In U.S. Fid. & Guar. Co. v. American Re-Ins. Co., 2013 WL 451666, 2013 N.Y. Slip Op. 00784 (N.Y. Feb. 7, 2013), the New York Court of Appeals recently reconfirmed the “follow the fortunes” or “follow the settlements” doctrine applicable to reinsurers but, unlike many of the leading decisions to date, held that a cedent’s allocation of its settlement losses under its reinsurance reinsurance treaty must be objectively reasonable – a factual issue that may not always be decided by the court as a matter of law.

In American Re-Ins. Co., United States Fidelity & Guarantee Company (USF&G), the cedent, had refused to defend and indemnify its insured, Western MacArthur Company (MacArthur), under a series of liability policies that it had issued between the 1950s and 1960s, with respect to thousands of asbestos lawsuits that had been commenced against MacArthur. As a result, MacArthur commenced a coverage action against USF&G in California and entered into agreements with the asbestos claimants, allowing them to enter default judgments against MacArthur that would not be executed against MacArthur – the claimants would only recover if MacArthur was successful in recovering from USF&G. By 2002, more than a thousand such default judgments, totaling $1.4 billion without interest, had been entered, and MacArthur faced the threat of additional asbestos lawsuits.

USF&G had not insured the full amount of MacArthur’s liability. Its policies contained “per person” and “per accident” limits, with the highest per person limit being $200,000, but no aggregate limit. MacArthur, however, asserted bad faith claims against USF&G for failing to defend and indemnify it. If MacArthur succeeded on its bad faith claims, USF&G faced the possibility of being held liable for the full amount of MacArthur’s liability to the asbestos claimants, regardless of policy limits.

USF&G settled the coverage action, paying in excess of $975 million to resolve the asbestos claims. USF&G then sought to recover approximately $391 million of its settlement from its reinsurers. The reinsurance treaties provided “excess of loss” coverage, pursuant to which the reinsurers agreed to pay USF&G for any amount over $100,000 of any loss occurring during the period covered by the treaties. The reinsurance treaties, like the primary policies, did not contain an aggregate limit. The reinsurance treaties also contained a standard “follow the settlements” clause.

Some of the reinsurers disputed USF&G’s allocation of the settlement to the reinsurance treaties on the grounds that: (1) all of the settlement amount was attributable to claims within the limits of USF&G’s policies, and none of it to the bad faith claims against USF&G; (2) the asbestos claims with lung cancer injuries had a value of $200,000 each, while certain other claims had values of $50,000 or less; and (3) that USF&G’s entire settlement should be allocated the policy in force in 1959, the last full year in which USF&G had issued coverage to the insured, rather than allocated on a pro rata basis under each of the policies that USF&G had issued (which would have resulted in few, if any losses exceeding the $100,000 retention in the reinsurance treaties).

The New York Court of Appeals noted, and the parties did not dispute, that it is well settled that the follow the fortunes clause in the reinsurance treaties prohibited the reinsurer from challenging “whether and for how much” to settle the claims. American Re-Ins. Co., 2013 N.Y. Slip Op. 00784 at 7 (citation omitted). This is because the cedent’s and reinsurer’s interests are likely aligned in this regard. Id.

The Court noted, however, that the cedent’s and reinsurer’s interests often conflict with respect to a cedent’s allocation of settlement amounts under the follow the settlements clause, as the cedent may try and maximize its reinsurance recoverables. 8. While a follow the settlements clause does require deference to a cedent’s decision on allocation, 8-9 (citing and agreeing with leading cases on subject), this “is not to say that [such decisions] are immune from scrutiny.” 10. “[C]ourts generally hold that a reinsurer is bound only by a cedent’s ‘good faith’ decisions.” Id.The allocation decisions of a cedent must be “objectively reasonable,” meaning that the cedent’s allocation “must be one that the parties to the settlement of the underlying insurance claims might reasonably have arrived at in arm’s length negotiations if the reinsurance did not exist,” without regard to the cedent’s motives and interests. 11.

Thus, reasonableness would not be established solely by showing that the cedent’s allocation for reinsurance purposes was the same as the allocation that the cedent, MacArthur and the asbestos claimants actually adopted in the underlying claims. Such a rule would invite collusion between underlying claimants and cedents, incentivizing the development and allocation of settlements so as to shift the burden to reinsurers.

The Court concluded evidence had been presented that could support the conclusion that two aspects of USF&G’s allocation were unreasonable. First, USF&G did not allocate any amounts toward the settlement of MacArthur’s bad faith claim, for which there was evidence that USF&G has previously quantified that claim. Second, USF&G had apparently valued the asbestos claims differently during the underlying disputes than it had in its allocation. Based on this evidence, a factual issue was presented. However, the Court concluded that USF&G’s allocation of the entire loss to a single policy in effect in 1959 was permissible under California law and could not be challenged.

The New York Court of Appeals decision is significant in that it concludes that the cedent’s allocation decisions may be challenged if the reinsurer can establish that they are not objectively reasonable, even if the reinsurance treaty contains a follow the settlements clause. In determining objective reasonableness, evidence from the underlying claims against the insured and from the underlying coverage litigation against the cedent may be considered and controlling.