Further, the memorandum speculated that, if Travelers billed its


reinsurers on a single occurrence basis, collection from them would be more difficult unless the insured agreed to that characterisation for settlement purposes.


Ultimately, as part of the settlement, the breast implant claims were


treated as non-products claims arising out of a single occurrence, while the chemical products claims were deemed to be products claims.


Of the $137 million paid to the insured, $80 million was allocated to


breast implant claims and $20 million to chemical products claims. The agreement further specified that $15 million of that $20 million was allocated to the XN policies and that no amounts were allocated to any of the AL policies with a policy period commencing after April 1, 1982, or to any of the XS policies, both of which were deemed to be exhausted. The parties agreed that, except as set forth in the agreement, each reserved the right to allocate the settlement amount to any other applicable policy.


After the settlement was finalised, Travelers allocated the remaining


portions of the payment among the different policies. With respect to the breast implant claims, Travelers characterised the


$80 million paid as ‘indemnity’ and employed a so-called ‘rising bathtub’ allocation methodology, beginning with the pre-1982 AL policies.


Under that formula, losses are first allocated to the lowest tier of


coverage, until exhaustion: like a bathtub filled with water. As a result, $56 million was allocated to the XN policies, two of which had three-year policy periods. Travelers treated the per-occurrence limits of the multi- year policies as applying separately to each policy year, a decision that tripled the amount that could be allocated to them.


Travelers then billed the settlement amounts to INA, which refused to


pay and challenged Travelers’ post-settlement allocation. A lawsuit was commenced by Travelers in the Eastern District of Pennsylvania, which led to two separate bench trials.


In the first phase, the District Court rejected INA’s contention that


Travelers had manipulated its post-settlement allocation to maximise its reinsurance coverage, and held that Travelers’ allocation decisions were reasonable, businesslike and made in good faith. As such, the District Court ruled that the ‘follow-the-fortunes’ doctrine bound INA to Travelers’ allocation.


However, in the second trial, the District Court found that, under


Michigan law (which governed the three-year XN policies), a single per- occurrence limit clearly and unambiguously applied to each three-year policy period. This reduced Travelers’ allocation and related reinsurance billing by the amount attributable to its decision to annualise the per- occurrence limits of the three-year policies.


Both parties appealed the District Court’s decision. The US Court of


Appeals for the Third Circuit began its analysis by agreeing with the Second Circuit’s view that the follow-the-fortunes doctrine applies when reviewing the propriety of a cedant’s post-settlement allocation.


48 | INTELLIGENT INSURER | November 2011


In order to prove the bad faith exception to this doctrine, the court noted


that a reinsurer ‘must either provide direct evidence that the [cedant] was motivated primarily by reinsurance considerations, or show that the after- the-fact rationales offered by the [cedant] are not credible’.


Most notably, the court stated that a cedant choosing among several


reasonable allocation methodologies is not required to select one that minimises its reinsurance recovery in order to avoid a finding of bad faith.


The Third Circuit held that INA had failed to make the requisite


showing. First, the court noted that Travelers’ decision to allocate money paid toward the breast implant claims to only the pre-1982 AL policies was not motivated by bad faith. This was because the net nature of the settlement between the parties accounted for certain amounts that would be owed to Travelers if it made payments under the post-1982 policies (that is, the retrospective premiums and captive reinsurance associated with those policies). Thus, the court held that it was reasonable for Travelers to take the position that the post-1982 policies were exhausted.


Next, the court found that Travelers’ decision not to allocate the payment made to resolve the chemical products claims to the XS policies was also made in good faith. Again, the court noted that it was not unreasonable for Travelers to deem those policies ‘exhausted’ as a result of the net nature of the settlement, because they were also captively reinsured by the insured’s subsidiary.


Despite the record indicating that Travelers failed to conduct a detailed


analysis of the chemical products claims, the court held that Travelers’ decision to pay $20 million was reasonable because that enabled Travelers to resolve the breast implant claims, which presented far greater exposure.


Last, and perhaps most significantly for ceding companies, the court


held that Travelers’ internal memorandum speculating on the reinsurance implications of its potential allocation methods did not constitute bad faith or prove that Travelers’ decisions were motivated primarily by its reinsurance recoverables.


The court noted that the memorandum concerned several issues, including Travelers’ overall potential exposure for the breast implant claims, not just its ability to recover from or maximise its reinsurance. Further, the Travelers’ employees most responsible for the details of the post-settlement allocation were screened off from the reinsurance implication of their decisions, which the court found to be important.


The fact that there was some evidence that Travelers’ allocation decisions


were driven, in part, by reinsurance considerations did not provide INA with a basis to overcome the follow-the-fortunes doctrine.


However, at least one aspect of the Travelers decision provides reinsurers with something to hang their hats on.


The Third Circuit agreed with the District Court in finding that the language of the three-year XN policies clearly provided for a single per- occurrence limit, and reduced Travelers’ reinsurance billing accordingly. The court noted that, although the term ‘annual’ was referenced with


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