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Case Note:
Travelers Cas. & Sur. Co. v. Insurance Co. of North America, No. 06-4100 (3rd Cir. June 9, 2010)

by ~ Michael F. Aylward (Email) (Web Site)

Third Circuit Analyzes Post-Settlement Allocation Decisions

Long-tail claims present peculiar difficulties for ceding carriers and reinsurers. Not only is the legal mosaic governing the resolution of such claims ever-shifting, but the settlement of long-tail claims involves numerous intangible factors that make assigning specific dollar values to each element of the settlement a process that is more art than science.

Now the U.S. Court of Appeals for the Third Circuit has produced a lengthy and provocative analysis of the standards that should be applied to a reinsurer’s challenge to a liability insurer’s post-settlement allocation of massive underlying products and toxic tort claim liabilities. In Travelers Cas. & Sur. Co. v. Insurance Co. of North America, No. 06-4100 (3rd Cir. June 9, 2010) the court ruled that the “follow the fortunes rule applies to post-settlement allocation decisions and that insurers are not acting in bad faith as long as they cede such losses to reinsurers in a reasonable manner that can be justified independently of reinsurance considerations. Accordingly, an insurer is free to consider the reinsurance implications of its settlement so long as its cession reflects reasonable, businesslike decisions made in good faith.

At issue in Travelers, was the propriety of its post-settlement allocation of sums paid to settle breast implant and pesticide/chemical exposure claims presented by an anonymous product manufacturer (designated, Wile E. Coyote-style, as “Acme Corporation). Travelers predecessor, Aetna, had underwritten three layers of insurance coverage for “Acme during the 1970s and 1980s. The first two layers (“AL and “XS) involved risks that were largely retained by Acme, whether through retrospective premiums or captive reinsurance. Only the third layer (XN), which included coverage for both products and non-products claims, had outside reinsurance, much of which was reinsured facultatively by INA under certificates containing “follow form and “follow the fortunes provisions.

Acme initially sought coverage for the breast implant claims under the AL policies but later expanded its tender to include chemical products claims under the Aetna XS and XN policies. In settlement negotiations, Travelers was adamant that the breast implant claims were “products losses and were not covered by the AL policies, and it was equally adamant that the breast implant claims arose out of a single occurrence, namely Acme’s negligent testing. This characterization affected Acme as prior losses had largely eroded the limits available for products claims under the XN line.

While negotiations were taking place, Travelers in-house counsel (Mark Wigmore) prepared a memorandum exploring the reinsurance implications of different coverage scenarios. The Wigmore memorandum concluded that if the breast implant claims were treated as non-products losses arising out of multiple occurrences, the claims might stay in the AL layer of coverage and never reach the reinsured XN layer. The memo also concluded that as reinsurers might well oppose the characterization of these claims as a single occurrence, Travelers would be in a better negotiating position with its reinsurers if this characterization of the dispute was agreed to by the insured and memorialized in a settlement.

Ultimately, Travelers agreed to settle with Acme for a lump sum payment of $137 million. Of this amount, $80 million was stated in the agreement to be for the breast implant claims, $20 million for chemical product exposures and a remaining $37 million for unrelated claims. Acme also agreed to Travelers request that the breast implant claims be treated as a single “occurrence. Further, the breast implant claims were agreed to involve “non-products losses, whereas the chemical exposure claims were characterized as “products claims. The settlement further stipulated that no payment would be allocated to any AL policy issued on or after April 1, 1982, as these policies were subject to captive reinsurance. Travelers also treated all of these loss payments as indemnity even though Acme had not yet paid any settlements or judgments and was vigorously contesting the underlying breast implant claims and incurring significant defense costs.

A disagreement ensued, however, whether the agreement should also reflect Travelers proposed internal allocation of these payments to the individual Aetna policies. Although Travelers draft included such an allocation, Acme eliminated these provisions in its response. Ultimately, the parties compromised, agreeing that the parties were free to allocate the settlement amounts to any policy but that neither party necessarily concurred in the other party’s allocation.

Of the $80 million allocated to breast implants, Travelers characterized the entire loss payment as indemnity, not defense, and confined it to the pre-1982 AL policies using a “collapsing bathtub approach whereby a layer of coverage is not reached until the entire layer below it is completely exhausted. This methodology resulted in a total of $24 million being allocated to the AL policies. The remaining $56 million of the breast implant settlement was allocated to the XN policies in accordance with the “collapsing bathtub method, starting with the XN policies with the lowest attachment policies. Ultimately, $11.6 million of the breast implant settlement and $2.2 million of the chemical products settlement was allocated to six of the nine XN policies reinsured by INA.

Travelers lost little time in ceding the claim to its reinsurers. INA disputed the cession, and Travelers sued it for breach of contract in federal court in Pennsylvania. INA did not question the propriety of the underlying settlement, but it disputed Travelers post-settlement allocation of it. In particular, INA contended that (1) Travelers had acted in bad faith by manipulating its rationale for the settlement to maximize reinsurance recoveries; (2) Travelers had artificially compressed the amount allocated to the reinsurance period by eliminating any allocation to any AL policy issued after 1982; and (3) Travelers had similarly inflated its reinsurance recovery by improperly claiming that the limits of coverage in two three-year policies should be calculated on a “per year basis. INA also criticized Travelers refusal to treat any of the breast implant settlement as involving defense costs.

A bench trial proceeded in two phases to determine: (1) whether Travelers had manipulated its post-settlement allocation to artificially increase the amount ceded to the reinsured XN policies; and (2) whether Travelers had improperly sought to “annualize the limits of two three-year policies in order to increase the amount of the settlement allocable to the reinsured period.

In Phase One, the court heard extensive testimony concerning the settlement negotiations and how Travelers later allocated the settlement in the reinsurance billing. The court ruled in Travelers favor, finding that although INA had reason to be suspicious, Travelers “did not act in bad faith and that its various decisions were reasonable, businesslike decisions made in good faith.

Having ruled for Travelers in Phase One, the court found for INA in Phase Two, ruling that the three-year policies were subject to a single limit and should not have been annualized.

The parties cross-appealed to the Third Circuit, which issued its ruling on June 9, 2010. Addressing the issue whether to apply the bad faith exception to the “follow the fortunes doctrine, the Third Circuit affirmed the district court. More particularly, it found that INA had failed to show that Travelers acted in bad faith by manipulating its post-settlement allocation to maximize recovery under the reinsured XN layer of coverage. Recognizing that there is a dispute among the Circuits with respect to whether the “follow the fortunes doctrine should apply to post-settlement allocations--especially where, as here, the allocation decisions being challenged were not the product of active bargaining between the policyholder and the insurance company -- the Third Circuit aligned itself with the majority view that the doctrine does apply to post-settlement allocations. Explaining, the Third Circuit declared that a contrary holding “would risk doing precisely what the follow the fortunes doctrine aims to prevent  interfering in settlement negotiations between insurers and their insureds by discouraging a particular type of settlement (here an all cash deal).

While acknowledging that post-settlement allocation decisions must be made in good faith, the Third Circuit emphasized “that the insurers negative duty not to make allocation decisions primarily in order to increase reinsurance recovery does not translate into a positive duty on the part of the insurer to minimize its reinsurance recovery. Accordingly, in order to prevail on a bad faith defense, the reinsurer must show more than that a particular allocation decision increased its obligations. Rather, the reinsurer must provide direct evidence that the insurer was motivated primarily by reinsurance considerations or else show that the after-the-fact rationales offered by the insurer are not credible.

In this case, the Third Court found that Travelers decisions were reasonable and were not designed solely to maximize its reinsurance recovery. The Third Circuit disagreed with the District Court’s conclusion that Travelers acted properly in excluding the post-1982 AL policies from its allocation. But even though it sided with INA on the substance of this argument, the Third Circuit found no bad faith. As it explained, “[b]ecause Travelers was under no duty to minimize its reinsurance recovery, the mere fact that it could have, consistent with its agreement with Acme, allocated it to all of the AL policies does not mean that it was required to do so.

The Third Circuit also rejected INA’s challenge to the allocation of $20 million to the chemical products claims. Even though there was no evidence that Travelers had conducted a detailed analysis of these claims before agreeing to allocate $20 million of the settlement to them, the Court ruled that it was not unreasonable for Travelers to have assigned $20 million to the chemical products claims in order to resolve the breast implant claims for only $80 million, significantly less than the reserves and liability exposure that Travelers had set internally.

The Third Circuit also was not persuaded by INA’s argument that some portion of the $80 million breast implant settlement should have been treated as costs of defense. The Court found that this decision was sufficiently grounded in Travelers prior interactions with Acme that it could not be characterized as solely designed to maximize Travelers reinsurance recovery. The Court also took note of the fact that another insurer (Fireman’s Fund) was paying Acme’s defense costs.

Turning to the issue of the Wigmore Memorandum, the Third Circuit found no clear error in the District Court’s conclusion that the memo was not used as a “road map to negotiate the settlement with Acme or to allocate the settlement dollars to the insurance policies. The Third Circuit also rejected INA’s argument that the District Court had improperly allowed Travelers to rely on the testimony of various attorneys who had advised it in the course of the settlement negotiations while still precluding INA from obtaining privileged communications. Notwithstanding this “sword/shield argument, the Third Circuit found that the District Court’s ruling in favor of Travelers in Phase One had not been entirely dependent on its general determination that Travelers receipt of such advice tended to support its conclusion that the settlement was “reasonable and “businesslike.

The Third Circuit next turned to the District Court’s rulings in Phase Two of the litigation. The Third Circuit agreed that two of the XN policies were issued for three years and that it was inappropriate to treat the policies single “per occurrence limit as applying to each annual period. The Court also rejected Travelers suggestion that before Travelers had entered the picture, Aetna had been negotiating with Acme based on annualization assumptions. Travelers conceded that the issue of annualization had never come up in its negotiations, nor would Acme have had any reason to insist that it annualize these limits since, under the agreement, Travelers was only allocating $80 million to the breast implant claims which meant that there was more than enough coverage available even without annualizing the limits.

Reading this opinion, one gets the sense that the Third Circuit may have been somewhat intimidated by the complexity of the underlying claims and resulting issues (which the court described at one point as “quasi-metaphysical) and thus erred on the side of caution in adopting a “reasonableness standard that allowed it to accept Travelers positions as “plausible even if they might not necessarily have been what the court might have agreed to had the claims been presented on a fresh slate. Not all courts have been so indulgent. For instance, in Allstate Ins. Co. v. American Home Assurance Co., 837 N.Y.S.2d 138 (App. Div. June 12, 2007), the Appellate Division of the New York Supreme Court ruled that a facultative reinsurer was not obliged to accept American Home’s cession of its payments to resolve environmental liability claims around the country on a “one site/one ‘occurrence’” basis. Unlike the trial court, the Appellate Division was not swayed by a single occurrence analysis that had been prepared after the fact by coverage counsel. Rather, the court declared that, “[a] reinsurer is not bound by the follow the fortunes doctrine where the reinsured’s settlement allocation, at odds with its allocation of the loss with its insured, designed to minimize its loss, reflects an effort to maximize unreasonably the amount of collectible reinsurance.

Michael Aylward can be reached at
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