In an important and long-awaited decision, the U.S. Court of Appeals for the Second Circuit ruled that the follow-the-settlements doctrine extended to a cedent’s post-settlement allocation decisions regardless of whether an inquiry would reveal an inconsistency between that allocation and the cedent’s pre-settlement assessments of risk as long as the allocation meets the typical follow-the-settlement requirements of good faith, reasonableness, and coverage within the applicable policies.
In this case, the cedent wrote excess insurance for Owens-Corning Fiberglass Corporation (“Owens-Corning”) between 1974 and 1983 covering portions of the insured’s 2nd, 3rd, 4th, and 5th excess layers (collectively ranging from $26 million to $251 million). The bulk of the facultative reinsurer’s certificates reinsured the 2nd ($26 million to $76 million) layer and all provided that the “liability of the Reinsurer . . . shall follow that of the Company.”
Facing imminent exhaustion of its products liability coverage in the wake of a flood of asbestos-related lawsuits, Owens-Corning sought an additional set of policy limits from its insurers by characterizing many of its asbestos-related claims as “non-products” claims. Prior to concluding an alternative dispute resolution proceeding against the cedent under the Wellington Agreement, the parties settled (including a policy buyback) for $335 million. During its settlement negotiations, the cedent had prepared an exposure analysis showing a range of potential Owens-Corning non-products exposure outcomes which would have pierced the 2nd and higher excess layers.
The federal district court ruled that the follow-the-fortunes doctrine (as it was referred to by the court) prevented the reinsurer from contesting its cedent’s post-settlement allocation of loss among reinsurers using the so-called “rising bathtub” approach, i.e., horizontal exhaustion. Because its total 2nd layer exposure for the 10-year coverage period was $345 million, the entire Owens-Corning loss settlement (minus the amount allocated for the policy buyback) of $332 million was allocated to that layer, a $49 million share of which was billed to the reinsurer.
On appeal to the Second Circuit, the reinsurer argued that the follow-the-settlement doctrine did not bind a reinsurer to anything other than the cedent’s settlement decisions and not to a settlement allocation inconsistent with the cedent’s own pre-settlement analysis. It also disputed the cedent’s decision to allocate the entire settlement to the 2nd excess layer, when it clearly eliminated exposure to the upper layers as identified and quantified by the cedent’s pre-settlement analysis.
Upholding the cedent’s allocation in this case, the Second Circuit cited the “main rationale” for the follow-the-settlements doctrine: “[T]o foster the ‘goals of maximum coverage and settlement’ and to prevent courts, through ‘de novo review of [the cedent’s] decision-making process,’ from undermining ‘the foundation of the cedent-reinsurer relationship.’”
The court of appeals rejected the reinsurer’s contention that the cedent’s post-settlement allocation must match its pre-settlement analyses: “But it is precisely this kind of intrusive factual inquiry into the settlement process, and the accompanying litigation, that the deference prescribed by the follow-the-settlements doctrine is designed to prevent. Requiring post-settlement allocation to match pre-settlement analyses would permit a reinsurer, and require the courts, to intensely scrutinize the specific factual information informing settlement negotiations, and would undermine the certainty that the general application of the doctrine to settlement decisions creates.”
The Second Circuit also rejected the reinsurer’s argument that the amounts billed by the cedent were outside the terms of the parties’ reinsurance contracts. This contention was based on the theory that, by deciding to settle with Owens-Corning, the cedent had considered potential loss exposure piercing the excess layers above the 2nd layer reinsured by the reinsurer. Therefore, the reinsurer should not be liable for that portion of the settlement paid to release the risk attributable to those upper layers. This argument, the court observed, “confuses risk of loss, and loss.” As a contract of indemnity, the reinsurance covered only the loss actually incurred by the cedent, not risk of loss. Allocation of the entire $332 million non-product Owens-Corning settlement to the 2nd layer using the cedent’s horizontal exhaustion allocation method did not violate the terms of its reinsurance contract and was within the definition of “loss” contemplated by the insurance contracts.
The Second Circuit also remanded for further proceedings the parties’ dispute over the proper application of the New York prejudgment interest law to the district court’s award given the reinsurer’s tender of a prior partial indemnity payment to the cedent.
The North River Insurance Co. v. ACE American Reinsurance Co., Docket No. 02-7902, 2004 U.S. App. LEXIS 4861 (2nd Cir. Mar. 15, 2004).