A round-up of some key cases in the UK and the US in 2006 highlights some basic issues with follow-the-settlement and claims cooperation clauses, explain Ian McKenna, Wendy Allen-Rodney, Matthew Ingber and Jordan Rosenfeld.

In 2006 there were a number of cases in England and the US concerning follow-the-settlements or claims cooperation clauses. Whilst such cases will often turn on the particular facts, a review of a selection of these cases shows that these clauses might not "do what it says on the tin". Reinsureds and reinsurers therefore need to negotiate the wording of these clauses carefully, and reinsureds need to review them carefully when handling inwards claims.

UK cases

Faraday Capital Limited v Copenhagen Reinsurance Company Limited - This case illustrated the need for reinsureds to negotiate carefully follow-the-settlements clauses and to review such clauses when negotiating the wording of settlement agreements with their cedants - otherwise reinsurers might not be obliged to follow.

Copenhagen Re provided the reinsurance for a property policy written by Faraday, which contained a follow-the-settlements clause that required Copenhagen Re to "follow in all respects the settlements or other payments of whatsoever nature excluding without prejudice and ex-gratia settlements made by the original underwriters". Following losses at the cedant's premises, Faraday entered into a settlement agreement with its cedant, which stated that: "The parties intend to adopt, by way of compromise and without prejudice to or waiver to their respective positions, without further trial or adjudication of any issues of fact or law, and without the London Market insurers admitting liability ... a full and final settlement"; and, "This agreement is intended to be and is a compromise between the parties and shall not be construed as an admission of coverage".

The follow clause varied from a "standard" follow-the-settlements clause because of the exclusion of "without prejudice and ex-gratia settlements". The judge held that:

- The parties clearly wished to modify the effect of the clause by the inclusion of these words;

- The inclusion of these words clearly cuts down the ambit of the clause;

- A "without prejudice settlement" is one that is made where there is no admission of the existence of any liability under the original policy to indemnify the insured; and

- The settlement agreement was therefore excluded from the follow clause.

This did not (necessarily) mean that Faraday could not recover from Copenhagen Re; but it did mean that Copenhagen Re was entitled to insist that Faraday must prove that there was, in fact, a liability under the original policy.

AIG Europe (Ireland) Limited v Faraday Capital Limited - This case shows that reinsurers have to carefully negotiate claims cooperation clauses, paying attention to the nature of the original policy - otherwise, they may not receive early notice or have the opportunity to cooperate.

Faraday wrote the reinsurance of a directors' & officers' policy written by AIG, which contained a claims cooperation clause. In November 2002, the insured announced that it would be restating some financial statements. As a consequence of this announcement and the immediate fall in its share value, the company's directors were sued by shareholders. In September 2003, the insured filed its restated accounts. In February 2004, the insured presented its case to AIG and AIG posted a reserve. In March 2004, the insured settled with the shareholders. In April 2004, AIG formally notified Faraday.

The clause required, as conditions precedent to Faraday's liability, that AIG "shall upon knowledge of any loss or losses which may give rise to a claim advise the reinsurers thereof as soon as is reasonably practicable and in any event within 30 days"; and "shall furnish the reinsurers with all information available respecting such loss or losses, and shall cooperate with the reinsurers in the adjustment and settlement thereof." The judge held that:

- The words "loss or losses" in the clause did not mean alleged, claimed or potential losses, or circumstances (as Faraday had argued). If this had been the intention, such words could have been used;

- The loss(es) in question is the loss(es) of the third party shareholders attributable to the acts or defaults of the directors, and does not include their costs;

- Such loss(es) is not an actual loss unless and until it was a proved fact;

- The posting of a reserve does not establish knowledge of any loss; and

- The earliest date on which the possible loss was turned into an actual loss was when the shareholders' action was settled. As AIG had notified Faraday within 30 days thereof, there had been no breach of the clause.

What Faraday really wanted was to be notified of circumstances or potential losses. This would have allowed time for the opportunity to cooperate in the adjustment and settlement of the losses, as required by the second limb of the clause. On the facts, however, no such opportunity arose.

US cases

Suter (liquidator of Integrity Insurance Company) v General Accident Insurance Company (GA) - This case illustrates that, even if there is a follow-the-settlements clause, reinsureds have to carry out reasonable, businesslike investigations of inwards claims and cannot rely on the investigations carried out by insurers of underlying layers.

Integrity wrote two high level excess-of-loss liability policies for the pharmaceutical company Pfizer, following the form of underlying policies. GA reinsured Integrity, agreeing that "all claims involving this reinsurance, when settled by (Integrity), shall be binding on the reinsurer, who shall be bound to pay its proportion of such settlements".

Pfizer was sued by recipients of heart valves, which it had manufactured. It settled the class action, compensating claimants whose valves had failed, whose valves had to be replaced and who had suffered anxiety at the prospect that their valves might fail. Integrity also settled on this basis. Was GA obliged to follow Integrity's settlement?

As a matter of California (or New York or New Jersey) law, the effect of the doctrine of follow-the-settlements is that "if a reinsured has made a good faith determination that a certain risk was covered by the underlying insurance policy, the reinsurer cannot dispute that determination". A good faith determination requires that the reinsured makes a reasonable, businesslike investigation of the claim. To defeat the presumption of good faith, a reinsurer must prove bad faith - meaning gross negligence or recklessness - or must show that the settlement was not even arguably within the scope of the policy coverage. The judge held that:

- Although the valves were implanted during the policy periods, this did not cause the injuries. Integrity's policies only covered injury occurring during the policy periods. It was not even reasonable to say that the claims occurred within the policy periods - no credible medical evidence supported this contention;

- Due to the complexity of the issues at stake, Integrity had been grossly negligent in not obtaining its own legal advice as to the trigger of coverage nor expert medical advice as to when the injuries occurred;

- Integrity's investigation was superficial and relied on the investigations carried out by underlying insurers; and

- Therefore, GA was not obliged to follow Integrity's settlement.

National Union Fire Insurance Company (NU) v American Re-Insurance Company (AmRe) - By contrast to the Integrity case, this case illustrates that it is not easy for reinsurers to prove that a settlement was not a good faith determination of the claim, and that reinsurers who have agreed to follow-the-settlements of the reinsured are prevented from second guessing the reinsured's allocation decisions.

NU wrote annual liability policies for the manufacturing company Milacron for several years. AmRe wrote a reinsurance of the 1994/1995 policy only, which contained a follow-the-settlements clause. A class action brought by claimants suffering from respiratory illnesses allegedly caused by exposure to fluids Milacron had produced was settled. Allocating on the basis that the injuries occurred when they first became known, Milacron claimed under the 1994/1995 policy and NU also settled on this basis. Was AmRe obliged to follow NU's settlement?

As a matter of Ohio law, because of the follow-the-settlements clause, AmRe was "not permitted to avoid liability by raising policy defenses and objections that were available to the reinsured unless the reinsured paid a settlement that was clearly or manifestly outside the scope of the reinsured's policy coverage or paid a settlement that was fraudulent, collusive or in bad faith". A reinsurer claiming bad faith "must make an extraordinary showing of a disingenuous or dishonest failure". The judge held that:

- It was at least arguably correct that (i) the injuries first manifested during the 1994/95 policy period, and (ii) Milacron's allocation was correct;

- NU had not acted in bad faith with respect to AmRe's interests by allocating the losses to the 1994/1995 policy (ie the only period for which it had reinsurance), because NU had taken various legitimate business considerations into account when deciding whether to settle with Milacron and "had no duty to American Re to minimise its reinsurance recovery";

- AmRe had agreed to follow NU's settlements. To undertake an analysis of Milacron's or NU's allocation of the losses anew is precisely the type of factual enquiry that the follow-the-settlements doctrine is designed to avoid; this would undermine the certainty that the doctrine creates and would foster litigation; and

- Therefore, AmRe was obliged to follow NU's settlement.

Ian McKenna, Wendy Allen-Rodney, Matthew Ingber and Jordan Rosenfeld are lawyers at Mayer, Brown, Rowe & Maw in London and New York.