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Travelers Casualty and Surety Company v. Insurance Company of North America

Issue Discussed: Allocation

Submitted by Andrew D. Shapiro

Date Promulgated: June 9, 2010

Issues:

1. Whether a cedent’s post-settlement allocation to an excess layer of coverage, and to certain policies within that layer, was made in good faith.

2. Whether prejudgment interest should be calculated according to the reinsurance certificates’ choice of law provision, or the law of the state in which the action was brought.

3. Whether post-judgment interest on the prejudgment interest award began to accrue on the date the Court entered judgment for the cedent, or on the date when the Court subsequently quantified the amount of prejudgment interest owed.

Submitted by Andrew D. Shapiro*

In Travelers v. INA, the Third Circuit issued four substantive rulings:

1. It upheld the trial court’s ruling that the reinsurer failed to meet its burden of showing that the cedent’s decision to allocate a settlement to an excess layer of coverage — thereby allowing the cedent to trigger its reinsurance — was done in bad faith;

2. It upheld the trial court’s determination that the cedent allocated more to certain policies in the excess layer than was reasonably allowed by the limits of those policies;

3. It reversed the trial court’s decision to calculate prejudgment interest using the law of the state in which the case was filed, and ordered the trial court to recalculate prejudgment interest using the law governing the parties’ reinsurance contracts; and

4. It affirmed the trial court’s holding that post-judgment interest on a prejudgment interest award does not begin to accrue until the court has quantified the amount of prejudgment interest owed.

Background

In 1998, Travelers reached a $137 million settlement with its insured. Travelers subsequently allocated the settlement dollars among three tiers of insurance — the highest layer of which was reinsured by INA (the “excess layer”). After INA refused to pay its allocated share of the settlement — more than $13 million — Travelers sued to recover in the Eastern District of Pennsylvania.

In the trial court, INA defended its non-payment by contending that Travelers manipulated its post-settlement allocation to maximize the amount allocated to the INA- reinsured policies. The court held two bench trials. In Phase I, the court ruled that Travelers had not manipulated its allocation of the settlement dollars to reach the excess layer. In Phase II, the court ruled that once Travelers reached the excess layer, however, it allocated more settlement dollars to certain INA-reinsured policies than was reasonably allowed by the limits of those policies. As a result, the court held that INA was responsible for only $8.2 million of the $13 million loss Travelers initially allocated to INA.

The trial court also issued two important post-trial rulings. In the first, the trial court held that prejudgment interest on Travelers’ award should be calculated according to the Pennsylvania statutory rate — notwithstanding that the relevant reinsurance contracts were governed by New York law. In the second, the court held that post-judgment interest on the prejudgment interest award did not begin to accrue until the court issued its order quantifying the amount of prejudgment interest due.
Both parties appealed. The Third Circuit affirmed both trial verdicts and the ruling concerning when post-judgment interest on the prejudgment interest award began to accrue. The Third Circuit disagreed, however, with the trial court’s conclusion that prejudgment interest should be calculated using the Pennsylvania statutory rate. Accordingly, the appellate court remanded the case back to the trial court so that prejudgment interest could be recalculated using the New York statutory rate.

Holding

The Third Circuit adopted the “majority view” that the follow-the-fortunes doctrine applies to post-settlement allocations. Accordingly, to demonstrate that the follow-the-fortunes doctrine should not apply, a reinsurer has the burden of establishing that the cedent breached its duty of good faith by making its allocation decision “primarily for the purpose of increasing its reinsurance recovery.” But the cedent’s negative duty not to make allocation decisions primarily in order to increase reinsurance recovery does not translate into a positive duty to minimize reinsurance coverage. Thus, where the cedent is able to point to some legitimate (i.e. non-reinsurance-related) reason for the challenged decision, a reinsurer fails to meet its burden by merely demonstrating that a particular allocation decision increased the cedent’s access to reinsurance. Instead, in order to prevail, the reinsurer must either: (1) provide direct evidence that the cedent was motivated primarily by reinsurance considerations; or (2) show that the cedent’s after-the-fact rationales are not credible.

Applying that test, the appellate court affirmed the trial court’s Phase I ruling that INA had failed to meet its burden of proving that Travelers’ decision to allocate settlement dollars to the excess layer was made in bad faith, notwithstanding that those excess policies were the only policies with third-party reinsurance. Interestingly, the appellate court found that there was enough evidence to “raise suspicions” that Travelers engineered its post-settlement allocation to maximize its reinsurance recovery. Nonetheless, the Third Circuit affirmed the trial court’s ruling, because INA had not met its burden of showing that Travelers’ allocation decision was driven “primarily by reinsurance considerations.”

The appellate court also affirmed the trial court’s Phase II ruling, which found that INA had met its burden of proving that Travelers’ decision to treat the per-occurrence limits of two three-year policies reinsured by INA as annual limits, renewing in each policy year, was not made in good faith. INA met its burden by showing that under Michigan law — which controlled the interpretation of the policies — the underlying policy language unambiguously provided that the per-occurrence limits were not subject to the treatment Travelers gave them.

In addition, the appellate court reversed the trial court’s decision to calculate prejudgment interest using Pennsylvania law, the law of the state in which the suit was filed. The appellate court concluded that under Pennsylvania law, the calculation of prejudgment interest in contract actions is substantive, not merely procedural. Thus, the Third Circuit found that the trial court should have used New York law — the law chosen by the parties to govern the relevant reinsurance contracts — to calculate prejudgment interest.

Finally, the appellate court affirmed the trial court’s conclusion that post-judgment interest on the prejudgment interest award did not begin to accrue until the court quantified the amount of prejudgment interest INA owed to Travelers. Although the Third Circuit recognized that “it was not hard to see the logic” of Travelers’ position that post-judgment interest should begin to accrue when the court initially entered judgment in favor of Travelers for more than $8 million, common law precedent mandated that post-judgment interest on the prejudgment interest award did not begin to accrue until the court quantified the amount of prejudgment interest owed, nearly 16 months later.

* Andrew D. Shapiro is a partner at Butler Rubin Saltarelli & Boyd LLP, where he specializes in reinsurance litigation and arbitration.