District of New York (which, for the benefit of readers without a U.S. circuit court map is in the Second Circuit and, therefore, is obliged to follow Second Circuit decision).
Telescoping the facts: Allendale fronted a coverage that was reinsured in part by certain U.K. reinsurers for $7,000,000 (the "limit"), part of the $14,500,000 layer between $25,000,000 and $38,500,00. When the loss payment exhausted the limit, Allendale sought to recover from these reinsurers an additional $5,000,000 for their share of loss adjustment expense and litigation costs.
Judge Scheindlein saw her task as resolving an apparent, although not actual conflict between the limit clause and the follow-the-settlements clause. She turned to basic principles of contract construction for guidance:
I begin the analysis of this question which a recitation of certain contract law fundamentals. "The cardinal principle for the construction and interpretation of insurance contracts--as with all contracts--is that the intentions of the parties should control." To determine the parties' intent, the contract must be read as a whole, and all its clauses must be considered together to determine if and to what extent one may modify, explain, or limit another. From this, it follows that a contract containing two clauses which may be in conflict should, if possible, be read to give meaning to both rather than to prefer one to the exclusion of the other. This is especially true when interpreting contracts drafted by sophisticated and experience entities, for such are not likely to inadvertently write meaningless, contradictory, or vestigial language into a contract.Judge Scheindlein went on to point out that, if the parties had intended a contrary result, they could easily have made that result clear. For example, the parties could have introduced the follow-the-settlements clause with such language as "notwithstanding any provision to the contrary in this contract." Without that language, the judge admonished:
--a straight-forward reading of the contract as a whole requires the opposite conclusion. The limitation clause comes before any other substantive provision of the reinsurance agreement, and the work "LIMIT" is both underlined and set apart physically from the following "CONTIDITONS." The term "LIMIT" is not expressly conditioned by another term in any way. Given the absence of any indication that any clause in the contract modified the words "LIMIT: $US 7,000,000," the most reasonable construction of the contract's language supports [the] defendants' position that the limit clause imposes an absolute cap on their liability at $7,000,000 in toto.Respecting Industry Practice
Judge Scheindlein also invoked industry practice, but with a different spin from the one that says expense should be paid in addition to limits:
This reading of the reinsurance agreement is buttressed by an understanding of the traditional role of follow-the-settlement clauses in the reinsurance industry. Such clauses generally reinforce what has been until recently the general practice in this industry--that is, for reinsurers to conduct their business with insurers on a handshake basis, without second-guessing the insurer's decision to pay a claim. Their purpose is to "preclude wasteful re-litigation by a reinsurer of defenses to underlying policy coverage in cases where the ceding insurer has in good faith paid a settlement or judgment." Follow-the-settlement clauses have not traditionally served to modify or eliminate the limit of the reinsurer's exposure.Respecting Precedent
By the time the judge's analysis turned to Bellefonte and Unigard, the cedant's clause was obviously lost:
Both cases rejected ceding insurers' claims that a follow-the-settlement clause required the reinsurers to pay for defense costs in addition to the reinsurers' express reinsurance limit. The primary ground for these holdings was the court's finding that the insurers' proposed interpretation effectively read the limit clauses out of the reinsurance contracts. Bellefonte explained:Finally, Judge Scheindlein regarded the fact that Bellefonte and Unigard involved liability insurance and Allendale property insurance as a distinction without a difference:
"To read the reinsurance [contract] in this case as [the insurer] suggest--allowing the 'follow the fortunes'--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. The 'follow the fortunes' clauses in the [contracts] are structured so that they co-exist with, rather than supplant, the liability claim."Bellefonte, 903 F.2d at 913. In addition, Bellefonte relied on the express language of the contract at issue in that case, pointing out that the insurer's suggested interpretation "would negate the phrase 'the reinsurer does hereby reinsure Aetna...subject to the...amount of the liability set forth herein' and concluding based on that language that '[t]he reinsurers are liable only to the extent of the risk they agreed to reinsure.'" Id. at 914.
[T]he primary underpinning of both cases is the parties' assumed intent to give meaning to both the limit clause and the follow-the-settlement clause. To fulfill this intent, the reinsurers' duty to follow the settlement must be understood to be capped by the limit clause. "To construe the [contracts] otherwise would effectively eliminate the limitation on the reinsurer's liability to the stated amounts."
These arguments rely on the kind of "idiosyncratic factors" that Unigard teaches should not be considered in determining whether a follow-the-settlement clause may extend a reinsurer's liability beyond the stated liability limit, see Unigard, 4 F.3d at 1071, and cannot allow Allendale to evade the clear holdings of Bellefonte and Unigard with regard [to] the effect of a standard follow-the-settlement clause on a limit clause in a reinsurance contract.The Conflict That Lies Ahead
While the follow-the-settlement clause requires defendants to accept Allendale's good faith decisions to settle a case, and to pay their proportion of that settlement, it does not increase their potential liability in excess of the risk for which they bargained. As a matter of law, the limit clause must be interpreted to cap the reinsurers' liability to $7,000,000 including all of Allendale's costs and expenses. Hence, the terms of the reinsurance agreement preclude Allendale's claim for loss adjustment expenses in addition to its claim for $7,000,000 in unpaid reinsurance.
Many members of the reinsurance community were shocked by Bellefonte and Unigard, not because they ere inherently horrifying decisions, but because they ran in the face of long-standing industry practice. What we see in Allendale is a reaffirmation and expansion of the judicial position: The irresistible force continues to roll on. However, there is no clear indication that the immovable object has even begun to give way, and it may be some time before that starts to happen. Insurance and reinsurance folk can be awfully stubborn, but the Second Circuit in general and New York in particular are important insurance venues. I'm guessing the people in the long black robes will eventually succeed in laying down the law.
- SOMETHING'S GOTTA GIVE, by Johnny Mercer.
© 1954, 1955 (Renewed) WB Music Corp.Eugene Wollan, Esq., is a partner in the law firm, Mound, Cotton & Wollan, in New York, NY.
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