1. Basic concept
C1 Some degree of confusion attends this area of reinsurance in that courts and even industry insiders display different understandings of the terms and concepts. Courts, particularly in the US, are often criticized as incorrectly collapsing the concepts into one and adopting a view of the concept that gives insufficient consideration to the interests of reinsurers. The follow-the-fortunes and follow-the-settlements principles are similar but distinct. For the purposes of the PRICL, the concepts of follow-the-settlements and follow-the-fortunes operate as set forth in this Article.
C2 The follow-the-settlements concept provides that the reinsurer is obliged to accept the settlements made by the reinsured. The follow-the-fortunes concept provides that the reinsurer shall be bound by developments beyond the reinsured’s control.
2. Follow-the-settlements
C3 The reinsurer’s duty to follow the reinsured’s settlements is subject to two requirements: first, the claim as settled by the reinsured is arguably covered by the underlying contract and, second, the claim as recognized is within the coverage of the contract of reinsurance as a matter of law.
C4 “Arguably covered” requires that the settlement of claims made by the reinsured is not collusive, fraudulent, deceptive, grossly negligent or reckless, clearly outside of coverage, or beyond the amount of limits set forth in the agreement. In determining what constitutes an unreasonable settlement, due regard should be given to the risks faced by the reinsured if it does not settle, including bad faith suits by policyholders, investigation and punishment by regulators, the risk of worse outcomes at trial, and increased disputing costs. If it cannot be said with positive assurance that after consideration of these factors, no reasonable person would support the amounts paid in settlement, the settlement should generally be considered sufficiently reasonable in amount and terms. In other words, in settling the claim, the reinsured must have acted honestly and have taken all proper and businesslike steps.
C5 A duty to follow the settlements can only arise where the claim is covered by the contract of reinsurance. A duty to follow the reinsured’s settlements is, thus, limited to the scope of cover of the contract and does not expand this scope. The relevant claim is the one as recognized in the settlement and the reinsured does not have to prove that the original claim falls within the risks covered by the contract of reinsurance.
Illustrations
I1. Reinsured A and Reinsurer B enter into a proportional reinsurance contract covering the general liability exposure of a major US automobile dealer. The automobile dealer’s insurance issued by Reinsured A expressly excludes coverage for punitive damages. The automobile dealer is sued in connection with an exploding gas tank that incinerates the occupant of the vehicle, a 60-year-old day laborer. Litigation ensues. During the course of the litigation, it is discovered that the automaker knew of the dangers of the gas tank but continued to sell vehicles with this problem and provided no warning. After trial, the estate of the victim obtains a judgment denominated as USD 1 million in compensatory damages and USD 100 million in punitive damages. While the defendant’s appeal from the USD 100 million verdict is pending, Reinsured A settles the claim with the victim’s estate for USD 10 million. Because the settlement obviously includes payment for punitive damages well above the USD 1 million of compensatory damages awarded, Reinsurer B is not bound to follow the settlement for the part of the damages exceeding USD 1 million. This is so because punitive damages are explicitly excluded in the underlying contract and it is not businesslike for Reinsured A to pay money for uncovered losses (facts based on American Ins Co v North American Co for Property & Cas Ins, 697 F2d 79 (2d Cir 1982) (applying New York law)).
I2. Reinsured A and Reinsurer B enter into an excess of loss reinsurance covering an automobile manufacturer that provides that Reinsurer B will be responsible for liability in excess of USD 5 million on any single claim. The automaker is sued in an exploding gas tank case. Eager to avoid a large punitive damages verdict, Reinsured A quickly settles the case for USD 2 million. Reinsurer B is not liable for any payments to Reinsured A because Reinsured A’s payments to the automaker’s victim do not exceed the attachment point of the contract of reinsurance. The claim as recognized under the underlying contract does not fall within the quantitative scope of cover of the contract of reinsurance (facts based on Michigan Millers Mutual Ins Co v North American Reins Corp, 452 NW2d 841 (Mich 1990) (Mich Ct App 1990)).
I3. Reinsured A, a general liability insurer, enters into a proportional reinsurance contract with Reinsurer B. Reinsured A’s policyholder, the owner of a bar/restaurant, is sued by the estate of a patron who was permitted to consume excessive amounts of liquor at the bar and then drove off the road to his death after leaving the bar or caused the death of other motorists or pedestrians after departing the bar. As general liability policies uniformly contain a clear liquor liability exclusion routinely enforced by courts, there is effectively not even a potential for coverage in this case. Consequently, the liability insurer need not even defend the claim. Nevertheless, Reinsured A negotiates a USD 500,000 settlement with the estate of the patron. This settlement is clearly not businesslike. Consequently, Reinsurer B is not bound to follow Reinsured A’s settlement.
I4. Reinsured A and Reinsurer B enter into an excess of loss reinsurance concerning Reinsured A’s general liability coverage of a large pharmaceutical company. The policy limit is USD 25 million. The policyholder company’s new drug is popular and widely prescribed by physicians. Serious side effects are later discovered that lead to a large class action lawsuit. Reinsured A settles the class action lawsuit for USD 50 million. Reinsured A’s settlement appears businesslike. However, since Reinsurer B’s liability under the contract of reinsurance is limited to USD 25 million and the follow-the-settlements rule does not expand this limit, the further USD 25 million are not within the coverage of the contract of reinsurance. Reinsurer B is not bound to follow Reinsured A’s settlement for the part of the settlement exceeding the reinsurance contract’s quantitative scope of cover (facts based on Bellefonte Reins Co v Aetna Cas & Sur Co, 903 F2d 910 (2d Cir 1990).
3. Follow-the-fortunes
C6 The follow-the-fortunes principle covers developments beyond the reinsured’s control, and this includes liability and coverage judgments against the reinsured. Even though the reinsured may have some influence on the judgment by exercising its rights as a party to the proceedings, ultimately the decision by the court or the arbitral panel is beyond its control. This will apply irrespective of whether the reinsurer approves the reinsured’s defense strategy. However, where the reinsured recklessly failed to put forward obvious defenses, the resulting judgment must be considered to have been rendered within the reinsured’s control. In such a case, the follow-the-fortunes rule does not apply. A judicial decision is equally to be considered to have been rendered within the reinsured’s control where the reinsured accepts the plaintiff’s claim and the judicial decision is based on such acceptance. An acceptance of the claim by the reinsured will be dealt with pursuant to the follow-the-settlements rule rather than the follow-the-fortunes rule. Similarly, where the reinsured provokes a default judgment, such judgment is rendered within the reinsured’s control so that the follow-the-fortunes rule is not applicable.
C7 The follow-the-fortunes rule also applies, e.g., where there is fluctuation in exchange rates. Where the value of insurance money to be paid by the reinsured under the underlying contract increases due to a change in the exchange rate, the reinsurer is bound to follow the reinsured’s fortunes. The reinsurance money to be paid includes the increased expenses incurred by the reinsured due to the change in the exchange rate.
C8 A further example of an application of the follow-the-fortunes rule is a change in national law which has an impact on the cover under the underlying insurance contract. For instance, if the law governing the underlying insurance contract forbids the coverage of punitive damages but later lifts such a ban, such change expands the reinsured’s cover under the underlying contract. The reinsurer must follow the reinsured’s fate unless the contract provides for an explicit exclusion of punitive damages.
C9 In the context of the follow-the-settlements rule, the reinsured is under a duty to act honestly and in a businesslike manner when settling a claim. In contrast, the follow-the-fortunes rule deals with developments beyond the reinsured’s control. Thus, there cannot be an evaluation of the honesty and businesslike manner of the reinsured’s conduct.
C10 The follow-the-fortunes rule will not expand coverage under the contract of reinsurance. Accordingly, the reinsurer is only required to follow the reinsured’s fortunes insofar as a claim is covered under the contract of reinsurance.
Illustrations
I5. Reinsured A and Reinsurer B enter into a proportional reinsurance covering the general liability exposure of a major US automobile manufacturer. The contract does not cover claims for punitive damages. The automobile manufacturer is sued in connection with an exploding gas tank that incinerates the occupant of the vehicle, an 80-year-old retiree. Litigation ensues. During the course of the litigation, it is discovered that the automobile manufacturer knew of the dangers of the gas tank but continued to sell vehicles with this problem and provided no warning. After trial, the estate of the victim obtains a judgment denominated as USD 10 million in compensatory damages and USD 100 million in punitive damages. The automobile manufacturer obtains a judgment for coverage of the entire tort award under the underlying insurance policy against Reinsured A. Reinsurer B is under an obligation to follow Reinsured A’s fortunes regarding the compensatory damages. By contrast, as punitive damages are outside the reinsurance coverage, Reinsurer B is under no duty to follow Reinsured A’s fortunes regarding punitive damages.
I6. Reinsured A and Reinsurer B enter into an excess of loss reinsurance concerning Reinsured A’s general liability coverage of a large pharmaceutical company. The policy limit is USD 25 million. The policyholder company’s new drug is popular and widely prescribed by physicians. Serious side effects are later discovered that lead to a large class action lawsuit. The case proceeds to trial and results in a USD 100 million judgment against the drugmaker. Reinsurer B is bound to follow Reinsured A’s fortunes only to the extent that the loss is within the quantitative scope of cover of the contract of reinsurance.
4. Justification and operation of the default rule
C11 Once the parties have chosen the PRICL to govern their contract, Article 2.4.3 operates as a default rule. This appears justified by the fact that most contracts of reinsurance on the market contain some kind of follow-the-fortunes and follow-the-settlements clauses. This common practice justifies a default rule even though under various national laws there is a debate about whether, e.g., the follow-the-settlements rule applies as a default rule in the absence of explicit language in the contract of reinsurance (see Staring & Hansell § 18:2 et seq.).
C12 Like with other default rules, however, this rule can be altered by the parties as part of the contracting process. As mentioned, use of follow-the-settlements and follow-the-fortunes clauses is quite common in reinsurance practice. Various wordings are used. Such clauses would prevail over Article 2.4.3.