Reinsurer Entitled to Discovery on Reasonableness of Insurer's Settlement and Allocation Decisions

On September 15, 2014, Justice Scarpulla of the New York County Commercial Division issued a decision in Lexington Insurance Co. v. Sirius America Insurance Co., 2014 NY Slip Op. 32429(U), ruling that a reinsurer was entitled to discovery regarding (1) the reinsured's settlement of a claim covered by the underlying policy, and (2) the allocation of the settlement proceeds, notwithstanding a policy provision that generally requires deference to the reinsured's settlement decisions.

Reinsurance contracts like the ones at issue in Lexington Ins. Co. commonly contain a provision known as a "follow-the-fortunes" (or "follow the settlements") clause, which precludes the reinsurer from "second guess[ing] the good faith liability determinations made by its reinsured," and therefore requires the reinsurer "to indemnify for payments reasonably within the terms of the original policy, even if technically not covered by it." Such provisions are designed to prevent extensive collateral litigation on the reasonableness of the settlement amount. As the Court of Appeal recognized in a recent decision cited by Justice Scarpulla on this issue, such deference is sensible because, in general, the interests of reinsurer and the reinsured are presumptively aligned (both want to settle for as little as possible). When it comes to issues of allocation, however, the interests may diverge, since, the reinsured could structure the settlement so as to shift responsibility for all, or a larger portion, of the settlement amount to the reinsured. Thus, in evaluating allocation issues, even where the reinsurance contract has a follow-the-fortunes clause, the courts defer to the reinsured's decision only if it is "objectively reasonable." In light of that background law, Justice Scarpulla found that the reinsurer was entitled to discovery concerning the settlement to establish a potential defense:

In United States Fid. & Guar. Co. v. American Re-Ins. Co., the New York Court of Appeals recently held that, while a cedent's decision on allocation is entitled to deference under a follow-the-settlements clause, the reinsurer will only be bound by the cedent's allocation if it is objectively reasonable. Further, it is well-settled that under a follow-the-settlements clause, a reinsurer is bound by the settlement or compromise of a claim agreed to by a cedent unless it can show impropriety in arriving at the settlement. Under these doctrines, Sirius is entitled to discovery regarding National and Lexington's settlement and allocation decisions.

(Citations omitted).