United States: Reinsurance Arbitration Clauses – Where The Courts Find Problems

The author gratefully acknowledges and thanks Marissa J. Savit, an attorney at Dewey & LeBoeuf LLP, for her research and initial drafting of this article. This article was presented at the American Bar Association's Annual Meeting on August 9, 2008, at a program entitled "Building a Better ADR Clause: An Inter-Disciplinary Approach," sponsored by the Excess, Surplus Lines & Reinsurance Committee of the Tort, Trial & Insurance Practice Section, which was co-chaired by the author.

Introduction

One way to improve the alternative dispute resolution process is to examine the disputes about alternative dispute resolution clauses that find their way into court. Typically, a court proceeding over the interpretation of a provision in an alternative dispute resolution clause arises because of some ambiguity or lack of clarity in the clause that the parties now need the court to sort out. Those provisions that routinely result in court proceedings may be candidates for modification.

This paper will focus on arbitration clauses in reinsurance agreements. The paper will examine some of the types of disputes over reinsurance arbitration clauses that find their way into court in an attempt to identify provisions that may be in need of amendment. By analogy, similar clauses in other commercial contracts may be in need of modification as well.

Reinsurance Arbitration Provisions With Ambiguous Scope

Because arbitration is a creature of contract¹, parties to a reinsurance agreement are free to contract for the scope of issues that they will submit to arbitration should there be a dispute in the future. Difficulties arise, however, when the parties' intentions regarding the scope arbitration are not clearly expressed in the reinsurance agreement. Lack of clarity over the scope of arbitration may lead to a dispute that has to be settled in court. Litigation over a poorly drafted arbitration clause may result in a judicial interpretation that is contrary to the parties' intentions.

One of the more significant examples of litigation over reinsurance arbitration provisions is where the arbitration clause does not clearly set out the scope of what conflicts are arbitrable. Many arbitration clauses provide that only matters dealing with the interpretation of a reinsurance agreement are to be arbitrated. When this language is used, disputes can arise over whether certain disputed issues deal with "interpretation" of the agreement as opposed to the formation of the agreement.

For example, in Gerling Global Reinsurance Co. v. ACE Property & Casualty Ins. Co., a dispute arose as to whether two facultative reinsurance certificates were void because the ceding insurer failed to disclose a material litigation to the reinsurer in violation of the cedent's implied duty of utmost good faith. The arbitration clause provided that "[s]hould an irreconcilable difference of opinion arise as to the interpretation of this Certificate...as a condition precedent of any right of action hereunder, such difference shall be submitted to arbitration." Because the validity of the reinsurance certificates was at issue, the court held that the reinsurer's claim raised doubt as to the very formation of the contract. According to the court, where a question arises as to a reinsurance contract's formation, the issue is not subject to a narrow arbitration provision that deals solely with the interpretation of the contract. Gerling Global Reinsurance Co. v. ACE Prop. & Cas. Ins. Co., 42 Fed. Supp. 522 (2d Cir. 2002).

In another case construing a similar narrow arbitration clause, the reinsurer brought a claim for a refund of monies allegedly paid as a result of the cedent's problematic reinsurance billings. The claim alleged nothing more than an error in billing and payment. The court found that while the claim may have been "connected to the main agreement that contains the arbitration clause," it did not go to the interpretation of the certificate. Gerling Global Reinsurance Co. v. The Home Ins. Co., No. 2125N, 2002 N.Y. App. Div. LEXIS 12519 (N.Y. App. Div. Dec. 12, 2002) (citing Louis Dreyfus Negoce S.A. v. Blystad Shipping & Trading Inc., 252 F.3d 218, 224 (2d Cir. 2001)), cert denied sub nom Negoce v. Blystad Shipping & Trading, Inc., 534 U.S. 1020, 122 (2001)). The court noted that the arbitration clause was drafted narrowly and therefore would be interpreted narrowly.

In New Hampshire Insurance Co. v. Canali Reinsurance Co., the court held that an arbitration clause requiring the submission to arbitration of "[a]ll disputes arising out of the interpretation of this Agreement" was a narrow clause that did not include a dispute over a party's alleged failure to deposit funds into an account as required by the parties' agreements. The court also noted that the inclusion of a separate service of suit clause providing that disputes regarding amounts due under the agreement must be litigated in court, served as evidence that the arbitration clause was meant to be read narrowly. New Hampshire Ins. Co. v. Canali Reinsurance Co., No. 03 Civ. 8889LTSDCF, 2004 WL 769775 (S.D.N.Y. April 12, 2004).

But not all courts give such a narrow reading to arbitration clauses that provide that only issues involving interpretation of a contract must be submitted to arbitration. In Railroad Insurance Underwriters v. Certain Underwriters at Lloyd's London, the court held that the issue of determining which entity should be paid by the reinsurer was a question of interpretation for the arbitrators to decide, and was not merely a failure to pay that would fall under the contract's service-of-suit clause. Railroad Ins. Underwriters v. Certain Underwriters at Lloyd's London, No. 07-cv-3071(LLS), (S.D.N.Y. Jun. 4, 2007) (mem.).

What these cases teach is that if the parties did not mean to limit the scope of arbitration to only those issues that concern the mere interpretation of the contract, as opposed to the failure to pay under the contract, they should have drafted the arbitration provision more clearly. Narrow arbitration clauses, however, may be appropriate where the parties want certain disputes to be litigated in court and not subject to arbitration (e.g., fraud in the inducement). If that is the case, parties should make this clear in the drafting of their dispute resolution clause. If, however, parties want all disputes concerning the contract subject to arbitration, whether the dispute is about the formation, interpretation, or application of the contract, then the dispute resolution clause should be written broadly and clearly to ensure that there is no ambiguity about the broad scope of the clause.

Presence of Both an Arbitration Clause and a Service-of-Suit Clause

Another cause of litigation over arbitration clauses is the presence in a reinsurance agreement of both an arbitration clause and a service-of-suit clause. Most courts hold that an arbitration clause and a service-of-suit provision are to be read as being compatible with one another. Essentially, these courts hold that an arbitration clause takes precedence over a service-of-suit clause and that a service-of-suit clause provides an auxiliary role to the arbitration clause.

In Boghos v. Certain Underwriters at Lloyd's of London, the arbitration clause stated: "Notwithstanding any other item set forth herein, the parties hereby agree that any dispute which arises shall be settled in Binding Arbitration." The reinsurance agreement also contained a service-of-suit clause providing that the Underwriters would submit to the jurisdiction of a United States court in the event of a failure of Underwriters to pay an amount due under the insurance. Even though the dispute involved the insurer's failure to pay a claim, the court still held that the dispute must be submitted to arbitration. According to the court, the phrase "notwithstanding any other item set forth herein" clearly indicated that the parties wished to submit all disputes to arbitration, even if another provision could arguably lead to a different result if read in isolation. Boghos v. Certain Underwriters at Lloyd's of London, 36 Cal. 4th 495 (Cal. 2005).

Similar facts were present in Security Life Insurance Co. v. Hannover Life Reassurance Co. of America. The arbitration provision was extremely broad and provided that arbitration was the "sole remedy for disputes arising under" the agreement. The service-of-suit clause applied if there was a "failure of the Reinsurer...to pay any amount claimed" under the agreement. The court stated: "the fact that the service of suit clause specifies that it applies to a 'failure to pay any amount claimed' does not exempt these specific claims from broad arbitration agreements." Sec. Life Ins. Co. v. Hannover Life Reassurance Co. of America, 167 F. Supp. 2d 1086, 1089 (D. Minn. 2001). The court reasoned that the purpose of service-of-suit clauses was to ensure that jurisdiction over the parties can be obtained. The court stated that the two provisions were to be read in harmony with one another. That is, the service-of-suit provision would come into play in order to compel arbitration or enforce an arbitration award.

In Gaffer Insurance Co. Ltd. v. Discover Reinsurance Co., the court held that the service-of-suit provision did not prevail over the arbitration clause even though the service-of-suit clause provided that "[n]othing in the Article constitutes...a waiver of [Gaffer's] rights to commence an action in any court of competent jurisdiction in the United States..." The court reasoned that contracts should be interpreted so as to give effect to every provision. The claim that the service-of-suit clause replaced arbitration as the mandatory dispute resolution mechanism would render the arbitration provision superfluous. Instead, the court held that the arbitration clause and the service-of-suit clause can be read as being compatible with one another. That is, parties to a reinsurance contract can mandate arbitration to resolve disputes, while also relying on the courts in order to file actions to compel arbitration or to enforce arbitration awards. Gaffer Ins. Co. Ltd. v. Discover Reinsurance Co., 936 A.2d 1109 (Pa. Super. 2007); see also Credit Gen. Ins. Co. v. John Hancock Mut. Life Ins. Co., No. 1:99 VC 02690, 2000 U.S. Dist. LEXIS 9003 (N.D. Ohio May 30, 2000) (stating that arbitration clauses, even those without specific language stating that arbitration is a precedent to any right of action, are enforceable despite the presence of a service-of-suit clause).

Other courts, however, have held that the inclusion of a service-of-suit clause in a reinsurance agreement may affect the scope of the arbitration clause. In New Hampshire Insurance Co. v. Canali Reinsurance Co. discussed above, the court found that the presence of a service-of-suit clause may serve as evidence that the parties intended the arbitration clause to be read narrowly. In New Hampshire, the service-of-suit clause provided that disputes over amounts due under the agreement would be litigated. The court held that the inclusion of the clause demonstrates that the parties contemplated issues that would not be arbitrated if a dispute arose. According to the court, this was evidence that the arbitration clause was not to be given an all-encompassing interpretation. New Hampshire Ins. Co. v. Canali Reinsurance Co., No. 03 Civ. 8889LTSDCF, 2004 WL 769775 (S.D.N.Y. April 12, 2004).

Contract wording experts have addressed the service-of-suit clause issue by amending the service-of-suit clause to clearly indicate that it is not meant to override the arbitration clause or narrow the scope of the arbitration. This additional sentence added to the service-of-suit clause avoids sideshows like the cases discussed above and gets the parties focused back on resolving the substantive dispute between them.

Presence of Both an Arbitration Clause and a Choice-of-Law Provision

Like the service-of-suit clause issue, the choice-of-law clause has also caused confusion when included in a contract with an arbitration clause. Many courts hold that an arbitration clause and a choice-of-law clause can be read in harmony with one another. In Preston v. Ferrer, the United States Supreme Court cited its decision in Mastrobuono v. Shearson Lehman Hutton, Inc. and stated that the "best way to harmonize" the two clauses is to read the choice-of-law clause to encompass the selected state's substantive principles, but to not give effect to special rules that would limit the authority of arbitrators. Preston v. Ferrer, 128 S. Ct. 978, (2008), citing Mastrobuono v. Shearson Lehman Hutton, Inc., 514 U.S. 52 (1995).

Some courts have held that the inclusion of a choice-of-law provision in a reinsurance agreement may affect the application of the arbitration clause. In Security Insurance Co. v. TIG Insurance Co., the Second Circuit Court of Appeals applied California law under the choice-of-law clause in the arbitration agreement in order to stay a reinsurance arbitration pending the result of a related litigation. The court noted that California abides by the proposition that sophisticated commercial parties include a choice-of-law clause in order to control the entire agreement. The court held that by including a broad choice-of-law clause, the parties intended to incorporate California's procedural rules for arbitration, including any special rules that limit the availability of arbitration under California law. Because this was the case, the Second Circuit held that a special rule under the California Civil Procedure Code applied, which permits a court to stay arbitration pending the outcome of an ongoing litigation that arises under the same transaction. Security Ins. Co. v. TIG Ins. Co., 360 F.3d 322 (2d Cir. 2004).

A choice-of-law clause may affect the substantive law governing the arbitration unless the parties make it clear how they wish the arbitrators to interpret the contract. As seen below, reinsurance contracts often have a provision that deals with this issue, the honorable engagement clause, which affects the arbitration panel's role in interpreting the law.

The Honorable Engagement Clause

Traditional arbitration provisions in reinsurance agreements provide that the arbitrators shall interpret the contract as an "honorable engagement" rather than as a strict legal obligation. This "honorable engagement clause" affords arbitrators more flexibility in resolving a dispute and allows them to forbear from applying the strict rules of evidence and law of a particular state. Arbitrators are given broad discretion to base their decisions on fairness and on the custom and common practice in the reinsurance industry. Arbitrators are thus freed from the duty to follow a strict construction of the agreement's text. The inclusion of an honorable engagement clause, however, may lead to an interpretation of a reinsurance agreement that was not intended by the parties, and may also lead to litigation over the extent of the discretion given to the arbitrators to depart from express contractual terms.

In Garamendi v. California Compensation Insurance Co., the reinsurance agreement contained a clause providing that the arbiters shall consider the contract as an "honorable engagement rather than merely as a legal obligation" and that they are "relieved of all judicial formalities and may abstain from following the strict rules of law." In this case, the reinsurer sought rescission based on claims of material misrepresentation and concealment of material facts. Although an applicable section of the California Insurance Code created a right to return of premium upon the rescission of an insurance contract, the arbitration panel ordered that only a portion of the premium be returned to reinsurer.

On review, the court vacated the arbitration award stating that an arbitration panel cannot violate a party's statutory rights even if an honorable engagement clause is included in a reinsurance contract. The court also noted that the arbitration panel lacked the authority to award arbitration fees to the reinsurer where the insurance contract expressly provided that each party would bear the cost of its own arbitrator, and that the joint arbitration costs would be split evenly between the parties. The court explained that although the honorable engagement clause relieves the arbitrators from following strict rules of procedure or law, arbitrators "are not, because of such freedom, released from the obligation to be guided by the basic agreement of the litigants." Garamendi v. California Compensation Ins. Co., No. B177760, 2005 Cal. App. Unpub. LEXIS 11799 (Cal. Ct. App. Dec. 21, 2005) (citing Firestone Tire & Rubber Co. v. United Rubber Workers, 168 Cal. App. 2d 444 (Cal. Ct. App. 1959).

In Nationwide Mutual Insurance Co. v. Home Insurance Co., the cedent entered into a reinsurance contract with the reinsurer. The cedent then entered into an assumption agreement with a third party. The Sixth Circuit Court of Appeals held that the arbitration panel could not order the reinsurer to make payments directly to the third party despite the presence of an honorable engagement clause. The court found that an arbitration panel's jurisdiction is limited to the debts related to the reinsurance contract at issue and does not reach to include debts that are external to the particular contract before the arbitration panel. The Sixth Circuit stated that although an honorable engagement clause allows the arbitration panel to abstain from following strict rules of contract interpretation, "it does not give the panel the power to exceed its own jurisdiction." Nationwide Mut. Ins. Co. v. Home Ins. Co., 330 F.3d 843, 849 (6th Cir. 2003).

These cases demonstrate that the courts will not allow an arbitration panel to exceed its jurisdiction or vitiate the parties' contract rights because the reinsurance contract contains an honorable engagement provision in its arbitration clause. Clarity in the honorable engagement provision goes a long way toward avoiding litigation over the scope arbitration panel's power under that clause.

Other Ambiguous Provisions in Arbitration Clauses That Create Disputes

A number of disputes have arisen over other ambiguous provisions or terms used in arbitration clauses of reinsurance agreements. For example, disputes have arisen over the ambiguity regarding the time period allocated for the selection of the arbitration panel. In Certain Underwriters at Lloyd's London v. Argonaut Insurance Co., the arbitration agreement called for either party to appoint an arbitrator "within thirty days after receipt of written notice" from the other party requesting it to do so. Litigation arose regarding the interpretation of the term "thirty days." Argonaut contended that "thirty days" did not mean thirty days if the thirtieth day fell on a weekend or holiday. Lloyd's urged a strict interpretation of the reinsurance agreement, contending that thirty days means thirty days regardless of what day of the week the thirtieth day fell on. The court held that in the absence of an express provision in the agreement, "[t]hirty days must mean thirty days." Certain Underwriters at Lloyd's London v. Argonaut Ins. Co., 500 F.3d 571, 582 (7th Cir. 2007).

Not all courts interpret time limitation provisions so strictly. In Ancon Insurance Co. (U.K.) Ltd. v. GE Reinsurance Corp., the court declined to strictly enforce an adverse selection clause in a reinsurance agreement. This adverse selection clause provided that if a party failed to appoint its arbitrator within thirty days of receiving written notice requesting it to do so, then the other party would get to choose two arbitrators instead of just one. According to the court, strictly enforcing the provision would vitiate the intent of the Federal Arbitration Act. The court noted that the result may have been different if the agreement made it clear that time was of the essence. Otherwise, said the court, a party that acts in good faith should not be stripped of the right to appoint an arbitrator. Ancon Ins. Co. (U.K.) Ltd. V. GE Reins. Corp, No. 06-2106-CM, 2007 U.S. Dist. LEXIS 24822 (D. Kan. Mar. 30, 2007). The majority rule, however, is that the adverse selection clause will be strictly enforced.

Litigation also has resulted from ambiguity over whether arbitration agreements under separate contracts underlying larger reinsurance programs call for consolidated or class arbitration, or for separate arbitrations. The clear trend among courts is to defer to arbitrators the question of consolidation, finding that the question is procedural in nature.

In Certain Underwriters at Lloyd's London v. Westchester Fire Insurance Co., a dispute arose as to whether separate contracts underlying a reinsurance program must have separate arbitrations or whether they must be consolidated for purposes of arbitration. The court cited extensive precedent for the proposition that where a reinsurance agreement is silent, the issue of whether parties are entitled to individualized arbitration or to consolidated arbitration is a procedural question for arbitrators to decide. Certain Underwriters at Lloyd's London v. Westchester Fire Ins. Co., 489 F.3d 58 (3d Cir. 2007); see also Argonaut Ins. Co. v. Century Indem. Co., No. 05-5355, 2007 U.S. Dist. LEXIS 65863 (E.D. Pa. Sept. 6, 2007) (holding that the issue of which of multiple arbitration panel was the appropriate body to hear a case is a matter of arbitral procedure for the arbitrators to decide); Employers Ins. Co. of Wausau v. Century Indemnity Co., 443 F.3d 573 (7th Cir. 2006) (holding that where an arbitration agreement is silent on consolidation, the question of consolidation is a procedural question for the arbitrators to decide, and not a question of arbitrability for the courts).

In Dorinco Reinsurance Co. v. ACE American Insurance Co., the cedent entered into a common reinsurance agreement (as well as individual slip agreements) with sixteen separate reinsurers. A dispute arose as to whether each one of the sixteen reinsurers was entitled to its own arbitration panel, or whether all of the reinsurers had to arbitrate as a group. The court concluded that the arbitration provision was ambiguous in addressing each reinsurer's right to separate arbitration proceedings. The court held that the arbitrators should determine the structure of the parties' arbitration absent an express provision in the arbitration agreement. Dorinco Reinsurance Co. v. ACE American Ins. Co., No. 07-12622, 2008 WL 192270 (E.D.Mich. Jan. 23, 2008).

Some courts find that ambiguity can be present even if a reinsurance contract seems unambiguous on its face. Litigation has arisen because of such "latent" ambiguities in arbitration clauses. In Medical Insurance Exchange of California v. Certain Underwriters at Lloyds, London, the arbitration provision contained an exception providing that if any matters in a dispute involve "allegations of misrepresentation, non-disclosure, concealment, or fraud, then either party shall have the right to litigate and shall not be compelled to arbitrate those or any other matters in dispute." The court held that there was a latent ambiguity in the arbitration clause because extrinsic evidence revealed more than one possible meaning. Although fraud was being alleged by the claimant, the court held that the allegation did not fall within the exception because extrinsic evidence revealed that the parties intended the exception to apply only to disputes as to the validity of the contract. Medical Ins. Exchange of Cal. v. Certain Underwriters at Lloyds, London, No. C 05-2609, 2006 WL 463531 (N.D. Cal. 2006).

Each of these cases demonstrates that ambiguous language will result in unnecessary collateral litigation.

Conclusion

This brief tour of recent court decisions arising from disputes over the interpretation of various provisions within arbitration clauses in reinsurance contracts leads to the conclusion that many arbitration clauses need clarity. Of course, no contract provision will be immune from a party's challenge to its meaning, but these cases help reveal areas of ambiguity that can be addressed by providing clear language reflecting the parties' intent.

Very often, parties to a reinsurance contract give short shrift in the negotiating process to the dispute resolution clause, often accepting boilerplate language from the reinsurance intermediary or from the cedent. And while marketing and underwriting personnel would rather assume that disputes will never happen, care in drafting the dispute resolution clause will inure to the benefit of both parties when disputes do arise.

Footnotes

1 Louis Dreyfus Negoce S.A. v. Blystad Shipping & Trading Inc., 252 F.3d 218, 224 (2d Cir. 2001), cert denied sub nom Negoce v. Blystad Shipping & Trading, Inc., 534 U.S. 1020, 122 (2001).

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