Legal - Following mixed signals.

(From Reinsurance)

Byline: Peter Chaffetz and Steven Schwartz.

The US Court of Appeals for the Second Circuit recently took a stand in the controversy over the application of the follow-the-settlements doctrine to cedants' allocation decisions. In North River Ins. Co. v Ace American Reins. Co., 361 F.3d 134, 141 (2d Cir. 2004), the court ruled that the doctrine does apply, stating that "the follow-the-settlements doctrine extends to a cedant's post-settlement decisions". The decision contrasts with another recent allocation decision, Travelers Cas. & Surety Co. v Gerling Global Reins. Corp. of America, 285 F. Supp. 2d 200 (D. Conn. 2003), in which the court held that follow-the-settlements did not bar a reinsurer from questioning its cedant's allocation of a settlement (see Reinsurance, February 2004, p41). However, despite the North River court's seemingly broad approach to follow-the-settlements, the decision might limit cedants' discretion in allocating losses to their reinsurers.

The issue

In North River, the cedant (North River) sought reinsurance coverage for its settlement of its non-products liability asbestos coverage of Owens-Corning Fiberglass Corporation (OCF). Over a ten-year period, North River participated in four excess layers of OCF's insurance program. North River in turn bought facultative reinsurance from various companies, including Ace American Reinsurance Company (Ace). Ace reinsured a share of North River's lowest layer, which had a maximum exposure of $345m for that ten-year period.

OCF ultimately faced hundreds of thousands of claims relating to asbestos products it had manufactured, sold or installed. By the mid-1990s, it had nearly exhausted the aggregate limits of its products liability coverage, and began to seek additional coverage by characterising these claims as non-products claims. North River initially denied coverage and OCF initiated arbitration pursuant to the Wellington Agreement. However, before the arbitration was decided, North River and OCF settled all of OCF's non-products claims. The settlement included a policy buy-back, which eliminated any further liability North River might have had under the policies. In total, North River paid OCF $335m in the settlement.

North River then sought coverage from its reinsurers. It attributed 1% of the $335m payment to the policy buy-back, and spread that portion of the payment across all of its policies. To allocate the 99% ($332m) it attributed to non-products asbestos claims, North River used the 'bathtub' method - horizontal exhaustion across each layer from lowest to highest, until all losses were paid. Because this $332m payment fell within North River's $345m first layer, North River allocated the entire 99% to that layer. It therefore sought coverage only from reinsurers of that layer, including Ace.