Adventures in Contract Wording: Jury Still Out on Meaning of "Sole Judge"
October 2007
Many reinsurance agreements contain the so-called
sole judge provision, which serves to place significant decision-making power
within the hands of the reinsured. This article explores the purpose and meaning,
as well as the outer boundaries of this contractual provision.
by Larry
P. Schiffer*
Dewey & LeBoeuf
LLP
The reinsurance contract is a complex agreement consisting of many clauses.
Each clause in a reinsurance agreement has its own history and specific purpose.
It is not surprising to find that the meaning of a particular contractual provision
in a reinsurance contract has been carefully delineated by the courts within
a voluminous historical record of caselaw. Much rarer is the opposite scenario,
where a common contractual provision that is used within reinsurance agreements
quite frequently is nonetheless almost entirely ignored by both commentators
and the courts. Within each of these neglected provisions lies potential for
future litigation, and it is therefore critically important that they are given
special attention during the contract drafting process.
Among this latter category of contractual reinsurance provisions is the so-called
"sole judge" clause. These clauses typically provide that the ceding company
is to be the sole judge as to what may constitute "one risk" under the reinsurance
agreement or, sometimes, as to what may constitute "one claim," "one occurrence,"
or "one loss or event." Other types of sole judge clauses, such as those making
the ceding company the sole judge as to what may constitute one insured or one
contract of reinsurance, exist, but are much less common.
"One Risk," "One Loss," "One Event"
The delineation of each specific risk is a crucial element to a reinsurance
agreement because the amount for which a reinsurer may be liable to reimburse
the reinsured is intrinsically tied to the nature of the risk that has been
reinsured. This interplay of remuneration and risk is especially pronounced
within certain property reinsurance contracts. Take, for example, a reinsurance
agreement providing coverage for a complex of buildings. Is each building, within
four walls and under one roof, to be considered one risk? Or, alternatively,
is a single risk to be defined as encompassing the entire complex? Obviously,
the reinsurance underwriter needs to understand the ceding company's views on
this issue to price the reinsurance properly in anticipation of the scope of
the risk assumed.
Likewise, the question of what may constitute one loss or one event under
a reinsurance agreement represents another pivotal issue that may be relevant
to the division of the underlying loss between the reinsurer and the ceding
company. For instance, an excess of loss reinsurance contract may provide that
the limit of liability be calculated on the basis of each and every loss and/or
series of losses arising out of one event, in which case the boundaries of a
loss and an event must be clearly delineated. This situation is more difficult
to manage from the reinsurer's point of view because no loss or event has yet
occurred and how the ceding company will define that loss or event usually cannot
be determined in advance.
The definitions of one risk, one loss, and one event thus present the drafter
of a reinsurance contract not only with the task of boundary-drawing, but also
with a dilemma concerning the apportionment of that task among the parties to
the agreement. The sole judge clause attempts to provide a solution to this
set of complex problems by effectively concentrating most of the decision-making
power in these areas within the hands of the ceding company.
Why Make the Reinsured the Sole Judge?
At first, the decision to make the ceding company the sole judge as to what
may constitute one risk or one loss or event may seem overly one-sided. Indeed,
this wording is at times difficult to secure in practice. The vagaries of the
reinsurance market, be it soft or hard, sometimes dictates whether the sole
judge clause will appear in a reinsurance agreement. Nonetheless, a certain
rationale for placing the decision within the reinsured's hands does exist.
As the direct underwriter of the underlying risk, the ceding company is intimately
familiar with its nature. The reinsurer, on the other hand, does not necessarily
possess that level of knowledge, and is thus not always in as good a position
to determine which events and circumstances are to be included within the boundaries
of a single risk or a single claim.
This rationale is consistent with the well-known reinsurance doctrine of
utmost good faith, which is imposed upon the ceding company at the inception
of the contract. As discussed in a prior Commentary ("The
Reinsurance Relationship—How Special Is It?" December 2000, the reinsured
has the obligation to disclose to the reinsurer all material facts about the
risk. Material facts about the risk would seem to include what the ceding company
had in mind when writing a building complex and how it will define one risk.
Another advantage of the sole judge provision is that it is clear and predictable,
which ultimately saves both the reinsurer and the ceding company the endless
costs associated with subsequent litigation of the issue. This avoidance of
transaction costs may in some cases be sufficient to convince the reinsurer
to agree to the sole judge clause despite its inherent one-sided nature. The
sole judge provision should thus be seen as a bright-line contractual rule that
aims to focus decision-making power within the hands of the party that generally
has the most information about the risk involved.
Does "Sole Judge" Really Mean "Sole Judge"?
The power granted to the ceding company by a sole judge clause is generally
considered to be tremendously broad. While reinsurers sometimes restrict this
provision somewhat by additional contractual language, the sole judge clause,
in its unrestricted form, gives the ceding company the ability to define a single
risk or a single claim as nearly anything that it wishes it to be. Additionally,
the sole judge clause goes as far as to grant the ceding company the power to
determine what is to constitute one loss even after that loss occurs, which
serves to expand its already prodigious power even further.
Given the broad sweep of the sole judge clause, it is perhaps surprising
how little caselaw addresses its scope. The leading case dealing with sole judge
provisions within reinsurance agreements is, perhaps, Brown v. GIO Insurance Ltd., Lloyd's Rep IR 201
(1998), decided by the Civil Division of the Court of Appeal in the United Kingdom.
Under the reinsurance agreement in that case, the ceding company was made the
sole judge as to what constituted each and every loss and/or one event. The
court reaffirmed the general rule that the sole judge language provides the
ceding company with extremely broad authority, but nonetheless attached two
restrictions to the ceding company's power in exercising the clause. Namely,
any act by the ceding company pursuant to the sole judge clause had to be made
both reasonably and in good faith.
This line of reasoning apparently was extended the following year during
the arbitration of the insolvent Svenska Kredit, which had been made the sole
judge as to what constituted one risk in its agreement with some of its reinsurers.
Svenska Kredit conceded that it could not have acted arbitrarily pursuant to
this sole judge clause, but rather must have solely acted in good faith. The
court, reasoning that sole judge clauses appear not in cases where the "one
company, one group equals one risk" rule, but in borderline cases, such as those
where separate companies have common shareholders, affirmed Svenska Kredit's
actions pursuant to the sole judge clause, as Svenska Kredit had the right to
exercise its discretion in borderline cases as long as it also acted in good
faith (Reinsurance Magazine, Apr. 6, 1999).
The limits of the sole judge clause have hardly been tested within the United
States court system, but some indications suggest that the U.S. answer to this
dilemma may be a bit different from that given in the United Kingdom. The U.S.
case dealing with the sole judge issue that is of most note is The Aetna Casualty & Surety Co. v. Certain Underwriters
at Lloyd's, London, No. 118676/95, (N.Y. Sup., N.Y. Co. 1997), which
had a follow-the-fortunes provision that included a term making the reinsured
the sole judge as to what should constitute a claim or loss covered. The reinsurers
argued that the ceding company's decision to settle the underlying claim had
to have been reasonable, made in good faith, and performed in a businesslike
manner. The court disagreed, commenting that if every decision made by a ceding
company were to be open for examination under this standard, then there would
no longer be a need for the follow-the-fortunes doctrine. This decision, while
useful, does not serve as a useful predictor for future treatment of sole judge
provisions occurring outside the follow-the-fortunes framework within the United
States.
Conclusion
The scant treatment afforded to sole judge provisions within reinsurance
contracts by the courts may be due to the fact that these provisions are widely
recognized bright-line rules, the meaning of which has long ago been settled.
Still, it is startling that even this fact has not been reaffirmed within the
United States in any clear caselaw. Until it is, however, drafters of reinsurance
agreements are advised to exercise caution when negotiating a deal involving
a sole judge clause.
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