In Travelers Casualty & Surety Co. v. Insurance Co. of North America, Nos. 06-4100, 06-4101 and 08-1032 (2010), the U.S. Court of Appeals for the Third Circuit affirmed the District Court’s decision holding that a cedent’s settlement allocation was reasonable and binding on the reinsurer, except for the portion of the allocation that was based upon annualized per-occurrence limits for multi-year policies.

In 1998, Travelers Casualty & Surety Company (“Travelers”) reached a $137 million settlement with its insured to resolve, among other things, claims involving breast implants and chemical products losses. Travelers then allocated the settlement among three tiers of insurance that provided coverage for those claims. The first tier consisted of primary policies (the “AL policies”) that were captively reinsured by the insured’s subsidiary and also subject to retrospective premiums whereby Travelers was reimbursed up to a particular policy’s loss limit for any payments it made. The AL policies provided coverage for all non-products claims brought against the insured, as well as certain types of product claims brought outside of the U.S.

The second tier of insurance, referred to as the “buffer or XS policies,” was also captively reinsured by the insured’s subsidiary. Those policies provided coverage for U.S. products liability claims. The third and highest layer of coverage, which included excess policies (the “XN policies”) facultatively reinsured by Ace America Reinsurance Company and Insurance Company of North America (collectively “INA”), covered both products and non-products claims, and attached excess all of the insured’s coverage (including the AL and XS policies). Each facultative certificate contained a follow form and follow-the-fortunes provision.

In its settlement negotiations with the insured, Travelers asserted that the breast implant claims were products claims covered by the AL policies, and that they arose out of a single occurrence. At trial, one of Travelers’ key witnesses testified that the number of occurrences issue was extremely critical, because if the breast implant claims were found to constitute multiple occurrences, Travelers would be potentially exposed to enormous liability under the AL policies, which had per-occurrence, but not aggregate, limits.

During negotiations, an in-house attorney in Travelers’ reinsurance department prepared a memorandum (the “Memo”) that explained the reinsurance implications of the different coverage scenarios for the breast implant claims. The Memo also noted, among other things, that a finding that the breast implant claims were non-products claims arising out of multiple occurrences could result in significant exposure to Travelers under the AL policies. Further, the Memo speculated that if Travelers billed its reinsurers on a single occurrence basis, collection from them would be more difficult unless the insured agreed to that characterization for settlement purposes.

Ultimately, as part of the settlement, the breast implant claims were treated as non-products claims arising out of a single occurrence, while the chemical products claims were deemed to be products claims. Of the $137 million paid to the insured, $80 million was allocated to breast implant claims and $20 million to chemical products claims. The agreement further specified that $15 million of that $20 million was allocated to the XN policies, and no amounts were allocated to any of the AL policies with a policy period commencing after April 1, 1982, or to any of the XS policies, both of which were deemed to be exhausted. The parties agreed that, except as set forth in the agreement, each reserved the right to allocate the settlement amount to any other applicable policy.

After the settlement was finalized, Travelers allocated the remaining portions of the payment among the different policies. With respect to the breast implant claims, Travelers characterized the $80 million paid as “indemnity” and employed a so-called “rising bathtub” allocation methodology, beginning with the pre-1982 AL policies. Under that formula, losses are allocated to the lowest tier of coverage first, until exhaustion, like a bathtub filled with water. Using that approach, $56 million was allocated to the XN policies. Two of those policies had three-year policy periods and Travelers treated their per-occurrence limits as applying separately to each policy year, a decision that tripled the amount that could be allocated to those policies.

Travelers then the settlement amounts to INA, which refused to pay and challenged Travelers post-settlement allocation. A lawsuit was commenced by Travelers in the Eastern District of Pennsylvania, which resulted in two separate bench trials. In the first phase, the court rejected INA’s contention that Travelers had manipulated its post-settlement allocation to maximize its reinsurance coverage, and held that Travelers allocation decisions were reasonable, businesslike, and made in good faith. As such, the follow the fortunes doctrine bound INA to Travelers’ allocation. However, in the second trial, the court found that, under Michigan law (which governed the three-year XN policies), a single per-occurrence limit clearly and unambiguously applied to each three-year policy period. Therefore, the court reduced Travelers’ allocation by the amount attributable to its decision to annualize the per-occurrence limits of the three-year policies.

Both parties appealed the District Court’s decision. The Third Circuit began its analysis by agreeing with the majority view that the follow the fortunes doctrine applies to a cedent’s post-settlement allocation decisions. In order to prove the bad faith exception to this doctrine, the court noted that a reinsurer “must either provide direct evidence that the [cedent] was motivated primarily by reinsurance considerations, or show that the after-the-fact rationales offered by the [cedent] are not credible.” Moreover, the court stated that a cedent choosing among several reasonable allocation methodologies is not required to select one that minimizes its reinsurance recovery to avoid a finding of bad faith.

The Third Circuit held that INA had failed to make the requisite showing. First, the court noted that Travelers’ decision to allocate money paid toward the breast implant claims to only the pre-1982 AL policies was not motivated by bad faith, because the net nature of the settlement between the parties accounted for certain amounts that would be owed to Travelers if it made payments under the post-1982 policies (i.e., the retrospective premiums and captive reinsurance associated with those policies). Thus, the court held it was reasonable for Travelers to take the position that the post-1982 policies were exhausted.

Next, the court found that Travelers’ decision not to allocate the payment made to resolve the chemical products claims to the XS policies was also made in good faith. Again, the court noted that it was not unreasonable for Travelers to deem those policies “exhausted” as a result of the net nature of the settlement, because they were also captively reinsured by the insured’s subsidiary. Moreover, even though the record indicated that Travelers failed to conduct a detailed analysis of the chemical products claims, the court held that Travelers’ decision to pay $20 million was reasonable because that enabled Travelers to resolve the breast implant claims (which presented far greater exposure).

Further, the court held that the Memo speculating on the reinsurance implications of Travelers’ potential allocation methods did not constitute bad faith, since the Memo also concerned Travelers’ potential exposure for the breast implant claims, and not just its ability to recover from or maximize its reinsurance.

Last, the court agreed with the District Court and found that the language of the three-year policies clearly provided for a single per-occurrence limit. The court noted that there was no indication that the occurrence limits were to apply annually, even though the term “annual” was referenced with respect to the aggregate limits.

Click here to review a copy of the Third Circuit’s decision.