Recent US court decisions mean that `follow the settlements' is not always implied in reinsurance contracts. By Robert S Soderstrom, DJ Sartorio, Bruce M Engel and Eileen Sloan Newlin.

A ppearing in US reinsurance contracts as early as the 1800s, `follow the settlements' clauses have long been a part of the risk-spreading function of reinsurance.1 Simply put, a `follow the settlements' clause provides that most claims-handling decisions of the cedant are binding on the reinsurer.2 It "requires reinsurers to reimburse the reinsured (or cedant) for payment of the settled claim so long as the payments were made reasonably and in good faith." International Surplus Lines Ins Co v Certain Underwriters and Underwriting Syndicates at Lloyd's of London, 868 F Supp 917, 921 (SD Ohio 1994) (`ISLIC'). `Follow the settlements' allows the reinsured the freedom of making good faith and reasonable claims-handling decisions without the risk of having to relitigate those issues with its reinsurer. Aetna Cas & Sur Co v Home Ins Co, 882 F Supp 1328, 1346 (SDNY 1995).

Whether an obligation to follow the reinsured's settlements applies in the absence of an express clause in the reinsurance contract has sparked debate and judicial scrutiny. Recently, in a pair of significant reinsurance decisions, the US District Court for the Southern District of Ohio in North River Ins Co v Employers Reinsurance Corp, 197 F Supp 2d 972 (S.D. Ohio 2002), and North River Ins Co v Employers Reinsurance Corp, 2002 US Dist LEXIS 11711 (June 3, 2002), held that absent an express clause, `follow the settlements' cannot be implied in a reinsurance contract either as a matter of law or based upon custom and practice in the industry.

North River Insurance Co (North River) issued excess liability insurance policies to Owens Corning Fiberglas Corp (OCF), a company that manufactured asbestos-containing insulation products. North River then entered into a facultative reinsurance agreement with Employers Reinsurance Corp (ERC). ERC agreed to indemnify North River for a percentage of North River's liability in the event that North River became obligated to satisfy claims submitted to OCF under one of the policies. No `follow the settlements' clause was included in the facultative certificate.

In the late 1980s and early 1990s, ERC paid certain amounts to North River following North River's payment to OCF for asbestos product liability claims. In 1998, OCF submitted additional claims to North River, asserting that in addition to asbestos product liability claims, it was liable to claimants who had been exposed to asbestos during OCF's installation of asbestos-containing products. North River initially contested OCF's claim for coverage, but eventually agreed to settle the `non-product' asbestos claims. North River then submitted a claim to ERC under the facultative certificate and later filed a breach of contract action against ERC for failing to pay.

The parties filed cross-motions for partial summary judgment on the issue of whether `follow the settlements' applied. North River argued that the duty to follow the reinsured's settlements is inherent in every reinsurance contract as a matter of law and that ERC was obligated to indemnify North River if its settlement with OCF was even arguably covered by the North River policy.3 North River relied on ISLIC, 868 F Supp 917, 920 (SD Ohio 1994), in which the court stated that: "It is commonly understood that reinsurers must `follow the fortunes' of their insured. This fact may be formally expressed in an agreement of reinsurance. Even if it is not, the `follow the fortunes' doctrine applied to all reinsurance contracts." (Citations omitted.)

The ISLIC court relied on Mentor Ins Co (UK) Ltd v Norges Brannkasse, 996 F 2d 506, 516 (2d Cir 1993), National American Ins Co of California v. Certain Underwriters at Lloyd's of London, slip op 91-4021 (CD Cal 1991) (`NAIC'), and a treatise authored by Henry D Kramer, The Nature of Reinsurance, in Reinsurance, 11-12 (RW Strain, ed 1980). ERC argued that these authorities did not support the ISLIC court's conclusion. First, the reinsurance contract at issue in Mentor contained an express `follow the fortunes/settlements' clause. It therefore did not address the issue of whether such an obligation was implied absent a clause. Second, the district court's decision in NAIC implying a `follow the settlements' clause was later reversed by the Ninth Circuit in National American Ins Co of California v Certain Underwriters at Lloyd's of London, 93 F 3d 529 (9th Cir 1996). The Ninth Circuit found genuine issues of material fact as to whether a custom to `follow the settlements' existed at the time the reinsurance contracts were entered into. Id at 537. Third, and finally, ERC contended that the Kramer article excerpt referred to the obligation to follow the reinsured's underwriting fortunes (or `follow the fortunes') and not to `follow the settlements'. ERC buttressed this last argument by pointing to another statement made by Mr Kramer, which indicated that he did not advocate a reading of a `follow the settlements' clause into every reinsurance contract.

ERC noted that in the case of Michigan Township Participating Plan v Federal Ins Co, 592 N.W.2d 760 (Mich Ct App 1999), the court rejected the ISLIC reasoning, finding that the ruling lacked authority for its `follow the settlements' conclusion. The Michigan Court of Appeals held that under Michigan law a `follow the settlements' clause could not be read into a reinsurance contract.

North River also relied on Aetna Cas & Sur Co v Home Ins Co, 882 F Supp 1328 (SDNY 1995), in support of its position that, as a matter of law, `follow the settlements' is inherent in every reinsurance contract. In Aetna, the court heard testimony on whether a `follow the settlements' clause is implicit in all reinsurance contracts based on custom and practice. In light of the lack of any evidence to the contrary from the reinsurer, the Aetna court held that "it is customary within the reinsurance industry for reinsurers to follow the claim settlement decisions of the ceding company even in the absence of an explicit loss settlement clause." Id at 1349-50.

In a thorough examination of the earlier cases, the North River court noted that, unlike in ISLIC and Aetna, expert testimony was offered by the reinsurer to refute the reinsured's argument that the `follow the settlements' principle was implied in every reinsurance contract as a matter of industry custom and practice. The court further distinguished ISLIC and Aetna on the basis that neither court was applying New Jersey law, which the North River court had deemed applicable. Based upon these factors, the court held that there was "no sound basis for applying the `follow the settlements' doctrine in this case as a matter of law." North River Ins Co v Employers Reinsurance Corp, 197 F Supp 2d 972, 986 (SD Ohio 2002).

North River also argued that the facultative certificate was governed by `follow the settlements' based on industry custom and practice as well as the actual intent of the parties. The court determined that, despite the absence of any ambiguity in the language of the contract, New Jersey law permitted the court to look beyond the face of the contract to determine the intent of the parties. The parties had submitted affidavit and deposition testimony of experts on reinsurance custom and practice as well as of individuals involved in the facultative certificate underwriting. Based on the evidence submitted by the parties, the court concluded that genuine issues of fact existed, and ordered a separate trial on this issue.

At trial, evidence was presented concerning whether the parties intended the facultative certificate to require indemnification for settlement losses in cases of disputed coverage. The ERC underwriter who drafted the certificate at issue testified that ERC only intended to be obligated to reimburse North River for settlements of claims actually falling within the scope of coverage of North River's policy with OCF. The court was persuaded that ERC had not intended its facultative certificate to indemnify North River for settlements of only arguably covered claims.

The parties each presented an expert witness to testify concerning reinsurance industry custom and practice. North River's expert, William J Gilmartin, testified that, when the facultative certificate was issued, "reinsurers would expect to follow the settlements of ceding insurers even in the absence of an express `follow the settlements' clause, unless there was fraud, collusion, bad faith, ex gratia payment or gross negligence in the handling of the claim." North River Ins Co v Employers Reinsurance Corp, 2002 US Dist LEXIS 11711, *14. ERC's expert witness, William C Hoffman, testified that "a reinsurance contract which is silent on the point does not impose an implied obligation on a reinsurer to `follow the settlements' of its reinsured and that there is no custom and practice in the industry which would impose such an obligation on a reinsurer." Id at *17. The court found that North River had failed to meet its burden that it was the custom and practice for reinsurers to honour a reinsured's good faith settlement of claims, unless the reinsurance contract contained an explicit `follow the settlements' clause. Id at *23, 24.

Having concluded that the parties did not intend a `follow the settlements' clause to be implied in the contract, and that there was no custom or practice in the reinsurance industry to do so, the court held that ERC was not required to indemnify North River for settlements of claims unless they were actually covered by the policy issued to OCF. Id at * 24.

Earlier cases that addressed the question of whether `follow the settlements' applies, absent an express clause in the reinsurance contract, seem to lack critical examination of the law, history and scholarship of the issue. As noted in Michigan Township, supra, the ISLIC decision - implying a "follow the settlements" clause as a matter of law - was predicated on a faulty analysis of the issue. The first North River decision presents the most careful analysis of the case law and treatises examining the issue to date, finding that a `follow the settlements' clause cannot be implied in a reinsurance contract as a matter of law.

The subsequent North River decision is the first case in which the issue of whether a reinsurer is bound to follow settlements based on custom and practice in the industry was tried with evidence presented from both sides. The trial court decision in NAIC and the Aetna decision implied `follow the settlements' clauses based on industry custom and practice. In both instances, however, the reinsured-proffered expert testimony of custom and practice was uncontroverted. Interestingly, the law applied in North River allowed for the consideration of extrinsic evidence despite the absence of any contractual ambiguity. Even under such liberal parol evidence rules, the North River decisions demonstrate that unless a `follow the settlements' clause is specifically written into a reinsurance contract, neither the law nor industry custom and practice will imply one.

What do the North River decisions mean for the insurance and reinsurance industries? Practically speaking, if you do not have a `follow the settlements' clause in your contract, it may not be implied. In other words, reinsurers have the right to challenge settlements entered into by their reinsureds and the reinsureds will have to prove that the claim is covered under the reinsured policy. As the clause is not implied, cedants should consider negotiating the inclusion of a `follow the settlements' clause in their reinsurance contracts to ensure that their good faith settlements are covered by reinsurance.

1 A `follow the settlements' clause typically recites that "settlements pursuant to the underlying insurance are binding on the reinsurer."

2 The term `follow the settlements' is frequently used interchangeably by courts with the term `follow the fortunes'. `Follow the fortunes', however, more accurately describes the obligation to follow the reinsured's underwriting fortunes, whereas `follow the settlements' refers to the duty to follow the actions of the cedant in adjusting and settling claims.

3 North River argued in the alternative that certain language in the facultative certificate could be interpreted as a `follow the settlements' clause. Specifically, North River pointed to the `right to participate' section of the contract claiming that, when read in conjunction with other sections of the certificate, it created a duty to `follow the settlements'. The court rejected this argument, finding that the certificate did not contain language that could reasonably be construed as a `follow the settlements' clause.

By Robert S Soderstorm

Robert S Soderstrom is a founding partner of Tressler, Soderstrom, Maloney & Priess, in Chicago. DJ Sartorio is a partner of the firm and a member of the firm's insurance services group. Bruce M Engel is a partner of the firm and Eileen Sloan Newlin is an associate of the firm.

The authors represented Employers Reinsurance Corp in the North River Ins Co v Employers Reinsurance Corp matter. The opinions expressed herein are those of the authors and do not necessarily reflect the views of Tressler, Soderstrom, Maloney & Priess or any of its clients.