3red - Insurance and Reinsurance

The reinsurer's obligation to "follow the fortunes"

Australian Insurance Institute Journal, February, 1988, Vol 11 No 1

By MJ Moyes, LLB

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This article examines such authorities as there are on the question of a reinsurer's obligation to follow a claims settlement arrived at by an insurer and applies the principles derived from this exercise to the contemporary situation.

In the very early days of reinsurance it seems to have been the intention that a reinsurer would follow any settlement of a claim negotiated by an insurer whether that claim came within the terms of the original policy or not. In other words, a reinsurer would follow ex gratia settlements and settlements where there was a dispute as to liability or quantum.

In Re London County Commercial Reinsurance Office (1922) 2 Ch 67 & 80, the court considered the obligation of a reinsurer in the absence of any express provision in the reinsurance contract. P.O. Lawrence J. stated the position thus:

"It is well settled that (subject to any provision to the contrary in the reinsurance policy) the reassured, in order to recover from their underwriters, must prove the loss in the same manner as the original insured must have proved it against them, and the reinsurers can raise all defences which were open to the reinsured against the original insured."

The court there held that if the original insurances were illegal, all following reinsurances were also illegal and void.

To pay as may be paid thereon

Towards the last quarter of the nineteenth century this intention began to be formally expressed in contract wordings. This was so despite the fact that the principle does not appear to have been tested in court up to this time. The first phrase which began to appear in reinsurance contracts was "to pay as may be paid thereon". The use of this particular wording can be better understood when it is appreciated that reinsurances were often created by attaching a reinsuring clause to the original policy.

The meaning of the expression was considered in Chippendale v. Holt (1895) 65 LJQB 104 & J06. That case involved a policy of reinsurance on a vessel, "Ajinir". The policy of reinsurance contained the clause: "Being a reinsurance subject to same clauses and conditions as the original policy, and to pay as may be paid thereon, but against the risk of total and/or constructive loss, total loss only". The vessel became stranded and the owners gave notice of abandonment and claimed she was a constructive total loss. The original insurers paid the claim but the defendant reinsurer refused to admit liability on the basis that the vessel was not shown to be a constructive total loss. The plaintiff insurer argued that the reinsurer was bound to pay whether there was a total loss or not as it, the insurer, had paid. The argument before Mathew J. proceeded on the two assumptions that there had been no constructive total loss and the payment of a total loss had been made in good faith. Therefore, the question considered by the court was whether the insurer had to prove its legal liability to the original insured before it could sustain a claim against its reinsurer.

The court held that a reinsurer is legally liable to indemnify an insurer only if the insurer was itself legally liable to its original insured. Any defence that was open to the insurer as against the original insured was therefore open to the reinsurer as against the insurer. In dealing with the insurer's argument as to the meaning of the phrase "to pay as may be paid thereon ", Mathew J. stated:

"But the contention of the plaintiff would involve the result that the clause must be read as if it were to pay such an amount as the insurers might choose to pay, whether liable or not. This seems to me altogether unreasonable. Such a contract would be a wager, and not reinsurance."

The court had a further opportunity to consider the phrase "to pay as may be paid thereon" in Firemen's Fund Insurance Company v. Western Australian Insurance Company Limited (1928) 138 LT 108, 112, 113.

In that case the plaintiffs were the insurers of 300 cases of gunpowder shipped from New York to La Plata. In addition to the gunpowder, the ship carried a large quantity of explosives and a large number of drums of sulphuric acid. During the course of the voyage the ship encountered bad weather and several drums of acid burst and the acid spread over the ship corroding the woodwork and disabling the pumps and other machinery. As a result the ship put into Barbados in distress where the harbourmaster ordered that the explosives and gunpowder be jettisoned.

The owners of the gunpowder subsequently made a claim against the plaintiffs which the plaintiffs settled without raising any objections or making a proper enquiry into the cause of the loss. The plaintiffs then sought to recover from the reinsurers. The reinsurers contended that the vessel was unseaworthy due to the nature of the cargo and method of packing and therefore the plaintiff insurers had no Iiability under the original policy to settle the claim.

The reinsurance contract contained the phrase "to pay as paid thereon". The plaintiffs contended that if they as original insurers, honestly paid a claim even though further discovery of facts would have disclosed a good defence, the inclusion of this phrase in the policy of reinsurance required reinsurers to follow such settlement. Bateson J. did not accept the plaintiff insurer's argument and found for the reinsurer. He stated:

"As I understand it, a contract of reinsurance is a contract to indemnify against a liability and a payment. There must be both liability and payment, and the precise liability must be covered in each case ... The original underwriter was not liable at all, and, if he was not liable, there is nothing for which he can claim over ... Another way of putting it is to say that the contract of reinsurance properly understood is a contract to indemnify against claims which the original underwriter has suffered but not against gifts. This was a voluntary payment so far as the original underwriter is concerned, and he did not insure himself for gifts that he might choose to make to his insured."

Follow the Fortunes

Following the authorities discussed above, underwriters sought another formulation of the reinsurer's obligation. The expression "follow the fortunes" started to appear in reinsurance contracts, initially in conjunction with an "errors and omissions" provision.

There was initially some judicial difference of opinion as to whether the inclusion of a follow the fortunes type clause restored the situation to that which underwriters had believed existed prior to Chippendale v. Holt. The whole question was considered in some detail in the recent Court of Appeal decision of Insurance Company of Africa v. SCOR (UK.) Reinsurance Company Ltd (1985) 1 Lloyd's Rep. 312, 322, 330, 331, 332, 334.

The original insurance in that case was on a warehouse situated in Monrovia. The sums insured were $500,000 for the buildings and $3 million for the contents. The insurer had reinsured 98.6% of its liability in the London market. SCOR was lead reinsurer. The reinsurance slip contained the following claims co-operation clause:

"It is a condition precedent to liability under this Insurance that all claims be notified immediately to the Underwriters subscribing to this Policy and the Reassured hereby undertake in arriving at the settlement of any claim, that they will co-operate with the Reassured Underwriters and that no settlement shall be made without the approval of the Underwriters subscribing to this Policy."

There was also contained in the slip a "follow the settlements" clause, inter alia, in the following terms:

"Being a Reinsurance of and warranted same - terms and conditions as and to follow the settlements of the Insurance Company of Africa - "

In February 1982 the warehouse was destroyed by fire. SCOR subsequently received anonymous information to the effect that the claim was fraudulent and the insurer and loss adjuster were implicated. SCOR refused to give permission to the insurer to settle the claim. The insurer was therefore in an impossible position. On the one hand it had the insured pressing for payment and on the other hand its reinsurers refusing to countenance any settlement. The insured subsequently sued the insurer and obtained judgment for $3.5 million plus $600,000 in punitive damages and $58,000 in legal costs. The insurer thereafter sought to recover from the reinsurer. The claim was litigated. On the question of the reinsurer's obligation to contribute to the loss, judgment was given for the insurer.

In the Court of Appeal Stephenson L.J. stated his understanding of the law in relation to a "follow the fortunes" clause to be:

"In this case ICA have been held liable to pay ATC's claim by the Liberian court and SCOR are bound to pay lCA unless in paying they can be seen not to have acted in good faith or to have acted in collusion with ATC or not to have taken all proper and business-like steps to have the amount of the loss fairly and carefully ascertained."

Robert Goff L.J in agreeing with the judgment of Stephenson L.J. on this point set out his understanding of the law as follows:

"In my Judgment, the effect of a clause binding reinsurers to follow settlements of the insurers, is that the reinsurers agree to indemnify insurers in the event that they settle a claim by their assured, i.e., when they dispose, or bind themselves to dispose, of a claim, whether by reason of admission or compromise, provided that the claim so recognised by them falls within the risks covered by the policy of reinsurance as a matter of law, and provided also that in settling the claim the insurers have acted honestly and have taken all proper and business-like steps in making their settlement."

The Relationship between a Follow the Fortunes and a Claims Co-operation Clause

As mentioned earlier, there was also contained in the reinsurance slip a "claims co-operation" clause. The court therefore had to consider the relationship between one clause which required reinsurers to accept the honest settlements of the insurer arrived at in a business-like manner and another clause that precluded the insurer from making any settlements without the approval of the reinsurers. Robert Goff L.J. resolved this apparent conflict in the following way:

"In my judgment the undertaking by the insurers not to make a settlement without the prior approval of the reinsurers, must have been intended to circumscribe the powers of the insurers to make settlements binding upon reinsurers, so that reinsurers would only be bound to follow a settlement when it had received their approval. In other words, the follow the settlement clause must be construed in its context in the policy, containing as it does a claims co-operation clause in this form, as only requiring reinsurers to follow settlements which are authorised by the policy, i.e., those which have received their approval, though presumably reinsurers, can, if they wish, waive that requirement."

Fox L.J approached the question in the following way:

"The position then is this. The appellants did not approve the settlement of ATC's claim of a loss of $3,500,000, the Judge however accepted, in my view rightly, that ATC incurred that loss and have proved it. That sum is, therefore, payable by the respondents."

What Fox L.J. appears to be saying is that the Insurance Company of Africa did not settle the claim. What happened was that the Liberian court held that it was liable under the policy. The claims co-operation clause did not, therefore, have any effect.

Extra Contractual Liability and Costs

We have seen earlier that the Liberian court also awarded punitive damages of $600,000 and costs of $58,000 against the Insurance Company of Africa. The Court of Appeal therefore, also had to consider whether reinsurers were liable to contribute to those expenses. The court (Robert Goff and Fox L.J, Stephenson L.J. dissenting) held that reinsurers were not liable to contribute to the punitive damages and costs. The majority held that, in order for reinsurers to be liable to contribute to such costs, it would be necessary to imply a term to that effect into the reinsurance contract. The court held that there was no justification for implying such a term in the present case. Robert Goff L.J. expressed his attitude in the following terms:

"In my judgment, in the absence of any request by the reinsurers to the insurers to take any particular course of action, they have not agreed to any such indemnity. They are simply saying that they are not prepared in the circumstances to give their approval, and the effect of this is that the insurers cannot rely on the follow settlements clause."

The punitive damages considered in the SCOR litigation are similar in nature to "extra contractual" damages which are commonplace in the United States of America and have now reached the Australian scene. A recent Australian example is provided by Protean (Holdings) Limited (receivers and managers appointed) v. American Home Assurance Company (1986) 4 ANZ Insurance Cases 60-683.

There is some American authority in relation to "extra contractual" damages in the context of a "follow the fortunes" clause. In Peerless Casualty Company v. Inland Mutual Insurance Company 251 F 2d 696 (1958) the court held that the reinsurer was obliged to indemnify the insurer in relation to extra contractual damages. However, this decision would seem to be based on a combination of a "follow the liabilities" clause and the conduct of the reinsurer, or some type of estoppel. The actual words used in the reinsurance contract were "the liability of the reinsurer shall follow that of the company in every case". The fourth circuit Court of Appeals stated the situation thus:

"Our holding is that under the facts of this case, where Peerless knew as much about the Arms case as did Inland; where Peerless' appreciation of the risks was different and sounder than Inland's; where Inland had already commited itself to $5,000, the risk retained by it, and stood to gain rather than to lose by a settlement within the policy limits; and where Peerless was freely and frankly consulted by Inland, and Peerless left the decision in Inland's hands, that decision became the decision of Peerless as well as Inland; Peerless is bound, along with Inland, by that decision, whether sound or unsound, favourable or unfavourable."

Ex Gratia Settlements

The question of whether a "follow the fortunes" clause would require a reinsurer to contribute to an "ex gratia" settlement has been subject to litigation in the United States of America. In American Insurance Company v. North American Company for Property and Casualty Insurance 697 F 2d (1982), Second Circuit Court of Appeals the insured was Dow Chemical Company which had a liability policy. Reinsurance was arranged for $500,000 in excess of $250,000. Dow Chemical Company was involved in a liability claim and in 1977 Judgment was given against that company for $146,000 in compensatory damages with a further $750,000 in punitive damages. The insurer subsequently settled the claim with Dow Chemical Company for $500,000 all up. The insurer then sought to recover from its reinsurers the amount of the settlement in excess of $250,000. Reinsurers refused to follow this settlement on the basis that the insurer was not legally obliged to indemnify Dow Chemical Company in relation to the punitive damages.

The Court of Appeal held, as a matter of policy construction, that the insurer was not responsible for the award of punitive damages. The reinsurance agreement contained the following clause:

"All claims involving this reinsurance, when settled by the company, shall be binding on the reinsurer."

This is a "follow the fortunes" type clause.

The court, in finding for the reinsurer, distinguished two classes of ex gratia payments. The first one is where the insurer knows that it has no legal liability, but decides to settle the claim for commercial or other reasons. The second class is where there is some ambiguity or doubt as to the insurer's legal liability and a settlement is agreed upon in view of that doubt. The court held that it is only in the latter class of case that the reinsurer is obliged to indemnify the insurer.

Conclusions

Although the above authorities are not binding on Australian courts, they would be persuasive in any litigation in Australia involving similar issues. This is particularly so of the English Court of Appeal decision in SCOR.

What lessons can we learn from the cases which would have application today? The following may be relevant:

• If there is no express provision in a reinsurance contract requiring reinsurers to follow the fortunes of an insurer, the reinsurer is only obliged to follow those settlements where the insurer had a legal liability under a policy with the original insured. Ex gratia settlements, punitive and extra contractual damages are not covered by the reinsurance contract. Likewise, costs incurred by the insurer are not payable by the reinsurer unless it is permissible to imply a term into the reinsurance contract that the reinsurer is so liable.

• A "follow the fortunes" clause requires reinsurers to follow settlements arrived at by an insurer where the insurer has acted honestly and taken all proper and business-like steps in achieving the settlement.

• Where a "follow the fortunes" clause and a "claims co-operation" clause appear in the same reinsurance contract and are in conflict, the former may well be read subject to the latter. This would have the effect that the reinsurer would only be bound to follow those settlements that had received their approval.

• Treaty wordings often make express provision for the contribution by reinsurers to ex gratia settlements and costs incurred by an insurer. (Whether or not express provision is required in relation to ex gratia settlements is perhaps doubtful in view of the pronouncements [albeit obiter] in American Insurance Company v. North American Company for Property and Casualty Insurance. It is always better, of course, to err on the cautious side and make express provision.) However, treaty wordings do not generally make provision for punitive or extra contractual damages. This type of award could become more prevalent in Australia in the future and perhaps consideration should be given to including express provision in treaties.

• A facultative reinsurance contract will generally not make express provision for any of the matters discussed above. A reinsurer is only obliged to follow settlements made pursuant to a legal liability under the original policy. Further, the decision in SCOR indicates that a court will not imply lightly a term requiring reinsurers to contribute to costs incurred by an insurer in defending a claim. This situation should be remedied, if not by provision in individual contracts then by medium of a facultative market agreement.