Adventures in Contract Wording: Jury Still Out on Meaning of "Sole Judge"

"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 article("The Reinsurance Relationship—How Special Is It?") in 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 case law 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 case law. Until it is, however, drafters of reinsurance agreements are advised to exercise caution when negotiating a deal involving a sole judge clause.