Reinsurance and Insurance Arbitrator and Umpire Ronald S. Gass
ARIAS-U.S. Certified Arbitrator and Umpire
AAA Roster of Neutrals
Reinsurance and Insurance Dispute Resolution Services Consultant

Multi-Year Fac Certs’ Liability Limits Trump “Follow Form” Clause – Annualization Denied Despite Conflicting Settlement Allocation

In this intriguing and significant decision, a Massachusetts federal district court held that the per occurrence liability limits of certain 3-year facultative reinsurance certificates were not subject to annualization because they trumped the certs’ preprinted “follow form” provisions; thus, the reinsurer need not pay more than this limit even though the cedent’s settlement of an insured’s environmental contamination loss was premised on the annualization of the underlying occurrence limits of its multi-year excess umbrella policies.

In this case, the cedent wrote $5 million limits, each occurrence and in the aggregate, excess liability coverage above either another insurer’s primary limits or a self-insured retention between 1962 and 1974 for W.R. Grace and Co. (“Grace”) under four 3-year umbrella policies. The policies did not state whether the limits applied on an annualized basis.

Between 1965 and 1971, the reinsurer issued three 3-year quota share fac certs to the cedent with varying per occurrence limits typewritten on each cert’s declaration page in the “Reinsurance Accepted” blank. Each certificate also included a version of a preprinted “follow form” provision, which provided, in essence, that the specified liability of the reinsurer would follow the terms and conditions of the cedent’s excess umbrella policies.

Due to litigation arising from Grace’s environmental contamination at numerous sites across the country, the cedent reached a $57.6 million cash settlement of all its liabilities under all of its umbrella policies premised on the annualization of the occurrence limits of its multi-year excess policies. In 1999, it billed the facultative reinsurer over $18.3 million as its share of the settled loss under the three multi-year certs. The reinsurer paid nearly $7.8 million as its share of the loss but objected to paying the remainder claiming that the cedent’s settlement allocation was inappropriate because it was based on a full annualization of the claims in contravention of the single per occurrence limits set forth in the 3-year fac certs. Both the cedent and reinsurer brought declaratory judgment actions in Massachusetts federal district court and subsequently filed summary judgment motions.

The reinsurer argued that the single per occurrence limitation of liability set forth in its 3-year fac certs trumped the “follow form” provision, i.e., its exposure was strictly limited to the stated amount and could not be annualized regardless of the cedent’s conflicting settlement allocation. The cedent countered that the “follow form” clause must be construed broadly to encompass the entire underlying policies’ “terms and conditions,” including the annualized limits of liability. Contending that the “terms and conditions” should be read narrowly, the reinsurer responded that the purpose of the preprinted “follow form” provision was to ensure concurrency of the reinsurance coverage with that of the underlying policy and not to cause the reinsurer to exceed its bargained for limits of liability as expressed in the certs.

Granting partial summary judgment in favor of the reinsurer, the court concluded that the “follow form” clause was not ambiguous, that the question of annualization was one of limits, and that the clear language of the fac certs did not permit the imposition of annualized limits on the reinsurer in excess of the certs’ stated per occurrence and aggregate limits.

The court also rejected the cedent’s argument that the inclusion of the “by endorsement made part of this Certificate” language in some of the certs and the absence of any such endorsements expressly limiting the reinsurer’s obligation to follow form with the cedent meant that the limits of liability were controlled by the “follow form” provisions. Analyzing the fac certs as a whole, the court held that the lack of any such endorsements did not mean that they provided no limits whatsoever to the reinsurer’s liability to the cedent given that the “crucial terms” of the reinsurance contract (i.e., policy period, per occurrence and aggregate limits, and premium charged) were not generally expressed as endorsements but rather set forth on the certs’ declarations pages. In this case, each of the three fac certs provided for per occurrence and aggregate limits for a 3-year period, “crucial terms,” according to the court, that existed prior to any endorsement and formed the “framework” to which any future endorsements would attach, i.e., “the mere fact that endorsements were not added to the policy is irrelevant to the existence, and preeminence, of the stated policy term and limits of liability.” Finding that the fac cert wording, when read as a whole, was not ambiguous regarding the annualization issue, the court held that the limits of liability applied to the entire 3-year policy term and could not be annualized.

Finding no conflict between the fac certs’ standard pre-printed “follow form” provisions and the limitation of liability provisions, the court further held that the typewritten limits wording trumped the “follow form” wording based on the legal principle that when there is a conflict between written or typewritten terms and standard or form language in an insurance contract, the written or typewritten language prevails. Observing that “the force of the limitations of liability as a specific, bargained for term, decisively outweighs the boilerplate follow form provisions which [the cedent] claims are controlling here,” the court ruled that the limitations of liability, which were specifically drafted to govern the parties’ relationship, may not be overwritten by the operation of the standard “follow form” language in the certs, citing the Second Circuit’s decisions in Unigard Security Insurance Co. v. North River Insurance Co., 4 F.3d 1049 (2d Cir. 1993), and Bellefonte Reinsurance Co. v. Aetna Casualty and Surety Co., 903 F.2d 910 (2d. Cir. 1990), as precedent. Because the stated limits of liability were both clear and unambiguous, judicial interpolation of the word “annual” into the express language of the certs would be “inappropriate” because there was no language remotely suggesting that “each occurrence” should be read as “each occurrence each year,” thereby rewriting the coverage and making the reinsurer liable for up to three times its express and bargained for liability.

In response to the cedent’s invocation of the controversial Seven Provinces follow-the-settlement decisions, Commercial Union Insurance Co. v. Seven Provinces Insurance Co., Ltd., 9 F. Supp. 2d 49 (D. Mass. 1998), aff’d, 217 F.3d 33 (1st Cir 2000), cert. denied, 531 U.S. 1146 (2001), which held that this doctrine required the reinsurer to pay its share of a cedent’s settlement of an environmental loss, the court deemed them “instructive” but not helpful as to what it characterized as the “threshold” question of whether the certs’ “follow form” provisions may be fairly read to require the reinsurer to pay for claims that exceed the stated limit of coverage. “Follow form” provisions, observed the court, are primarily intended to avoid litigation between cedents and reinsurers over whether a claim is “of a type” to be covered by the primary insurance and to achieve concurrence between the reinsured contract and the reinsurance.

Notwithstanding the importance of enabling concurrence between primary and excess policies, the court concluded that the “follow form” provisions should not be read to “erase the limitations of liability” set out in the fac certs. Such limitations of liability must be viewed as an “express statement of the terms and conditions of the policy sufficient to resolve an apparent ambiguity regarding the coverage.” Summing up, the court held that the “follow form” provisions may not be read through the “unexpressed vehicle of annualization” to increase the reinsurer’s aggregate liability beyond that stated in the limitations of liability. Those limitations stood as a “ceiling” for the reinsurer’s liability to the cedent during the three-year policy period.

Readers should keep an eye on this important case, which reportedly goes to trial later this year, as it is likely to have a significant impact on the course of the “follow form” and “follow-the-settlements/allocations” debate. Depending on the outcome of this litigation at trial and the fate an another parallel case raising a similar “follow form” issue now wending its way through the Massachusetts federal district court, albeit before a different judge, an appeal to the U.S. Court of Appeals for the First Circuit may be in the offing.

Commercial Union Insurance Co. v. Swiss Reinsurance America Corp., Civ. Action No. 00-12267-DPW, 2003 U.S. Dist. LEXIS 4974 (D. Mass. Mar. 31, 2003).

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