Follow the Fortunes Does Not Require Reinsurers to Pay Claims Not Covered by the Underlying Reinsured Policies

ASSOCIATED INDUS. INS. CO. V. EXCALIBUR REINSURANCE CORP. (No. 13 Civ. 8239 CM; Nov. 26, 2014)

Excalibur Reinsurance Corporation reinsured its cedent, Associated Industries Insurance Company, Inc. (AIIC) under two workers’ compensation treaties: an excess of loss treaty and a quota share agreement. Under the excess of loss treaty, Excalibur agreed to pay 65 percent of each loss between $500,000 and $5 million. Excalibur was also liable under the excess of loss treaty for coverage limits of $5 million in excess of $5 million. The quota share agreement required Excalibur to post a letter of credit when its A.M. Best rating drops below “A.”

Pursuant to an arbitration agreement, the parties agreed to arbitrate any dispute or other matter arising out of the reinsurance agreements. The excess of loss treaty explicitly stated that the “arbitrators shall not be obliged to follow judicial formalities or the rules of evidence.” Each party appointed one arbitrator who then selected a third neutral arbitrator. The particular arbitration in dispute arose to determine Excalibur’s obligation to reinsure settlements AIIC entered that Excalibur disputed and whether Excalibur was obliged to post a letter of credit.

In front of the arbitrators, Excalibur argued and offered evidence that AIIC gratuitously paid claims for which it was not liable and handled other claims settlements in a grossly negligent manner, subjecting Excalibur to a higher level of liability. AIIC argued that Excalibur was liable for all of the amounts claimed pursuant to the “follow the fortunes doctrine.” A split panel awarded AIIC most of the relief it sought. AIIC was awarded over $2.7 million in claims under the excess of loss treaty with interest in addition to the requirement that Excalibur post a letter of credit. The panel, however, discounted the total amount requested by AIIC, as it found some of the claims were negligently handled and one was paid gratuitously. With support from the dissenting arbitrator, who was appointed by AIIC, the cedent petitioned to the Southern District of New York to have those parts of the award discounting the amount vacated. AIIC argued for vacatur of the discounts, claiming the other two arbitrators manifestly disregarded the “follow the fortunes doctrine.”

Judge McMahon of the Southern District of New York first noted the uneasy ground upon which the “manifest disregard for the law” standard is predicated. Normally, courts may only vacate an arbitrator’s award under a statutorily designated basis in § 10(a) of the Federal Arbitration Act. The Second Circuit has vacated awards under this basis, though it is not in the FAA and it has been called into question by the U.S. Supreme Court. The court determined that vacatur on this standard is “severely limited, highly deferential, and contained to those exceedingly rare instances where some egregious impropriety on the part of the arbitrators is apparent.” Under this standard the cedent must establish that the arbitrators “simply chose to disregard the ‘follow the fortunes’ doctrine entirely.” The court held that AIIC could not meet this heavy burden.

AIIC did not offer proof to show that the arbitrators disregarded the doctrine. Instead, AAIC provided a 30-page factual summary, in addition to its arbitrator’s dissent, alleging that the other two arbitrators had misapplied the facts and come to the wrong conclusion. Calling it a “waste of paper,” the court reiterated that when parties agree to arbitration, it is the arbitrators who hear the factual issues and courts have no authority to retry the case or substitute its opinion of the evidence. In each of the five disputed claims, the court held that the two arbitrators had at least some evidentiary and legal basis upon which to provide a decision.

The arbitrators below, and the court here, disagreed with AIIC’s strict reliance on the “follow the fortunes” doctrine, which requires a reinsurer to pay its share of claims settled by its cedent. The court ruled that the follow the fortunes doctrine is not without its limits and held that it does not apply to claims that are mishandled with gross negligence, or claims that are paid gratuitously (where the cedent is not liable for the claim).

One claim in dispute, the Zaiour claim, was found to be gratuitously paid as the claimant gave late notice of the claim, voiding the policy. AIIC argued that it did not contest the claim because it arose in Florida, and Florida courts are allegedly highly protective of workers’ compensation claimants and would still hold AIIC liable. However correct AIIC was in its interpretation of what a Florida court might do with the claim, the court here determined that, because the parties agreed that the arbitrators “shall not be obliged to follow judicial formalities,” the arbitrators did not need to look into how a Florida court would adjudicate it. Thus, the court held AIIC paid the claim gratuitously and the “follow the fortunes” doctrine did not apply to that claim.

IMPACT: This case illustrates that, despite the Supreme Court’s negative treatment of the “manifest disregard for the law” as a basis of vacating an arbitration award, the Second Circuit continues to apply its manifest disregard doctrine. This case also reaffirms a long line of jurisprudence that the follow the fortunes doctrine does not apply when the cedent is grossly negligent in handling claims settlements or if the cedent pays claims it is not liable for.