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

D.J. Expense Claims under Facultative Certificates Rejected by Second Circuit

The thorny issue of whether facultative certificate wording covers payment of a cedent’s declaratory judgment expenses (“d.j. expenses”) was the subject of an August 26th U.S. Court of Appeals for the Second Circuit decision, which rejected the cedent’s d.j. expense claim because it found the certificate wordings to be unambiguous and, thus, not open to interpretation based on alleged industry custom and practice.

Between 1977 and 1980, a Mexican reinsurer issued 26 facultative certificates, each containing essentially identical Reinsurance Clauses, which provided in pertinent part:

“This Certificate of Reinsurance is subject to the same risks, valuations, conditions, endorsements (except changes of location), assignments and adjustments as or may be assumed, made or adopted by the reinsured, and loss, if any, hereunder is payable pro rata with the reinsured and at the same time and place . . . .”

Under these certificates, the cedent sought to recover d.j. expenses it had incurred in coverage disputes arising from its underlying policies. When the reinsurer refused to pay those expenses, the cedent commenced litigation in federal court. A default judgment was entered against the reinsurer for $11,801,025 because it had failed to post pre-answer security as required under New York Insurance Law. The reinsurer appealed to the Second Circuit, which affirmed the default but remanded the case on the issue of whether the reinsurer was obligated to indemnify the cedent for its pro rata share of $630,736 in d.j. expenses. On remand, the district court granted summary judgment for the reinsurer because it found that the certificates were silent and unambiguous on the d.j. expense issue.

On appeal again to the Second Circuit, the cedent sought a reversal on three grounds: (1) the facultative certificates’ wording was ambiguous; (2) the then-prevailing custom in the industry required the reinsurer to pay a pro rata share of the cedent's d.j. expenses in resisting coverage; and (3) such payment was compelled pursuant to the follow-the-fortunes doctrine.

Applying New York law and contract construction principles, the court of appeals held that the cedent failed to articulate any ambiguity in the facultative certificates’ terms. It rejected the contention that the Reinsurance Clause’s reference to "risks" was the source of ambiguity that could cover d.j. expenses and that that ambiguity must be resolved by resorting to industry custom. Citing as a “leading case” on the use of industry custom in a reinsurance dispute over d.j. expenses, the Second Circuit distinguished Affiliated FM Insurance Co. v. Constitution Reinsurance Corp., 416 Mass 839, 626 N.E.2d 878 (1994), and another case on the basis that the facultative certificates in this litigation did not even mention the word “expenses,” the multiple interpretations of which were central to the courts’ finding of contractual ambiguity in these other precedents.

The record evidence of d.j. expense custom and practice offered by the cedent, according to the Second Circuit, was insufficient notwithstanding the submission of two affidavits from reinsurance experts, the gist of whose testimony was that prior to 1983 it was the custom and practice for reinsurers to pay d.j. expenses.

As for the cedent's follow-the-fortunes doctrine argument, the court of appeals held that the invocation of this doctrine required a showing that the cedent's own d.j. expenses in litigating against its policyholders was potentially within the coverage of the reinsured policies and that was obviously not the case here.

British International Insurance Co. Ltd v. Seguros La Republica, S.A., Docket No. 01-9079, 2003 U.S. App. LEXIS 17751 (2d Cir. Aug. 26, 2003).

THE GASS COMPANY, INC.
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