As the international reinsurance industry moves forward to the twenty-first century, there is a need for a uniform approach to the analysis of reinsurance claims practices. Mitchell L. Lathrop suggests an approach which may meet that need.
As mergers and acquisitions continue unabated in the world's reinsurance market and smaller players are threatened with an inability to compete in a soft market, little attention has been paid to a rapidly growing trend: manipulation of billings by cedants to reinsurers to maximize reinsurance recoveries. In some cases such billings are the result of honest mistakes or reasonable, good faith interpretations of the wording of reinsurance contracts. In others, however, they are deliberate fabrications, concealments or billings designed to mislead.
Consider, for example, a cedant which bills its reinsurer for extra-contractual damages imposed on the cedant for bad faith, but reports the loss as covered by the reinsurance agreement. A variant on the theme is the assignment of loss for reinsurance purposes to the most heavily reinsured policy whereas the actual loss was shared between several policies, many of which had greater retentions by the cedant. Perhaps changing the number of occurrences on the reinsurance billing for losses in a long-tail environmental case will yield similar windfalls for the cedant. Unusual, you say? Regrettably such conduct is becoming ever more common as the face of the insurance industry changes and long-standing and proven relationships are cast aside. The most well-known recent case involving such conduct is US v Brennan.1
The case involved the loss of an aircraft and its passengers when a disgruntled former employee of the airline, Pacific Southwest Airlines (PSA), managed to get through security and board an aircraft with a loaded .45 caliber pistol. During the flight, the ex-employee shot the supervisor who had fired him and then killed the pilot and co-pilot. The plane crashed killing all aboard.
During the resulting trial of the liability claims brought by the families of the passengers, defense counsel repeatedly reported that liability would probably be shared between the security service and the airline. The case was settled before verdict. Then came the reinsurance billings.
US Aviation Insurance Group (USAIG) insured both PSA and the security service. The security service policy was 75% reinsured, while PSA policy was 100% reinsured. The president of USAIG, Mr Brennan, assigned 100% of the loss to the PSA policy, resulting in the saving of some $7 million in losses to USAIG. This time, however, the scheme failed. Mr Brennan and USAIG were indicted on forty (40) counts of mail fraud, one count for every telex which had been sent with the improper allocation of 100% of the loss to PSA. Mr Brennan was convicted on all counts and sentenced to almost five years' confinement.
The Brennan case is currently on appeal to the US Court of Appeals for the Second Circuit, probably the most knowledgeable appellate body in the United States on insurance and reinsurance issues. The trial court held that the relationship between a cedant and its reinsurer rose to the level of a fiduciary relationship, and that will be the key issue on appeal.
Numerous cases both in the United States and the United Kingdom have considered the reinsurance doctrine of uberrima fidei, or "utmost good faith," in the context of applications for reinsurance. Indeed, the concept is as old as reinsurance itself. A prospective reinsured must disclose to underwriters everything that the prospective reinsured knows, or reasonably should know, would be material to the underwriters in making the decision on whether to accept the particular risk. Failure to do so may entitle the reinsurer to void the reinsurance contract ab initio.
Unlike the application situation, there are almost no cases which have considered the application of "utmost good faith" to the claim situation. The Brennan court applied a fiduciary duty standard when arguably the "utmost good faith" standard could have yielded a similar result, at least in respect of civil consequences. The use of criminal proceedings under the circumstances of the Brennan case is highly unusual and seems certain to cause confusion in the final analysis regardless of how the appeal is decided. As the old adage goes, "Hard cases make bad law," and the Brennan case is certainly "hard" in that sense.
When challenged on their reinsurance billings, cedants frequently argue that the reinsurer is obligated to "follow the fortunes" or "follow the settlements" regardless of the circumstances. Such a sweeping and all-encompassing interpretation of those two concepts has never been the law, either in the US or the UK.2 American courts have been particularly confused by these concepts, as evidenced by the strange turnaround of the US Court of Appeals for the Ninth Circuit in National American Insurance Company of California v. Certain Underwriters at Lloyd's.3 The case involved an action brought by National American Insurance Company of California (National) to collect on two reinsurance contracts issued by various underwriters at Lloyd's (Underwriters). The reinsurance certificates were apparently lost, and consequently notice was not given to Underwriters until after the cedant had settled the underlying case. Underwriters sought to avoid the reinsurance contracts by asserting, essentially, that National failed to give timely notice and failed to obtain the Underwriter's written consent, which precluded National from recovering a pro rata share of the costs incurred in investigating and settling the underlying claim The district court entered summary judgment against Underwriters and Underwriters appealed. In its first decision,4 the Ninth Circuit affirmed, holding (1) that Underwriters must show actual prejudice as a result of late notice, (2) that the existence of the reinsurance contracts had been proved, and (3) that Underwriters were obligated to "follow the fortunes" of the cedant even though there was no "follow the fortunes" clause in the reinsurance contracts. The court determined that "follow the fortunes" is implied in every reinsurance contract. In a correction,5 the court observed: "National presented expert testimony that 'follow the fortunes' clauses were not generally included in reinsurance policies prior to the mid-1970s, and that prior to that time the principle embodied by the 'follow the fortunes' doctrine was widely understood within the industry to be a tacit part of every reinsurance agreement." Almost one year later, however, the Ninth Circuit withdrew the original opinion and the correction, and remanded the case to the district court for a trial on custom and practice, and a determination of whether "follow the fortunes" was, in fact, implied in the contract in issue. The court found "a genuine issue of material fact whether there existed a custom or usage to 'follow the settlements' at the time the certificates were made. We so conclude notwithstanding the Underwriters' tenacious reliance on 'the law' in favor of their claim and their studied reluctance to advance Mr Dunlap's declaration in their favor. Based on an assertive amicus brief filed by the Reinsurance Association of America after our original opinions in this case, and our own review of the record and cases, we now find a factual question as to whether there existed within the facultative insurance industry prior to the 1970s a custom or usage to 'follow the settlements'. Accordingly, a trial is necessary on this issue." 6
As the international reinsurance industry moves forward to the twenty-first century, there is a need for a uniform approach to the analysis of reinsurance claims practices. It is suggested that the following proposal may meet that need. Whether a particular conflict between a cedant and its reinsurer is being resolved by a court or by arbitration, the threshold question in every instance should be: "Have both parties acted with utmost good faith?" If the question can be fairly answered in the negative with respect to either party, then that party found to have breached the requirement of utmost good faith should forfeit its rights under the reinsurance contract. In other words, if the cedant has acted in bad faith in the submission of its claim, it will either be denied recovery on the claim or the reinsurance contract may be declared void ab initio depending upon the circumstances and the gravity of the breach. Conversely, if the reinsurer has acted in bad faith, then the cedant should be permitted to recover not only the amount it is due under the reinsurance contract, but also its costs and attorney fees together with interest from the date of the breach. By considering the issue of utmost good faith at the outset, courts and arbitrators handling reinsurance disputes may be able to reach a more prompt resolution while at the same time reinforcing an essential reinsurance doctrine.
If both parties are found to have acted with utmost good faith, then the applicability of "follow the fortunes" or "follow the settlements" can be considered in light of the specific contract wording. By approaching every dispute from the standpoint of uberrima fidei in the first instance, judges and arbitrators will put the insurance industry on notice that this foundational doctrine is alive and well. To countenance manipulations by either party designed to artificially alter what was intended to be the true benefit of the bargain harms the entire fabric of reinsurance, creates hopeless confusion, and increases the costs to everyone.
Mitchell L. Lathrop is a partner in the national law firm of Luce, Forward, Hamilton & Scripps, and divides his practice between the firm's San Diego and New York offices. He is the National Environmental Co-ordinating Counsel for a group of American (re)insurers, and handles (re)insurance matters throughout the country. He is a member of the American Board of Trial Advocates and a Certified Civil Trial Specialist by the National Board of Trial Advocacy. Among his published works are Insurance Coverage for Environmental Claims (Matthew Bender, New York, 1993), Environmental Insurance Coverage: State Law and Regulation (Butterworth Legal Publishers, 1992) and State Hazardous Waste Regulation (Michie Legal Publishers, 1993).
1. No. CR 95 0420, E.D.N.Y., filed May 5, 1996.
2. See, eg, Ins. Co of Africa v Scor (UK) Reinsurance Co, Ltd, 1 Lloyd's Rep. 312 (Q.B. 1985); Forsikringsaktieselskapt Vesta v Butcher, 1 Lloyd's Rep. 331 (House of Lords 1989); Bellefonte Reinsurance Co v Aetna Casualty & Surety Co, 903 F.2d 910, 913 (2d Cir. 1990).
3. 93 F.3d 529 (9th Cir. 1996).
4. No. 94-55047, 9th Cir, May 3, 1995, 1995 US App. LEXIS 16084.
5. No. 94-55047, 9th Cir., June 30, 1995, 1995 US App. LEXIS 16084.
6. Id, slip op. at 22-23.