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

June 9, 2010

TRAVELERS CASUALTY AND SURETY COMPANY, F/K/A THE AETNA CASUALTY AND SURETY COMPANY, APPELLANT/CROSS-APPELLEE
v.
INSURANCE COMPANY OF NORTH AMERICA APPELLEE/CROSS-APPELLANT PER COURT'S ORDER OF 10/7/08



Appeal from the United States District Court for the Eastern District of Pennsylvania, (D.C. Civil Action No. 01-cv-00098), District Judge: Honorable William H. Yohn.

The opinion of the court was delivered by: Ambro, Circuit Judge

PRECEDENTIAL

Argued May 12, 2009

Before: AMBRO, ROTH and ALARCÓN*fn1, Circuit Judges.

OPINION

This is a dispute over reinsurance coverage. In 1998, Travelers Casualty and Surety Co. ("Travelers") reached a $137 million settlement with its insured, Acme Corporation ("Acme").*fn2 Travelers then proceeded to allocate those $137 million dollars among three tiers of insurance coverage, only the highest of which-the so-called "excess" layer-included policies reinsured by Ace America Reinsurance Company and Insurance Company of North America (collectively, "INA"). When Travelers billed INA $13,762,395 based on its allocation, INA refused to pay, and Travelers sued to recover in the Eastern District of Pennsylvania.

At issue before the District Court was whether Travelers manipulated its post-settlement allocation so as to maximize the amount allocated to policies reinsured by INA, thus excusing INA from its normal duty as a reinsurer to "follow" all coverage decisions made by its reinsured. The District Court held two bench trials, each addressing a different aspect of Travelers' allocation, and ultimately reached what was, in effect, a split decision. The Court ruled, following the first bench trial, that Travelers had not manipulated its allocation of the settlement dollars so as to allow it to reach the excess layer of coverage (and thus tap into its reinsurance). But the Court also ruled after the second bench trial that, once Travelers reached the highest tier of coverage, it allocated more to certain policies reinsured by INA than was reasonably allowed by their policy limits. The result of those two verdicts was to leave INA responsible for only $8,226,817 of the loss initially allocated to it.

The Court then issued two consequential post-trial rulings. In the first, it held that prejudgment interest on Travelers' award should be calculated according to the Pennsylvania rate, even though the reinsurance contracts under which Travelers sued were governed by New York law. In the second, it held that post-judgment interest on the prejudgment interest did not begin to accrue until the District Court issued its order quantifying the amount of prejudgment interest due.

Both parties appealed.*fn3 We affirm both trial verdicts as well as the ruling concerning when post-judgment interest on the prejudgment interest began to accrue. However, because we believe that Travelers' award of prejudgment interest should be calculated according to the higher New York rate, we remand on that issue only so that the prejudgment interest can be recalculated.

I. BACKGROUND

A. The Follow-the-Fortunes Doctrine and the Reinsurance Relationship

Because the events that gave rise to this dispute occurred in the context of a relationship between an insurer (Travelers) and its reinsurer (INA), we begin with some background into the reinsurance relationship. Reinsurance is a mechanism "'by which one insurer insures the risk of another insurer.'" N. River Ins. Co. v. ACE Am. Reins. Co., 361 F.3d 134, 137 (2d Cir. 2004) (quoting People ex rel. Cont'l Ins. Co. v. Miller, 70 N.E. 10, 12 (N.Y. 1904)). The insurer pays the reinsurer a premium in exchange for which the reinsurer assumes "a portion of the [insurer's] potential financial exposure under certain direct insurance policies it has issued to its insured." Id. Obtaining reinsurance allows an insurer to diversify its risk exposure, thus increasing its "capacity to insure other customers and decreas[ing] the likelihood that . . . insolvency will result from any large claim." N. River Ins. Co. v. CIGNA Reins. Co., 52 F.3d 1194, 1199 (3d Cir. 1995).

A crucial feature of the reinsurance relationship is that "[r]einsurance involves contracts of indemnity, not liability." Unigard Sec. Ins. Co. v. N. River Ins. Co., 4 F.3d 1049, 1054 (2d Cir. 1993). That is, in providing reinsurance, the reinsurer acquires no direct liability to the original policyholder; rather, the reinsurer assumes an obligation to indemnify the insurer for payments it makes under the reinsured policies. Id. Indeed, a reinsurance agreement typically contains two specific provisions designed to prevent the reinsurance relationship from encroaching on coverage disputes between the insurer and its insured: a "follow-the-form" provision, in which the reinsurer agrees to reinsure the policies as written, and a "follow-the-fortunes" provision, in which the reinsurer agrees to "follow" the coverage provided by the insurer. See CIGNA, 52 F.3d at 1199--1200.

Of these two provisions, the most crucial is the followthe-fortunes provision. See Barry R. Ostrager & Mary Kay Vyskocil, Modern Reinsurance Law & Practice § 2.03[d] (2d ed. 2000), at 2-17 (noting that the "follow-the-fortunes" provision lies "at the heart of the reinsurance agreement"). The follow-the-fortunes doctrine significantly restricts a reinsurer's ability to challenge the coverage decisions that led to its liability to the insurer. This is so for a basic reason-"[i]f the [insurer] knew that its settlement decisions could be challenged by every reinsurer, there would be little incentive to settle with the insured. The costs and risks of litigation avoided by settling with the insured would only be revived at the reinsurance stage." Commercial Union Ins. Co. v. Seven Provinces Ins. Co., 9 F. Supp. 2d 49, 66 (D. Mass. 1998); see also CIGNA, 52 F.3d at 1206 ("To permit the reinsurer to revisit coverage issues resolved between the insurer and its insured would place insurers in the untenable position of advancing defenses in coverage contests that would be used against them by reinsurers seeking to deny coverage.").

Accordingly, the follow-the-fortunes doctrine "insulates a reinsured's liability determinations from challenge by a reinsurer unless they are . . . in bad faith, or the payments are clearly beyond the scope of the original policy."*fn4 ACE, 361 F.3d at 140 (internal quotation marks and citation omitted). In other words, a reinsurer seeking to avoid payment must show either that the coverage decisions that led to the reinsurer's liability to the insurer were made in bad faith, or that the coverage provided clearly fell outside the scope of the policies the reinsurer agreed to reinsure. See Mentor Ins. Co. (U.K.) Ltd. v. Brannkasse, 996 F.2d 506, 517 (2d Cir. 1993). Otherwise, the reinsurer must simply cover the losses allocated to it.

B. Acme v. Travelers and Travelers v. INA

In April 1996, Travelers acquired Aetna Casualty and Surety Company ("Aetna CS"). At the time, Acme was seeking coverage under insurance policies issued by Aetna CS in the 1970s and 1980s. Acme sought coverage primarily for two sets of claims being brought against it: (1) breast implant claims, relating to safety testing of silicone breast implants that Acme had performed for its parent, Acme Parent Corporation*fn5 ("Acme Parent"); and (2) chemical products claims, relating to chemical products manufactured by Acme, including the pesticide commonly known as "DBCP."*fn6 The Aetna CS policies potentially implicated by the breast implant claims and the chemical products claims made up three distinct layers of coverage-primary policies (bearing the designator "AL"), buffer policies (bearing the designator "XS"), and excess policies (bearing the designator "XN").*fn7 Because the distinct features of each layer's policies became central to the dispute between Travelers and INA that followed, it is worth describing those policies in some detail.

1. The Insurance Policies

The AL policies were issued between April 1976 and April 1987 and provided coverage for all non-products claims brought against Acme, as well as products claims brought against it outside the United States. Each of the AL policies had a per-occurrence coverage limit, but only the policies issued between April 1985 and April 1987 had aggregate coverage limits.

In addition, the AL policies had three features that became particularly significant to the reinsurance dispute that followed. First, the policies were subject to retrospective premiums from Acme. For any payment Travelers made on an AL policy, it was entitled to reimbursement from Acme up to that particular policy's "loss limit."*fn8 The AL policies covering the period from April 1976 through April 1982 included a limit on the amount in retrospective premiums that could be collected, while the post-April 1982 AL policies included no such limit. Second, the AL policies were subject to captive reinsurance, that is, reinsurance provided by an Acme subsidiary. Each AL policy was reinsured for 95% of all losses above the loss limit, except the last policy, which was reinsured at 95.5% above the loss limit.*fn9 Finally, the AL policies included an obligation to cover defense expenses in addition to an obligation to indemnify Acme for liability it incurred. For the April 1976 through April 1982 AL policies only, defense costs did not count toward the policy limits, while, for all the AL policies, captive reinsurance could not be sought for defense costs unless Travelers also made indemnity payments to Acme.

The XS policies covered the period between April 1976 and April 1982. They provided United States products liability coverage and were in excess of Acme's primary layer of products liability coverage, meaning that they were only available to Acme once its primary layer of products liability coverage (which was supplied by a Acme subsidiary) was exhausted.*fn10 The XS policies were also subject to captive reinsurance. The policies spanning from April 1976 to April 1978 were 100% reinsured for bodily injury claims, while the remaining XS policies were 95% reinsured for all claims.

The XN policies provided the final layer of coverage. These policies covered both products and non-products claims, and were in excess of all Acme's insurance coverage (including its coverage under the AL and the XS policies).*fn11 While none of the XN policies was subject to either retrospective premiums or captive reinsurance, the XN layer was the one layer that did possess non-captive reinsurance, including reinsurance from INA.*fn12 INA assumed, through facultative reinsurance certificates,*fn13 a portion of nine of the XN policies. Each certificate issued by INA contained both a follow-the-form provision and a follow-the-fortunes provision.

2. The Settlement Negotiations

Acme initially sought coverage for the tens of thousands of breast implant claims brought against it under the AL policies, and sought coverage for the chemical products claims under both the XS policies and the XN policies.*fn14 At first, Aetna CS declined coverage, and then, starting in February 1996, made a series of settlement offers to Acme, each of which was rejected. Upon its acquisition of Aetna CS, Travelers restarted settlement negotiations from scratch. Negotiations were handled, from Travelers' end, by Timothy Yessman, who was Senior Vice President of Travelers' Special Liability Group, and Susan Stonehill-Clafin, who was General Counsel for Travelers' Environmental Litigation Group. Yessman acted as lead negotiator, while Stonehill-Clafin provided legal advice.

Up to that point, Acme had not yet settled, or received an adverse judgment on, any of the claims against it, but had incurred substantial defense costs. Accordingly, the parties focused initially on reaching a "coverage-in-place" deal. Under such an arrangement, Travelers would agree to pay a fixed sum to cover Acme's past losses, and, for Acme's future losses, the parties would work out a formula for matching the specific claims against Acme to the specific insurance policies. Travelers would then make payments pursuant to that formula-subject to a finite cap-as Acme's ultimate liability developed.

In its negotiations with Acme about how to characterize the claims for which coverage was being sought, Travelers was adamant about two points-that the breast implant claims were products claims, and thus were not covered by the AL policies,*fn15 and that they arose out of a single occurrence (namely, a single act of negligent testing on Acme's part). According to testimony Yessman later provided, it was the number of occurrences issue that was viewed as the most critical. Because the AL policies possessed per-occurrence limits, but were not (for the most part) subject to aggregate limits, Travelers' greatest concern was that the breast implant claims would be characterized as non-products claims arising out of multiple occurrences. Under such a scenario, it was possible that Travelers' exposure under the AL policies would be exponentially greater, at least if the liability for each occurrence was below the per-occurrence limit.*fn16

While the negotiations with Acme were ongoing, Yessman had Mark Wigmore, a Vice-President and Associate General Counsel in Travelers' reinsurance department, produce a memo (the "Wigmore Memo") that became central to the litigation that followed.*fn17 The Wigmore Memo explored the reinsurance implications of different coverage scenarios for the breast implant claims. The Memo noted a number of issues of potential concern, only two of which are particularly germane to this appeal. First, the Memo suggested that, because Travelers could not collect captive reinsurance on payments made to cover defense costs unless it also paid out in indemnity, it was possible that "Acme [would] litigate each and every case to the fullest extent, without making any settlements, in order to avoid its . . . reinsurance obligations." (J.A. at 615.) Second, the Memo mentioned that, if the breast implant claims were determined to be non-products claims arising out of multiple occurrences, Acme might never get out of the AL layer of coverage and into the reinsured XN layer, since, if the liability for each occurrence was low enough, it was possible that it would never exhaust the per-occurrence limits of the AL policies not subject to aggregate limits. The Memo also speculated that, if Travelers were to bill its reinsurers based on a single occurrence characterization, "[c]ollection [from them would] likely . . . be more difficult," but that, if Acme agreed to that characterization in any settlement, Travelers "would have a strong position" in "litigation or arbitration" with its reinsurers. (J.A. at 616.)

The final settlement meeting between Travelers and Acme took place on July 7, 1998, at which point both parties changed their approach. Acme proposed moving to an all-cash net settlement. That meant that, rather than (as with a coverage-in-place deal) coming up with a formula for how to treat Acme's future losses, Travelers would simply pay Acme a lump sum-forgoing both retrospective premiums and captive reinsurance-in exchange for Acme releasing all of its future claims under the policies.*fn18 Travelers accepted the proposal and, with the new framework in place, the parties quickly agreed on a figure of $137 million. They then decided that, of that $137 million, $80 million would be dedicated to the breast implant claims, $20 million would be dedicated to the chemical products claims, and the remaining $37 million would go to claims that are not at issue in this case. In addition, the parties agreed that the breast implant claims would be treated as non-products, single occurrence claims, while the chemical products claims would be treated as products claims. Beyond that, they did not come to any agreement about how to allocate the settlement to the specific policies potentially implicated.

3. The Final Settlement Agreement

Although Travelers and Acme reached an agreement in principle during the July 7, 1998 meeting, the settlement was not finalized until September of that year. The primary issue in dispute was Travelers' proposed allocation of the agreed-upon sum among the different policies. According to Robert Miley, who, along with William Kingston, was primarily responsible for drafting the settlement agreement on behalf of Travelers,*fn19 it was not that Acme objected to Travelers' proposed allocation so much as that it "wondered whether . . . it [i.e., the allocation language] needed to be . . . in the settlement agreement." (Trial Tr. vol. 1, 216, Jan. 11, 2005.)

In a draft dated July 27, Travelers included language indicating that, of the $20 million dedicated to the chemical products claims, $5 million would be allocated to the TIC policies, while the remaining $15 million would be allocated to the XN policies. That draft also included language providing that no amount could be allocated to the post-April 1982 AL policies. In a draft returned to Travelers on September 1, Acme crossed out most of the allocation language, put a question mark next to the line indicating that the post-April 1982 AL policies were not to be used, and added language stating that, with the exception of any allocations specifically set forth in the agreement, each party reserved the right to allocate the settlement as it pleased. In a draft returned on September 4, Acme continued to designate the allocation language "IN DISPUTE," and specifically crossed out the section regarding allocation to the post-April 1982 AL policies.

The settlement agreement became final in mid-September. It provided that Travelers' payments to Acme were "net of any reinsurance obligations the Acme Insurance Subsidiaries have or may have to Travelers and net of any retrospective premium or other obligations Acme has or may have to Travelers." It also included the language indicating that the $20 million for the chemical products claims would be divided between the TIC policies ($5 million) and the XN policies ($15 million). In addition, the final version included a paragraph providing that "[n]o payments . . . shall be allocated to any [AL] Primary Policies with a policy period commencing on or after April 1, 1982, or to any . . . XS Policies because the payments of the Settlement Amount are net payments and such Policies have been exhausted by virtue of the settlement." Lastly, the final version provided that "[w]ith the exception of the agreements explicitly set forth in . . . this Agreement, Acme and Travelers each reserve to themselves the right to allocate any or all of the Settlement Amount to any Policy; Acme will not be deemed to concur in any such allocation by Travelers, and Travelers will not be deemed to concur in any such allocation by Acme." In the subsequent litigation with INA, Travelers conceded that the allocation language was included in the settlement agreement at its behest.

4. The Post-Settlement Allocation and Reinsurance Billing

Once the settlement agreement was finalized, Miley and Kingston proceeded to allocate the settlement among the different policies. As agreed, of the $20 million dedicated to the chemical products claims, $5 million was allocated to the TIC policies and $15 million to the XN policies. Travelers characterized the $80 million dedicated to the breast implant claims entirely as indemnity, not defense coverage. In allocating that $80 million, Travelers began with the AL layer of policies, but, in accord with the agreement, confined itself to the preApril 1982 AL policies. In allocating within that layer, it employed the so-called "fill the bathtub" method.*fn20 Starting with the earliest of the policies, Travelers allocated to each eligible AL policy up to its single-occurrence limit (minus the amount owed in retrospective premiums) before moving on to the next policy.*fn21 This resulted in a total of $24 million being allocated to the AL policies. The remaining $56 million of the $80 million dedicated to the breast implant claims was then allocated to the XN policies in accordance with the fill-the-bathtub method (starting with the XN policies with the lowest attachment points). Two of the XN policies implicated by Travelers' allocation of the breast implant claims settlement had three-year policy periods. In exhausting those three-year policies (each of which was reinsured by INA), Travelers treated their per-occurrence limits as applying separately to each policy year, a decision that tripled the amount that could be allocated to those policies.

Ultimately, six of the nine XN policies reinsured by INA had settlement dollars allocated to them. Pursuant to its allocation, Travelers billed INA $11,604,328 for the breast implant claims and $2,158,067 for the chemical products claims. Travelers agrees that the following decisions likely increased the amount of its coverage it was able to allocate to INA-(1) treating the breast implant claims as arising out of a single occurrence; (2) bypassing the post-April 1982 AL policies in allocating the $80 million dedicated to the breast implant claims; (3) bypassing the XS policies in allocating the $20 million dedicated to the chemical products claims; (4) not allocating the $80 million for the breast implant claims exclusively to defense costs (even though, at the time of the settlement, Acme had not yet incurred any liability on those claims); and (5) allocating to the three-year XN policies on the assumption that their per-occurrence limits applied separately to each policy year.*fn22 The decision to annualize the per-occurrence limits alone resulted in an increase of $5,535,578 to the amount of loss assigned to INA. At any rate, INA refused to pay any of the amount Travelers allocated to it.

C. The District Court Proceedings

In January 2001, Travelers brought its breach of contract action against INA, contending that INA was barred, under the follow-the-fortunes doctrine, from challenging Traveler's resolution of its coverage dispute with Acme. In insisting that it was not obligated to pay, INA did not question the propriety of the underlying $137 million settlement. Rather, it challenged only Travelers' post-settlement allocation of that settlement.

At the close of discovery, both parties moved for summary judgment. In August 2004, the District Court denied both parties' motions for summary judgment and the case proceeded to two separate bench trials. The first trial ("Phase I") addressed whether Travelers had engineered its post-settlement allocation to maximize the amount of the settlement that ended up in the reinsured XN layer of coverage. The second trial ("Phase II") addressed the propriety of Travelers' decision, once it reached the XN layer, to treat the three-year policies as subject to three separate per-occurrence limits.

Prior to the Phase I bench trial, INA made a motion in limine seeking to preclude testimony relating to discussions with, or analyses prepared by, Travelers' in-house*fn23 or outside counsel. In its motion, INA asserted that, under the so-called "sword/shield" doctrine, Travelers could not both invoke a privilege to shield its communications with its attorneys (as it had throughout discovery) and defend its conduct with reference to advice received by counsel. The District Court partially denied and partially granted the motion, limiting Travelers' testimony on its advice from counsel to the topic, rather than the content, of those communications. Ultimately, the Court ruled that Travelers could refer generally to its use of counsel in making certain decisions to show that it proceeded in a "businesslike" manner, but could not attribute any particular decision to the advice of counsel. (J.A. at 30.)

The Phase I trial was held in January and February of 2005. The District Court heard testimony from both parties' experts, as well as the Travelers employees who worked on the settlement with Acme (including the post-settlement allocation and the reinsurance billing),*fn24 all of whom denied that reinsurance recovery considerations motivated any of their decisions. In December 2005, the District Court ruled in favor of Travelers on the issues addressed in the Phase I trial. The Court summed up its findings as follows:

Although there is certainly enough evidence in the record to raise the suspicions of [INA], I generally find Travelers' witnesses to be credible. I further find that Travelers did not allocate the sum plaintiff owed under the settlement agreement to maximize its potential reinsurance recovery from [INA], that Travelers did not act in bad faith, and that its various actions were reasonable, businesslike decisions made in good faith.

(J.A. at 57.)

The Phase II trial was held in February 2006. After once again hearing testimony from both parties' experts, as well as from Travelers' employees, the District Court ruled in INA's favor. The Court concluded that, under Michigan law (which governed the insurance policies Aetna CS had issued to Acme), "the three-year XN policies clearly and unambiguously have a single per-occurrence limit for the entire policy period." (J.A. at 96.) It therefore held that Travelers' interpretation of the those policies' per-occurrence limits was not binding on INA as its reinsurer. The Court then (in an order summing up both its Phase I and its Phase II rulings) entered judgment in favor of Travelers in the amount of $8,226,817, a figure ...


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