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Court of Appeal, Second District, Division 7, California.

The CENTRAL NATIONAL INSURANCE COMPANY OF OMAHA and Cravens, Dargan & Company, Pacific Coast, Plaintiffs, Respondents, and Cross–Appellants, v. PRUDENTIAL REINSURANCE COMPANY, Defendant, Appellant, and Cross–Respondent.

No. B003532.*

Decided: November 19, 1987

Flahavan, Hudson & Francis, and James T. Hudson, Los Angeles, for appellant and cross-respondent Prudential Reinsurance Co. Sedgwick, Detert, Moran & Arnold, George E. Sayre, Andrew C. Jordan, and Dale E. Fredericks, San Francisco, for respondents and cross-appellants Central Nat. Ins. Co. of Omaha, and Cravens, Dargan & Co.—Pacific Coast.

In this breach of facultative reinsurance contract 1 and bad faith action, we are compelled to reverse judgment for the reinsured plaintiffs and remand due to prejudicial errors in excluding evidence and instructing the jury.   These errors precluded defendant reinsurer from raising potentially meritorious coverage defenses.


California Sports, Inc. owns the Los Angeles Lakers basketball team and the Los Angeles Forum.   Two actions against California Sports arose as follows:  On December 9, 1977, Laker Kermit Washington punched and severely injured star Houston Rockets team captain, Rudy Tomjanovich. during a basketball game at the Forum.   Tomjanovich sustained serious injuries, including fractures of the nose, sinuses, jaw and skull, resulting in a concussion and leakage of spinal fluid.   Tomjanovich missed the rest of the 1977–1978 season due to his injuries.

In December 1978, Tomjanovich and his wife filed suit in Harris County, Texas, against California Sports for an unspecified amount of compensatory and punitive damages.   On March 21, 1978, the Houston Rockets, Inc. (Rockets) also filed suit against California Sports in the Southern District of Texas, Houston Division, of the United States District Court.   The Rockets prayed for $700,000 in compensatory damages, and $700,000 in punitive damages.

California Sports notified its insurers of the Tomjanovich and Rockets actions.   These insurers included:  (1) Fireman's Fund Insurance Company, which had issued the first layer of liability insurance coverage for $50,000;  and (2) plaintiff herein, Central National Insurance Company of Omaha (Central National), which had issued two excess liability policies—a “CNX” policy for $950,000 in excess of $50,000, and a “CNU” umbrella policy for $4 million in excess of $1 million.

As California Sports' primary insurer, Fireman's Fund was contractually obligated to provide a defense in the consolidated actions.   Fireman's Fund assumed this duty, but offered $50,000 to Central National, because it considered California Sports' potential liability to exceed its policy limits.   Central National refused the $50,000 because it did not wish to assume the defense, which it was not contractually obligated to provide.

The jury awarded the Tomjanoviches compensatory damages of $1,746,376, punitive damages of $1,500,000, and loss of consortium damages of $150,000.2  The award exceeded Tomjanoviches' prayer for compensatory damages of $1,500,000 and punitive damages of $1,000,000.

After the Tomjanovich verdict of August 17, 1979, Cravens, Dargan & Co.—Pacific Coast (Cravens), which as Central National's managing agent handled California Sports' claims against the CNX and CNU policies, feared a runaway verdict on the damages portion of the Rockets' trial.3  Cravens thus settled the Rockets' action for $750,000 on August 28, 1979, which it paid under the CNX policy.

Cravens also hired an attorney, Sayre, for advice on coverage issues.   Upon Sayre's advice, on August 24, 1979, Cravens sent California Sports a letter reserving Central National's right to raise coverage defenses concerning (1) the uninsurability of punitive damages.4  (City Products Corp. v. Globe Indemnity Co. (1979) 88 Cal.App.3d 31, 151 Cal.Rptr. 494);  (2) the insurer's lack of liability for wilful acts of its insured (Ins.Code, § 533); 5  (3) the CNX and CNU athletic participant exclusion endorsements,6 and (4) the CNU exclusion of coverage for “liability of any insured hereunder for assault and battery committed by or at the direction of such insured․”

California Sports took the position that Cravens' reservation of rights was not timely.   California Sports also disputed Cravens' position that the exclusions applied, stating that Cravens had previously represented that punitive damages were unlikely to be awarded.

Cravens settled the Tomjanoviches' action for approximately $2.13 million, during the pendency of California Sports' appeal.   The Tomjanovich settlement was paid as follows:  Fireman's Fund paid its $50,000 limit;  Cravens paid the $200,000 remaining under the CNX policy,7 and also $1.2 million under the CNU policy;  California Sports and its insurance broker each contributed $341,274.40.   As part of the Tomjanovich settlement agreement, Cravens dismissed its two declaratory relief actions against California Sports.   However, Cravens did not dismiss its action against California Sports for half of the $750,000 Rockets' settlement.

This action arose when Central National, through Cravens, sought indemnification from its CNU facultative reinsurers for losses paid under the CNU policy to the Tomjanoviches.   Cravens, on behalf of Central National, had purchased facultative reinsurance of the CNU policies.   As a result of reinsurance, Central National retained only 12.5 percent of the risk on the CNU policy.

Defendant herein, Prudential Reinsurance Company (PruRe), one of three facultative reinsurers of the CNU policy, assumed 50 percent of the risk on the CNU policy on a straight quota share basis.8

When PruRe first received notice of the claims from Cravens on August 21, 1979, after the Tomjanovich verdict was returned, PruRe's Mel Berliner requested a complete copy of Cravens' claims files.   Berliner inquired as to why an excess claim file was not established, and why PruRe was not notified earlier.   Berliner reserved PruRe's rights under the terms of the reinsurance certificate's notice provisions,9 and also inquired as to whether Sayre, Cravens' attorney, advised filing a declaratory relief action against California Sports on the punitive damages issue.

In response, Cravens forwarded its claims file on August 22, 1979, with the following cover memo, which stated in part:  “Here's our file on this bomber.   My sincere apologies for this late notice.   We have yet to determine the reserve on this layer due to the problems with coverage for the 1,500,000 punitive damage award.   We are also considering whether to make further offers to the Rockets, which case will go to the jury sometime next week.”

On January 8, 1980, PruRe denied any liability under the CNU reinsurance contract because (1) the late notice deprived PruRe of its contractual right to investigate, defend, participate in settlement discussions, or otherwise act to protect its interests in connection with the lawsuits;  and (2) Cravens' mishandling of the claims may have subjected Central National to liability for damages awarded against California Sports which are not covered by the CNX and CNU policies, and such damages are not covered by PruRe's facultative reinsurance certificate.   PruRe further notified Cravens the facultative reinsurance certificate was void and rescinded, and offered to return Cravens' premiums.

PruRe also filed a declaratory relief action against Central National, raising the aforementioned coverage defenses.   Central National unsuccessfully attempted to file a cross-complaint for damages, and then filed this action for breach of contract and bad faith.   Cravens was added as co-plaintiff in an amended complaint.   The two actions were consolidated and this breach of contract and bad faith action was tried first.

At trial below, PruRe attempted to establish payment of excluded claims by offering evidence of the coverage dispute and litigation between Cravens and California Sports.   This evidence was excluded, however.10  The court also refused to instruct the jury that payment of excluded claims was a defense under the reinsurance contract.   The court concluded that once PruRe denied coverage on January 8, 1980, PruRe waived its right to complain about subsequent settlements by its reinsured.

The jury found PruRe liable for its proportionate share of damages for breach of reinsurance contract and bad faith in the amount of $811,611.83.   This amount included breach of contract damages of $605,311.53, and bad faith damages of $206,280.30 (the amount of interest Cravens paid at 21.5 percent, for money borrowed to fund the Tomjanovich settlement).   PruRe's declaratory relief action was dismissed.

Both parties have appealed.


 At the heart of this appeal is the question of whether a reinsurer, upon denying coverage, may thereafter litigate coverage defenses against its reinsured.   We find no authority to support Central National and Cravens' position that PruRe is estopped from litigating coverage defenses because PruRe had denied coverage.   Such a result is especially unjust because PruRe attempted to litigate those defenses in its declaratory relief action, filed prior to this action.

A. Payment of Claims Excluded Under the CNU Policy is a Valid Defense

 At Central National and Cravens' request, the trial court instructed the jury that a reinsurer, upon denying coverage, may not thereafter litigate coverage defenses.11  This instruction reflects the general principle that reinsurers “follow the fortunes” of their reinsureds with respect to losses.   The PruRe certificate contains such a clause.12

Intuitively, it is obvious that PruRe's “follow the fortunes” clause does not preclude PruRe from asserting that the claims are excluded from coverage under the reinsurance contract.   Indeed, the language in the clause explicitly states that PruRe's obligation to pay is predicated upon receipt of satisfactory proof that the claim is covered by the reinsurance.

 The extent of a reinsurer's liability is determined by the language of the reinsurance contract.   Once a reinsured sustains a loss, “[a] debt from the reinsurer to the reinsured arises on the loss.   The case stands between them upon the terms of the policy and the facts connected with the loss at the time the reinsurers are sued, and the reinsurer may make the same objections and raise the same defenses which the reinsured could in a suit on the primitive policy.  [Fns. omitted.]”  (13A J. Appleman, supra, § 7693, p. 524.)

 It is evident from the above that a reinsurer cannot be held liable beyond the terms of its contract merely because the original insurer has sustained a loss.  (See 19 G. Couch, supra, § 80:66, p. 674.)   The reinsurer can refuse a reinsured's claim if the reinsured paid for excluded claims.   (American Ins. Co. v. North American Co. etc. (2d Cir.1982) 697 F.2d 79, 81.)   The reinsured cannot subject the reinsurer to a share of the loss “by adjusting a loss for which it was not liable [citation];  furthermore, despite a ‘follow the fortune clause,’ the reinsurer is only liable for a loss of the kind reinsured.  [Citations.]”  (13A J. Appleman, supra, § 7698, p. 556.)

Central National and Cravens argue that excluded losses were not paid under the CNU policy to the Tomjanoviches.   They contend the jury was properly instructed on this question and concluded only covered losses had been paid.   Central National and Cravens misstate the record, however, because the jury was never instructed on this issue.   The proposed instruction on this issue 13 was ultimately rejected after the court found the record failed to support an argument that punitive damages were paid under the CNU policy.   The jury thus never considered whether excluded losses were paid.

Central National and Cravens further assert the record fails to support an argument that excluded losses were paid under the CNU policy.   Closer examination, however, reveals PruRe's evidence on this point was erroneously excluded.

According to PruRe's offer of proof, Sayre, Central National's attorney, and Friedman, California Sports' attorney, would have testified about the Tomjanovich settlement negotiations, California Sports' coverage disputes with Central National and Cravens, and whether Central National paid for excluded losses under the CNU policy.   This evidence was excluded, however, because the court cut off all testimony concerning what transpired after PruRe denied coverage.   The court's rationale was that (1) PruRe was estopped from complaining of the results of the settlements once it denied coverage, and (2) the evidence was inadmissible under Evidence Code, section 352, because it would only have unnecessarily prolonged the trial and confused the jury.

The estoppel theory is inapplicable for all the reasons previously discussed.   Nor can the estoppel theory be justified under the line of cases cited by Central National and Cravens.  (Samson v. Transamerica Ins. Co. (1981) 30 Cal.3d 220, 237, 178 Cal.Rptr. 343, 636 P.2d 32;  Mullen v. Glens Falls Ins. Co. (1977) 73 Cal.App.3d 163, 172–173, 140 Cal.Rptr. 605;  Hartford Accident & Indem. Co. v. Civil Service Employees Ins. Co. (1973) 33 Cal.App.3d 26, 35, 108 Cal.Rptr. 737.)   While it is true the general rule is “that if there is a wrongful refusal to defend, the insurer loses its right to control the litigation, and is liable for ‘any reasonable settlement’ arrived at in good faith thereunder and paid by the insured” (ibid.), that rule has no application here.   This is not a case of a wrongful refusal to defend.14

 As for the court's ruling under Evidence Code section 352, we conclude the trial court abused its discretion.   By no stretch of the imagination can it be said that the probative value of the proffered evidence was outweighed by prejudice due to confusion or consumption of time.   This evidence goes to the heart of PruRe's defense that the claims were excluded and hence not covered under the reinsurance contract.

 These instructional and evidentiary errors resulted in a miscarriage of justice.   We believe, after examining the entire cause, it is reasonably probable a result more favorable to PruRe would have been reached in the absence of these errors (Clifton v. Ulis (1976) 17 Cal.3d 99, 105–106, 130 Cal.Rptr. 155, 549 P.2d 1251).

 The question of whether the proximate cause of loss comes within a policy exception is generally regarded as a question of fact.  (See Cobb v. Home & Auto Ins. Co. (1978) 86 Cal.App.3d 673, 679, 150 Cal.Rptr. 370.)   In actions upon all-risks policies, the burden is on the insurer to prove that an excepted risk caused the loss, or the occurrence of a condition subsequent.   (Strubble v. United Services Auto. Assn. (1973) 35 Cal.App.3d 498, 503–504, 110 Cal.Rptr. 828.)   PruRe stands in the position of the insurer in proving the applicability of any exclusion.

1. The Athletic Participant's Exclusion Endorsement

 It is undisputed that the cause of loss at least with respect to Rudy Tomjanovich arose from bodily injury sustained while engaged in a game, as required by the CNU athletic participant exclusion endorsement.   The trial court rejected this exclusion outright, however.15

Central National and Cravens contend the trial court properly rejected the athletic participant exclusion because Tomjanovich was not under contract with the Lakers.   They argue the athletic participant exclusion endorsement is ambiguous as to whether it covers athletic participants not under contract with the insured.   And because exclusionary clauses in insurance contracts must be strictly construed against the insurer, they argue this ambiguous language must be resolved in favor of coverage.   Thus they contend the athletic participant exclusion is not applicable to Tomjanovich.

Central National and Cravens rely on testimony supporting their interpretation of the athletic participant exclusion endorsement given by Cravens employees Clark and Beiser.   But their self-serving statements are inconsistent with Cravens' reservation of rights letter to California Sports of August 24, 1979, and Cravens' two declaratory relief actions filed against California Sports.   In those instances, Cravens assumed the contrary position that the athletic participant exclusion endorsement applied to Tomjanovich.   Because the declaratory relief actions were dismissed, however, no judicial determination of the question has been made.

We think PruRe is entitled to a trial on the applicability of the athletic participant exclusion, notwithstanding Central National and Cravens' settlement of the question with its insured.   The reinsured's settlement of a loss for which it may not have been liable is not binding on a reinsurer, provided noncoverage is shown.  (13A J. Appleman, supra, § 7698 at p. 556.)

The trial court's determination of the exclusion's inapplicability as a matter of law was improper.   We do not think the exclusion is ambiguous.  “While uncertainties and ambiguities are to be construed against the insurer, this does not mean that courts are authorized to put a strained and unnatural construction on terms of the policy in order to create an uncertainty or ambiguity.”  (Cobb v. Home & Auto Ins. Co., supra, 86 Cal.App.3d at p. 679, 150 Cal.Rptr. 370.)   However, we cannot determine the exclusion's applicability as a matter of law because of evidentiary gaps in the record.   For instance, the record contains no evidence of California Sports' knowledge and acceptance of this exclusion.  (Underwriters Ins. Co. v. Purdie (1983) 145 Cal.App.3d 57, 64–65, 193 Cal.Rptr. 248.)

2. Assault & Battery Exclusion and Insurance Code Section 533

With respect to the assault and battery exclusion, it is reasonably probable that a jury could conclude that California Sports ratified and encouraged Washington's intentional conduct and enforcer image, and that the occurrence was thus excluded from coverage under the CNU policy as a “battery committed by or at the direction of such insured․”  We note the Tomjanovich jury's implied finding of ratification supports our conclusion.

Similarly, with respect to Insurance Code section 533, which states that an insurer “is not liable for a loss caused by the wilful act of the insured,” we also think it reasonably probable that a jury could conclude that Central National and Cravens paid for losses excluded under this section because California Sports ratified the wilful act of its agent, Washington.  (Nuffer v. Insurance Co. of North America (1965) 236 Cal.App.2d 349, 354–355, 45 Cal.Rptr. 918.)

Central National and Cravens assert that even assuming ratification, the Tomjanovich jury's finding of negligence against California Sports makes a separation of covered and uncovered claims impossible, and hence renders PruRe liable even if a portion of the claim was not covered under the CNU policy (see Hogan v. Midland National Ins. Co. (1970) 3 Cal.3d 553, 564, 91 Cal.Rptr. 153, 476 P.2d 825).   We are not convinced.

 As we previously stated, a reinsured's payment to its insured is not in and of itself determinative of a reinsurer's obligation to indemnify its reinsured.   For whatever reasons, the reinsured may choose to waive coverage issues with its insured.   A settlement of excluded claims does not necessarily bind the reinsurer, even where, as here, the reinsurer had denied coverage and filed a declaratory relief action.   The burden of separating the covered claims from the excluded claims rests with the reinsured under the terms of this reinsurance contract, and not with the reinsurer.   The contract permits PruRe to require the reinsured to present satisfactory proof of covered claims.

Moreover, we are not persuaded by Central National and Cravens' assertion that “indisputable mathematical facts show that no punitive damages were paid, i.e., the total settlement payment to the Tomjanoviches was less than the compensatory damages award plus interest.”   This approach disregards the erroneous exclusion of evidence concerning settlement discussions and motivations therefor.

Accordingly, we reverse the judgment and remand for retrial in accordance with the views set forth herein.   In the interest of judicial economy and for the guidance of the trial court, we shall address several of the remaining issues raised by the parties.

B. PruRe Lacks Standing to Allege the Claims Were Mishandled Under the CNX Policy

 At trial, PruRe attempted to show that its proportionate share of the Tomjanovich settlement was too high because the claims could have been settled below or near CNX policy limits, and because excluded claims (punitive damages) were paid to the Rockets under the CNX policy.   PruRe had sought jury instructions to that effect which the court refused to give.   PruRe contends on appeal this constituted error.   We disagree.   We conclude PruRe lacks standing to raise the alleged mishandling of the claims under the CNX policy.

 PruRe concedes that its standing does not arise by way of equitable subrogation.16  PruRe nevertheless asserts its standing arises from the implied covenant of good faith and fair dealing contained in the CNU reinsurance contract.   PruRe claims that this implied covenant required Central National to settle the two actions within CNX policy limits and to pay only covered claims to the Rockets under the CNX policy.

We note that had the CNX and CNU policies been written by different insurers, the CNX insurer's handling of claims would not have been governed by the implied covenant contained in the CNU insurer's reinsurance contract.   PruRe is a stranger to the CNX policy, and would have had no contractual relationship with the CNX insurer if the two policies had been issued by different companies.

 PruRe cites no applicable authority for its theory that Central National's alleged mishandling of the claims under the CNX policy constitutes a breach of the implied covenant of good faith and fair dealing contained in the CNU reinsurance contract.17  We conclude Central National's alleged mishandling of the claims under the CNX policy is not actionable by PruRe absent a right of subrogation.   We see no sufficient justification for concluding Central National's duty of good faith under the CNU reinsurance contract to PruRe extends to its handling of claims under the CNX policy.

We do, however, think it significant that Central National, having written the CNX policy, obtained claims information that it might not otherwise have acquired had it only written the CNU policy.   Fireman's Fund notified Central National that the CNX layer of coverage was likely to be involved, and tendered $50,000 and the defense to Central National.   Although Central National refused to assume the duty to defend, Cravens hired an attorney to value the claims on behalf of Central National, and to handle settlement negotiations.   This claims valuation evidence obtained by Cravens is relevant to establish the timeliness of the notice given to PruRe, and the existence of prejudice to PruRe if notice was late.   The issues of notice and prejudice are further discussed, infra.

C. The Reinsured's Recovery is Limited to a Contract Measure of Damages

 PruRe was found liable for tort damages (interest at the market rate of 21.5 percent) for its breach of the implied covenant of good faith and fair dealing.   We conclude this was error.   Reinsurance contracts serve the essentially commercial purpose of reducing the reinsured company's reserve requirement by spreading the risks assumed and therefore allowing it to undertake more business and increase its profitability.  (American Re–Insurance Co. v. Insurance Com'n., etc (C.D.Cal.1981) 527 F.Supp. 444, 452–453.)   Reinsurance contracts lack the characteristics inherent in ordinary insurance contracts that justify imposing tort liability for breach of the implied covenant of good faith and fair dealing.

The nature and purpose of reinsurance was informatively discussed in American Re–Insurance Co. v. Insurance Com'n, etc., supra, 527 F.Supp. at pp. 452–453:  “Under California law, insurance companies must meet certain financial standards in order to do business.  [Citation.]  The insurer must maintain specified minimum reserve requirements based on the amount and type of insurance in force and the insurer's loss exposure.  [Citation.]  The reserve requirements establish the assets that an insurer must have available to pay all claims, losses, and adjustment and settlement expenses.   These requirements have the express purpose of ‘adequately protecting the insured and securing the solvency of the insurer.’  [Citation.]  [¶]  ‘A contract of reinsurance is one by which an insurer procures a third person to insure him against loss or liability by reason of such original insurance.’  [Citation.]  A fundamental purpose of reinsurance is to permit an insurer to reduce its reserve requirement.   California requires insurers to file financial statements with the state.  [Citation.]  On those statements, an insurer may deduct certain risks from its liabilities, provided those risks are subject to reinsurance.  [Citations.]  By utilizing reinsurance, therefore, an insurer can spread the risk it undertakes over a larger number of policies, effectively reduce the amount of reserves required to maintain its business, and increase its profitability․ [¶]  Thus, reinsurance agreements are separate and distinct from the policy agreements entered into by the insurer and its insured, for which, in the event of liability, the reinsurance would provide indemnification.  [Citations.]  Cal.Ins.Code § 623 states that ‘[t]he original insured has no interest in a contract of reinsurance.’ ”

Reinsurance contracts, even though they are contracts of insurance, are negotiated in settings that more closely resemble arms length commercial transactions rather than typical insurance transactions between a small consumer and a large insurance company.18  Moreover, the reinsured retains the right to control the handling of claims.   Here, Central National retained the right to control the handling of claims despite the fact it retained only 12.5 percent of the risk on the CNU policy.   The reinsurers who were at risk for 87.5 percent of liability would follow the fortunes of the reinsured in terms of paying covered losses.

Clearly both the manner of negotiation and the retention of control by the reinsured bears no resemblance to the experience of an individual purchasing insurance.   This is so because reinsurance is only purchased by insurance companies.   Even though reinsurance contracts are contracts of insurance (Ins.Code, § 620),19 they share characteristics of ordinary commercial contracts that are not found in insurance policies.   Thus we refuse to blindly adhere to the rule allowing recovery of tort damages against insurers for breach of the implied covenant of good faith and fair dealing.

In Seaman's Direct Buying Service, Inc. v. Standard Oil Co. (1984) 36 Cal.3d 752, 206 Cal.Rptr. 354, 686 P.2d 1158, the Supreme Court discussed the circumstances in which tort remedies for breach of the implied covenant of good faith and fair dealing would be extended to noninsurance cases with similar characteristics to insurance cases.   Even though this is an insurance case, we feel it is appropriate to carefully compare the circumstances of reinsurance and insurance, because a reinsured is not like an ordinary consumer of insurance.20

In Wallis v. Superior Court (1984) 160 Cal.App.3d 1109, 207 Cal.Rptr. 123, the court considered Seaman's and enumerated characteristics that must be present in contracts for purposes of serving as predicates of tort liability:  “(1) the contract must be such that the parties are in inherently unequal bargaining positions;  (2) the motivation for entering the contract must be a nonprofit motivation, i.e., to secure peace of mind, security, future protection;  (3) ordinary contract damages are not adequate, because (a) they do not require the party in the superior position to account for its actions, and (b) they do not make the inferior party ‘whole’;  (4) one party is especially vulnerable because of the type of harm it may suffer and of necessity places trust in the other party to perform;  and (5) the other party is aware of this vulnerability.”  (Id., at p. 1118, 207 Cal.Rptr. 123.)

None of the Wallis factors are present herein.   Reinsurance contracts serve a primarily commercial purpose of increasing the insurer's ability to write more policies by reducing its reserve requirement through spreading the risk, thus helping insurers increase profits.   Reinsurance contracts do not relieve insurers of obligations to their insureds.

Accordingly, we hold tort damages are not recoverable against a reinsurer for breach of the implied covenant of good faith and fair dealing.

On cross-appeal, Cravens contends the trial court improperly denied it leave to amend its complaint to include a claim for punitive damages, and that the trial court improperly refused to permit recovery of attorney's fees as tort damages for bad faith.  (Brandt v. Superior Court (1985) 37 Cal.3d 813, 210 Cal.Rptr. 211, 693 P.2d 796.)

In view of our conclusion that tort damages are not recoverable, both contentions are meritless.   Punitive damages are not recoverable in actions based on breach of contract (Contractor's Etc. Assn. v. Cal. Comp. Ins. Co. (1957) 48 Cal.2d 71, 77, 307 P.2d 626);  and attorney's fees are not recoverable absent a statutory provision or agreement of the parties (Code Civ.Proc., § 1021).

D. Compliance With the Notice Clause

California decisional law requires an insurer to show substantial prejudice in order to establish a late notice defense.21  The issue before us is whether a reinsurer is also required to show substantial prejudice in order to establish a late notice defense.

Contractually, Central National was required to give PruRe “prompt notice” of “any occurrence or accident which, without regard to liability, appears likely to involve this reinsurance․”  Although Central National retained control of any claim, suit, or proceeding, the claims cooperation clause required Central National to allow PruRe, at its own expense, the “opportunity” to associate “in the defense and control of any claim, suit or proceeding which may involve this reinsurance with the full cooperation” of Central National.

In this case, Cravens failed to follow its usual practice of notifying reinsurers of claims.22  Although the CNX reserve was set above the 50 percent mark on July 24, 1979, no minimum reserve was set on the CNU policy.   This apparently was due to Beiser's ignorance of the existence of the CNU policy.   Beiser testified he first learned of the CNU policy during the Tomjanovich trial on August 13, 1979.   He thereafter set a minimum $100 reserve at the direction of Cravens' Regional Vice President of Claims.   However, PruRe's notice was misaddressed, and PruRe first received notice of the claims against California Sports three days after the Tomjanovich verdict was returned.

PruRe argues Cravens had claims information which required it to notify PruRe prior to the Tomjanovich verdict.23  PruRe contends post verdict notice deprived it of its contractual right to associate in the defense and control of the claim.   PruRe argues that both actions could have been settled for much less prior to the Tomjanovich verdict.24

PruRe contends that in the context of reinsurance, this court should adopt the position taken by many jurisdictions requiring notice as a condition precedent to recovery against an insurer.  (See Southern Guaranty Insurance Co. v. Thomas (Ala.1976) 334 So.2d 879.   See cases cited in Annot. “Liability Insurer–Failure to Notify,” 32 A.L.R.4th 141, § 3[a], pp. 146–152.)   Under this strict contractual approach, the presence or absence of prejudice to the insurer occasioned by the delay in notice is viewed as immaterial.   The rationale underlying the strict contractual approach is that courts should not presume to interfere with the right to freedom of contract by redrafting insurance policy provisions where the parties' intent is clearly and unambiguously expressed.

Jurisdictions that have abandoned this strict contractual approach in insurance cases have criticized its freedom of contract rationale for disregarding the weaker bargaining position of the insured.  (See Brakeman v. Potomac Ins. Co. (1977) 472 Pa. 66, 72 [371 A.2d 193];  Cooper v. Government Employees Ins. Co. (1968) 51 N.J. 86, 93–94 [237 A.2d 870].)  PruRe contends there is no cause for alarm here with regard to the reinsured's bargaining position because the reinsured is a professional insurance company.

We agree that Central National had a strong bargaining position and find persuasive the rationale of the court in Liberty Mut. Ins. Co. v. Gibbs (1st Cir.1985) 773 F.2d 15.   There, the court explained why reinsureds are unlike other insureds, and set forth policy reasons why reinsurers should not be required to comply with a Massachusetts statute requiring the insurer to show prejudice from late notice:  “Strictly speaking, the reinsurance contract between Liberty and Lloyd's can be considered a contract of indemnity, not a contract ‘insuring against liability ․ on account of bodily injury or death’ within the meaning of section 112 [of Mass.Gen.Laws Ann. ch. 175].  [Citation.]  This construction comports with the apparent purpose behind section 112, which is to protect lay policyholders from the hypertechnical application of notice requirements inserted in forms drafted by primary insurance carriers.  [Citation.]  That rationale would not extend to a situation like the present, involving two experienced insurance underwriters who bargained at arm's length.”  (Id., at p. 18.)

 We think it proper in this context to hold Central National to a higher degree of care with respect to notice because it is an insurance company handling a claim on behalf of its reinsurer.   It is evident that PruRe relied on Central National's expertise as a fellow insurer in evaluating claims.   When it “appeared likely” to Central National as an insurance company that the reinsurance would be involved, PruRe required prompt notice.   Insurance companies and insurance professionals have been held to a higher standard with regard to compliance with notice clauses in insurance contracts.  (See Ohio Casualty Insurance Company v. Rynearson (7th Cir.1974) 507 F.2d 573, 577;  and Stuyvesant Insurance Co. v. United Public Ins. Co. (1966) 139 Ind.App. 533, 221 N.E.2d 358, 360.)

Central National maintains it had as much reason as PruRe to see that the claims were properly handled, and thus argues notice to PruRe was not as essential as notice to a primary insurer.  (Security Mut. Cas. Co. v. Century Cas. Co. (10th Cir.1976) 531 F.2d 974, 978.)   We are not convinced, for PruRe had assumed 50 percent of the risk on the CNU policy, whereas Central National had retained only 12–1/2 percent of the risk.   PruRe had a far greater financial stake in the outcome of the litigation;  yet PruRe was not notified of the claims until after the Tomjanovich verdict was returned.   Under these circumstances, notice to PruRe was crucial to enjoyment of its rights under the claims cooperation clause.

As we stated earlier, Central National and Cravens acquired a great deal of claims information by virtue of the fact that Central National had issued the CNX policy, which Fireman's Fund considered most likely to be involved in the disposition of the claims.   Given the factors present herein—that both parties are experienced insurance companies who bargained at arm's length, and that Central National and Cravens acquired all of the claims information that PruRe lacked—we conclude it equitable and just to place the burden of proving compliance with the notice clause upon Central National.

 In adopting this rule we do not intend to establish an iron clad rule requiring notice as a condition precedent to recovery against a reinsurer.   (But see Liberty Mutual Ins. Co. v. Gibbs, supra, 773 F.2d 15, and Fortress Re, Inc. v. Jefferson Ins. Co., etc., supra, 628 F.2d 860.)   We believe prejudice is a factor that must exist before late notice is deemed to invalidate or reduce a claim under a reinsurance contract.   If the reinsurer suffers no prejudice from the unexcused delay in notice, the purpose of the notice clause has not been frustrated and there is no reason to relieve the reinsurer of its contractual obligation.25

 Accordingly, we hold that the reinsured bears the burden of proving compliance with the notice clause.   If the reinsured is unsuccessful in meeting its burden, a rebuttable presumption of prejudice arises.   The reinsured may rebut the presumption by showing lack of prejudice to the reinsurer.


The judgment is reversed and remanded for further proceedings consistent with the views expressed herein.   The trial court is directed to vacate its order dismissing PruRe's complaint for declaratory relief.   PruRe shall recover costs on appeal.


1.   Reinsurance contracts are indemnity contracts as opposed to liability contracts.   Reinsurance is a contract whereby one insurer for a consideration contracts with another to indemnify it against a loss by reason of a risk which the latter has assumed under a separate and distinct contract as the insurer of a third party.   The original insurer which issues a policy remains liable to its insured for the full amount of the insured risk even though it obtains reinsurance.  (See 13A J. Appleman, Insurance Law & Practice (1976) §§ 7693, 7694, pp. 523–537.)In general, there are two basic types of reinsurance.   Facultative reinsurance covers a specific policy issued by the reinsured, who seeks to place reinsurance in order to spread the risk involved with a large policy exposure.  (See 19 G. Couch, Cyclopedia of Insurance Law 2d (Rev. ed. 1983) § 80:3, p. 626.)   Treaty reinsurance covers either all or specified classes of a reinsured's policies, at a specified percentage.  (Ibid.)

2.   The Tomjanovich jury instructions required a finding of ratification in order to award punitive damages.   Tomjanovich's trial strategy was to show California Sports endorsed or ratified Washington's battery by not suspending or fining him.   Tomjanovich introduced evidence that Washington, with Laker approval, posed for a Sports Illustrated magazine cover photo depicting him as the “enforcer.”   On the other hand, the NBA imposed a $10,000 fine and two month suspension on Washington following the Tomjanovich incident.California Sports' defense strategy was to show Tomjanovich's complete recovery and superb playing.   California Sports argued Tomjanovich should not have rushed to the scene of a fight, and that Washington merely reacted instinctively when he thought he was going to be blindsided, as he had been before.   California Sports further argued Washington was falsely portrayed as an “enforcer” and that punitives were unjustified against the new owner of California Sports who had nothing to do with the Tomjanovich incident.

3.   California Sports' liability to the Rockets had been determined in the liability phase of the Tomjanovich trial.

4.   During the Tomjanovich trial, on August 8, 1979, Cravens' Senior Supervisor of Excess and Surplus Lines, Leonard Beiser, notified California Sports he was reserving Central National's right to raise a coverage defense with respect to punitive damages.   But Beiser also advised California Sports that in his opinion, punitive damages would not be awarded.

5.   Although Beiser's memorandum of April 12, 1979 mentioned “obvious coverage questions” concerning the intentional nature of the alleged acts, Beiser did not send a reservation of rights letter with respect to intentional acts at that time.   Beiser testified he did did not make a reservation of rights because he considered Fireman's Fund to be responsible for California Sports' defense.   Fireman's Fund, however, did not reserve its right to raise this coverage defense.

6.   The CNX and CNU athletic participant exclusion endorsements state:  “It is agreed that such insurance as is afforded by the policy for bodily injury liability shall not apply to injury ․ sustained by any athletic participant including any player, coach, manager, assistant coach, assistant manager, or any person under contract to the insured while engaged in any game or contest or practice therefor, or in the course of travel to any destination for the purpose of practicing for, or participating in any contests, whether regularly scheduled or in exhibition or post season games.”Prior to the Tomjanovich verdict, Beiser never considered reserving Central National's rights with respect to the CNX and CNU athletic participant exclusion endorsements.   Beiser considered the exclusions inapplicable to Tomjanovich, because Tomjanovich was not under contract with California Sports.An August 8, 1979 internal memorandum from Cravens' underwriting department raised the issue of the CNX athletic participant exclusion.   The August 16, 1979 reply memorandum responded that the exclusion's ambiguous wording would in all probability disallow any attempted denial.   The author of the August 16 memorandum noted Fireman's Fund had defended without a reservation of rights, although no comparison had been made between the Fireman's Fund policy and the CNX and CNU policies.The Fireman's Fund policy Participants Exclusion Endorsement uses different language.   It states:  “Insurance as is afforded by the policy for bodily injury liability shall not apply to injury ․ sustained by any player, coach, manager, assistant coach or assistant manager of an athletic team under contract to the insured, while engaged in any game or contest or practice thereof.”

7.   $750,000 had previously been paid under the CNX policy in the Rockets' settlement.

8.   Straight quota share basis means that although Central National retained 12–1/2 percent of the risk on the CNU policy, the reinsurers would become liable for their percentage of the risk when the first dollar was paid out under the CNU policy.

9.   Contractually, Central National was required to notify PruRe of claims as follows:  “Prompt notice shall be given by the Company to PRUDENTIAL REINSURANCE of any occurrence or accident which, without regard to liability, appears likely to involve this reinsurance․”PruRe was contractually entitled to associate in the defense and control of any claim, suit or proceeding, as follows:  “[W]hile PRUDENTIAL REINSURANCE does not undertake to investigate or defend claims or suits it shall nevertheless have the right and be given the opportunity to associate with the Company and its representative at PRUDENTIAL REINSURANCE'S own expense in the defense and control of any claim, suit or proceeding which may involve this reinsurance with the full cooperation of the Company.”

10.   The court also excluded evidence that Central National returned California Sports' $25,000 contribution toward the Rockets settlement because Central National refused to consider the coverage issues to be thereby settled.

11.   The jury was instructed as follows:  “A reinsurer which denies coverage of a claim submitted by a reinsured does so at its peril, and cannot be heard to complain of the result of settlements thereafter by the reinsured with others.   Therefore, with the exception of the Tomjanovich settlement agreement and payments made by plaintiffs in their settlement of the Tomjanovich case, you should not consider any evidence which pertains to any matters that occurred after January 8, 1980 regarding plaintiffs' handling of the Tomjanovich settlement and related coverage aspects.”

12.   “All claims covered by this reinsurance, when settled by the Company, shall be binding on PRUDENTIAL REINSURANCE which shall be bound to pay its proportion of such settlements․  [¶] PRUDENTIAL REINSURANCE's agreement to promptly pay its proportion of loss and expense incurred by the Company is predicated upon receipt by it of a satisfactory proof of such loss and expense from Company.”

13.   Plaintiffs' Instruction No. 13, which was refused, stated:  “A reinsurer has the burden of proving that a reinsured company has paid sums for claims not covered under the reinsured's policy.”

14.   Under the terms of the reinsurance contract, PruRe had no duty to defend the original insured.  “It is not necessary for a reinsurer to actively participate in the defense of the action, provided it is proved that the reinsurer has notice of the pendency of the action and is afforded an opportunity to defend, and the defense is carried on without fraud or collusion by the original insurer.”  (Sawyer v. Sunset Mutual Life Ins. Co. (1937) 8 Cal.2d 492, 501, 66 P.2d 641.)   PruRe's claims that Central National breached the notice and claims cooperation clauses of the reinsurance contract are addressed, infra.

15.   The trial court stated:  “Furthermore, just sitting here as an observer trying to look at the law and the whole bevy of cases that deal with exclusions and how they are to be strictly construed and must be construed in light of their plain language, I for the life of me can't see how any court would ever say that the participants exclusion would exclude Tomjanovich's claim.”

16.   PruRe never paid Cravens its disputed share of the Tomjanovich settlement.   Thus PruRe is not subrogated to the rights of California Sports for any cause of action it may have for a wrongful failure to settle under the CNX policy.  (See Commercial Union Assurance Companies v. Safeway Stores, Inc. (1980) 26 Cal.3d 912, 917–918, 164 Cal.Rptr. 709, 610 P.2d 1038 [“It has been held in California and other jurisdictions that the excess carrier may maintain an action against the primary carrier for [wrongful] refusal to settle within the latter's policy limits [citations].  This rule, however, is based on the theory of equitable subrogation:  Since the insured would have been able to recover from the primary carrier for a judgment in excess of policy limits caused by the carrier's wrongful refusal to settle, the excess carrier, who discharged the insured's liability as a result of this tort, stands in the shoes of the insured and should be permitted to assert all claims against the primary carrier which the insured himself could have asserted [citation].  Hence, the rule does not rest upon the finding of any separate duty owed to an excess insurance carrier.”].)Nor does PruRe rely on the doctrine of equitable subrogation to challenge the payment of excluded claims under the CNX policy in the Rockets settlement.   As PruRe points out, the insurer's waiver of coverage defenses does not give rise to a cause of action by the insured, who could only benefit by payment of excluded claims.

17.   The cases relied on by PruRe do not support its contention that it has standing by virtue of the CNU reinsurance contract to complain of the settlement paid under the CNX policy to the Rockets.   In Merritt v. Reserve Ins. Co. (1973) 34 Cal.App.3d 858, 110 Cal.Rptr. 511, the insured assigned his cause of action against the insurer to the plaintiff.   In Northwestern Mut. Ins. Co. v. Farmers' Ins. Group (1978) 76 Cal.App.3d 1031, 143 Cal.Rptr. 415, and Continental Cas. Co. v. United States Fid. & Guar. Co. (N.D.Cal.1981) 516 F.Supp. 384, the excess carrier paid the claim against the insured and then brought a subrogated action against the primary carrier.

18.   As Central National's managing agent, Cravens sought facultative reinsurance of the CNU policy because the risk exceeded the limits covered by Cravens' treaty reinsurance.   Cravens solicited bids from eleven reinsurers, specifying a gross annual premium of $50,000 less 25 percent ceding commission.   Cravens provided potential reinsurers with details of California Sports' operations, payroll figures, sales, receipts, auto fleet, air craft, water craft, and loss history of claims.   PruRe's premium was $29,155, less 25 percent ceding costs, for 50 percent of the $4 million exposure in excess of $1 million, on a straight quota share basis.

19.   Insurance Code section 620 defines reinsurance as follows:  “A contract of reinsurance is one by which an insurer procures a third person to insure him against loss or liability by reason of such original insurance.”

20.   By doing so, we heed the warning in Seaman's, supra, 36 Cal.3d at p. 769, 206 Cal.Rptr. 354, 686 P.2d 1158:  “When we move from such special relationships to consideration of the tort remedy in the context of the ordinary commercial contract, we move into largely uncharted and potentially dangerous waters.   Here, parties of roughly equal bargaining power are free to shape the contours of their agreement and to include provisions for attorney fees and liquidated damages in the event of breach.   They may not be permitted to disclaim the covenant of good faith but they are free, within reasonable limits at least, to agree upon the standards by which application of the covenant is to be measured.   In such contracts, it may be difficult to distinguish between breach of the covenant and breach of contract, and there is the risk that interjecting tort remedies will intrude upon the expectations of the parties.   This is not to say that tort remedies have no place in such a commercial context, but that it is wise to proceed with caution in determining their scope and application.  [Fn. omitted.].”

21.   “It is settled that breach of a notice clause by an insured may not be asserted by an insurer unless the insurer was substantially prejudiced thereby;  that prejudice is not presumed as a matter of law from such breach;  and that the insurer has the burden of proving actual prejudice and not just a mere possibility of prejudice.  [Citations.]”  (Moe v. Transamerica Title Ins. Co. (1971) 21 Cal.App.3d 289, 302, 98 Cal.Rptr. 547.)

22.   Cravens' usual practice in handling claims where Central National had issued two consecutive layers of coverage was to set a minimum $100 reserve on the higher layer of coverage when the reserve on the lower layer reached 50 percent of the lower layer's policy limits.   Then, pursuant to Cravens' procedure, facultative reinsurers of the higher layer of coverage would automatically be sent notice of the claim.

23.   Beiser hired an attorney, Ralph Abernathy, to value the claims on behalf of Cravens and Central National.   Abernathy based his valuation on his examination of the files of the attorney hired by Fireman's Fund to defend California Sports.In a letter dated July 5, 1979, Abernathy informed Beiser that Tomjanovich's compensatory damages claim was worth $400,000 to $600,000, with a possible upper limit of $1 million.   Abernathy believed chances of a defense verdict were not better than 15 percent.Abernathy's July 5, 1979 valuation did not include Tomjanovich's claim for punitive damages, future lost earnings and future medicals.   Nor did it include Tomjanovich's wife's claim for loss of consortium, and the Rockets' claims for $902,000 in compensatory damages and $902,000 in punitive damages.In a letter dated July 25, 1979, Abernathy supplied some of the missing figures:  future lost wages—$300,000, future medicals—$10,000, future pain and suffering—$20,000, past mental and physical pain and suffering—$200,000, and past medicals—$27,000.   On August 1, 1979, Abernathy increased future medicals to $100,000.

24.   Cravens handled all settlement discussions on behalf of California Sports, since it was understood that Central National could count on a full $50,000 contribution from Fireman's Fund.   Tomjanovich's first settlement demand for $850,000 came in July 1979.   His lowest pretrial demand was $750,000.   Central National's highest pretrial offer to Tomjanovich was $550,000.Carsey, attorney for the Rockets, testified he would have recommended a settlement in the area of $250,000 to the Rockets had the Tomjanovich action settled.

25.   “[A] reasonable notice clause is designed to protect the insurance company from being placed in a substantially less favorable position than it would have been in had timely notice been provided, e.g., being forced to pay a claim against which it has not had an opportunity to defend effectively.   In short, the function of a notice requirement is to protect the insurance company's interests from being prejudiced.   Where the insurance company's interests have not been harmed by a late notice, even in the absence of extenuating circumstances to excuse the tardiness, the reason behind the notice condition in the policy is lacking, and it follows neither logic nor fairness to relieve the insurance company of its obligations under the policy in such a situation.”  (Brakeman v. Potomac Ins. Co., supra, 472 Pa. 66 [371 A.2d 193, 197].)

THOMPSON, Associate Justice.

LILLIE, P.J., and JOHNSON, J., concur.

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