Why Reinsurance Matters, and Other Must Know Reinsurance Concepts

Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

May 2019 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Reinsurance Matters Risk managers and other purchasers of insurance rarely think about how reinsurance affects their company or the insurance they purchase for their company. Insurance buyers mainly focus on the direct insurers—the primary, excess, and umbrella carriers that provide the coverage.

Smart insurance buyers look for insurance companies with high financial ratings and long his- The quality of the reinsurance security pur- tories of standing by their insureds when losses chased by the direct insurer is what helps to en- occur. Other buyers rely on their broker to put sure that losses will be paid. It is therefore im- together the best quality insurance program portant to understand the reinsurance function, with the best insurance security available. After relationship, claims services, and fronting ar- all, the insured must rely on the insurance poli- rangements. cy issued by the direct insurer.

About the Author ... Also in this issue

Larry Schiffer Reinsurance Terminology Explained: Partner, Squire Patton Boggs (US) LLP Bordereau ...... 3 Reinsurance Contract Wording Mr. Schiffer practices in the areas of Revisited ...... 6 commercial, insurance, and reinsurance Adventures in Contract Wording: litigation, arbitration, and mediation, in- The Effect of Ambiguous cluding matters concerning insurance insolvency and Reinsurance Contract Language ...... 10 run-off. He also advises on insurance and reinsurance coverage and contract wording matters. The Interplay between Fronting and MGA Arrangements ...... 13 He serves as a mediator for the mandatory commer- If It Looks Like a Claim, and cial mediation program of the US District Court for the Sounds Like a Claim, Is It a Claim Southern District of New York and for the New York for Reinsurance Purposes?...... 16 Supreme Court Commercial Division, Alternative Dis- Playing the Name Game—An Update pute Resolution Program. on Cut-Through Clauses ...... 19

Mr. Schiffer is active in the American Bar Associa- Allocation in the Mind of the tion and the New York State Bar Association where Ceding Insurer ...... 23 he serves in leadership positions and several commit- Interplay of Loss Portfolio Transfers tees. and Other Reinsurance Contracts ...... 26

But what stands behind the A-rated insurer or relationship. Generally, there is no contractual the high quality insurance program for a com- relationship between the insured and a reinsurer, plex commercial risk? Reinsurance. Commercial and no right of action by the insurer against the insurance cannot exist without reinsurance. The reinsurer. The insured must look to its insurer for quality of the reinsurance security purchased by payment of any claims, not to the reinsurer. the direct insurer is what helps to ensure that losses will be paid. Under normal circumstances, the reinsurer has no interaction with the insured. Usually, the The Reinsurance Function identity and often the existence of the reinsurer are unknown to the insured. Why then should Quality reinsurers provide special expertise to the insurance buyer care about reinsurance if their direct insurer clients and assist the direct there is no contractual relationship or interac- insurer in providing the best possible protection tion between the two? and risk management for the direct insurer’s own clients. Some large professional reinsurers Depending on the insurance program pur- help small insurance companies expand into chased, the reinsurance standing behind that in- new areas and provide them with technical, ac- surance may have a significant impact on the in- tuarial, and claims expertise and training. sured when losses arise. A highly leveraged insurance program that predominantly relies on Reinsurance has been defined in various ways by reinsurance may create a substantial risk for the expert commentators and the courts. In simple insured. If the reinsurance fails—the reinsurers terms, reinsurance is insurance for insurance com- refuse to pay or become insolvent—the direct in- panies provided in the form of a contract of insurer may have serious difficulty responding to demnity rather than a liability contract. Generally, claims if the direct insurer reinsured or ceded the direct insurer must first pay a loss and then most of the risk to its reinsurance program. seek reimbursement for that loss from its reinsurer. Although the direct insurer is solely responsible Stated another way, reinsurance essentially is to the insured for claims, the failure of a reinsur- an extension of the theory of insurance itself. ance program behind the direct insurer may re- The insurance risk is spread from one risk bear- sult in the insolvency of the direct insurer. This, er to other risk bearers. This allows the initial in turn, may result in the insured effectively be- risk bearer to continue to provide insurance coming a self-insurer and relying on state securi- products to its clients, knowing that when loss- ty funds for the minimal protection they pro- es occur, others will share those losses. Rein- vide. surance also allows a direct insurer to strength- en its balance sheet by reducing its liability for loss and replacing that liability with an asset. Risk Management/ Claims Services The Reinsurer/ Insured Relationship A highly leveraged insurance program also may be a sign that the direct insurer has very little in- The relationship between a reinsurer and the interest in the program. Where the risk retained by sured differs markedly from the insurer/insured the direct insurer is minimal, the direct insurer

2 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts may not provide the level of risk management fronting insurer will even reinsure its retained and claims services that the insured may require. portion of the risk through a separate reinsurance program, leaving it with none of the risk it A direct insurer that cedes the vast majority of originally assumed. Where the direct insurer the reported loss to its reinsurers may not wish transfers all of its risk to others, the likelihood to incur loss adjustment expenses, but would that the direct insurer will provide the insured rather its reinsurers shoulder the loss. While this with any risk management services and stand by may seem to favor the insured, whose claims the insured when claims arise is diminished. will be paid and passed along to reinsurers, the lack of proper claims handling may result in un- Conclusion necessary loss payments and resistance from reinsurers who expect the reinsured to handle These doomsday scenarios need not come true claims properly. if the insurance buyer insists on a high-quality insurer and questions the reinsurance protec- Fronting Arrangements tion standing behind the insurance program it has purchased. Reinsurance is a normal part of The direct insurer’s interest in the insurance the risk transference system, and the insured program may be nonexistent because the direct should have comfort in knowing that its risk is insurer is merely acting as a front for the rein- being transferred in an appropriate manner to surance program. Many commercial risk pro- reinsurers of quality. grams are fronted because the risk bearers with the expertise and interest in insuring the risk If the direct insurer refuses to discuss the rein- are not licensed to do business in the insured’s surance protection it anticipates for the pro- state or are not licensed to write direct insur- gram it plans to write for the insured, the in- ance. Generally, a fronted program is well- sured should consider whether doing business known to the insured and arranged in advance. with that insurer is the right business decision for the company. ❒ For example, it may be that the insurance market for a certain type of insurance is made only Reinsurance Terminology in London. The insured may be uncomfortable in accepting direct insurance through the excess Explained: Bordereau or surplus lines market and may insist on licensed or admitted paper. In that case, a licensed direct insurer may write the policy and cede most of the risk to the market that provides the actual coverage.

Sometimes, however, the direct insurer retains enough of the risk so that the insured does not Reinsurance contracts are filled with exotic and know the program is really fronted. The direct in- equally mind-numbing terms like facultative cer- surer may have little interest in the insurance pro- tificate, follow-the-fortunes, cede, treaty, honor- gram if it is merely collecting a fronting fee. The able engagement, ultimate net loss, and more.

3 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Some of our previous commentaries have ad- Strain, Robert W., ed. Reinsurance Contract dressed a few of these terms, such as “Under- Wording. Athens, TX: Strain Pub, 1992. The standing Reinsurance Terminology—Follow-the- IRMI.com Glossary definition of bordereau is: Fortunes” (October 2001), “Sorting Out the Re- “A report providing premium or loss data with insurance Contract Morass” (March 2002), and respect to identified specific risks. This report is “Reinsurancese—Time for a Change?” (March periodically furnished to a reinsurer by the ced- 2008). ing insurers or reinsurers.” A single report or list is a bordereau. When describing more than one As one delves into the more technical aspects of bordereau, add an “x” after the “u” to make the a reinsurance contract, the term “bordereau” of- term plural: “bordereaux.” ten comes up. The uninitiated may immediately recoil from a word like bordereau, but those Why Bordereau? who have been around the block know that a bordereau is just a list or report. But is it just a The word “bordereau” derives from the middle list? French word “bordrel” and from the old French word “bort,” which means edge or margin. Bordereau Defined Merriam-Webster’s shows the first known use around 1858, but A Treatise on the Law of The venerable Robert W. Strain, whose final re- Principal and Agent, Chiefly with Reference insurance and contract wording training course to Mercantile Transactions (Paley, William. 3rd was conducted in July this year, defines bor- ed. New York: Banks, Gould, 1847) mentions dereau as follows: bordereau in the context of a statement or memorandum listing the details of negotiable in- Furnished periodically by the reinsured, a de- struments. Earlier uses can also be found if you tailed report of reinsurance premiums or rein- search the Internet or hang out in dusty corners surance losses. A premium bordereau contains of business libraries. a detailed list of policies (or bonds) reinsured under a reinsurance treaty during the reporting Interestingly, the errors and omissions clause period, reflecting such information as the name found in many reinsurance contracts was devel- and address of the primary insured, the amount oped in the time when all information received and location of the risk, the effective and termi- by the reinsurer was presented on comprehen- nation dates of the primary insurance, the sive bordereaux. The errors and omissions amount reinsured and the reinsurance premium clause was created to ensure that coverage was applicable thereto. A loss bordereau contains a provided even though an item was inadvertently detailed list of claims and claims expenses out- left on a bordereau. Salm, Robert F. “Reinsur- standing and paid by the reinsured during the ance Contract Wording.” In Reinsurance. Ath- reporting period, reflecting the amount of rein- ens, TX: Strain Pub, 1980. See our Expert surance indemnity applicable thereto. Bor- Commentary, “When Errors Occur in a Rein- dereau reporting is primarily applicable to pro surance Relationship” (December 2002). rata reinsurance arrangements and to a large extent has been supplanted by summary report- Bordereau is just one of many terms of art used ing. in the reinsurance industry. Terms of art are of-

4 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts ten used to set a particular industry or profes- Typically, the reinsurance contract will specify sion apart from others by using jargon that has the reporting requirements for the periodic pre- a “special” meaning only understood by those mium bordereau. Many reinsurers are now stan- working in that industry or profession. As Pro- dardizing the format for these bordereaux and fessor Kingman Brewster Jr. said, “[i]ncompre- accepting them electronically either in a propri- hensible jargon is the hallmark of a profession.” etary format based on the reinsurance account- As with most terms of art, “bordereau” was ing system being used or in a common format used instead of report or list by reinsurance pro- like Excel. Certain statistical organizations and fessionals and became common usage in the in- industry compilers of information in certain dustry in the 1800s. markets have standardized electronic bordereau reporting. Types of Bordereaux The premium bordereau typically goes directly The term bordereau is used to describe most to the reinsurer’s accounting function so that lists or reports of premium or losses required the ceded premium can be booked. Neverthe- under the reinsurance contract from the rein- less, it is important for the reinsurer to examine sured to the reinsurer. In the facultative con- the premium bordereau for anomalies in either text, where an individual risk is reinsured, a the premium volume or the risk information be- bordereau is not necessary. The premium re- ing supplied. The premium bordereau also port is the reinsurance premium paid for the serves as an important tool for the reinsurer facultative certificate for that individual risk. when selecting certain risks for audit should the On the loss side, typically there is individual reinsurer engage in periodic audits of the busi- loss reporting. But if a facultative certificate ness being ceded to the treaty. generates multiple losses emanating from an individual risk, monthly or quarterly reports A proportional treaty typically will have report- listing all claims and all payments on claims at- ing requirements for losses, and these often tributable to that single risk may be deemed a manifest as a loss or claims bordereau. The re- bordereau. insurance contract will set out the information requirements for the loss bordereau. Generally, In the treaty context, a premium bordereau is the loss bordereau will contain risk details such merely a detailed report of the premiums ced- as the insured’s name, claimant’s name, policy ed from each of the underlying policies subject number, claim number, effective date, date of to the proportional reinsurance treaty. Typical- loss, loss reserve, expense reserve, and any ly, the premium bordereau will set out policy- paid losses or expenses. The loss bordereau, level detail, including the gross premium, the like the premium bordereau, generally is provid- brokerage if any, and the ceded premium, ed in electronic format and often in a standard- along with basic details for each policy ceded ized design. On a quota share treaty, the loss to the treaty. The premium bordereau is also bordereau is often the only way the reinsurer the initial method by which the reinsurer finds will obtain information about the losses being out the exact details of the business being writ- ceded to the treaty unless there are special reten by the reinsured and assumed by the rein- porting requirements for certain risks. Like the surer. premium bordereau, the loss bordereau will be

5 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

the tool against which the reinsurer will make The bordereau is to include the following selections when doing a claims audit. items:

Reinsurance Contract A. Name of Insured Requirements B. Policy Number C. Effective/Expiration Dates Not every reinsurance contract requires premi- D. Type of Transaction (New, Renewal, um bordereau reporting. Very often, reporting Endorsement, or Cancellation) clauses require summary accounting informa- E. Policy Limit tion rather than the individual risk detail typical- F. Premium ly found in bordereau reporting. For example, a G. Ceding Commission reporting clause may provide simply as follows: H. Net Premium

The Company shall render a monthly ac- Conclusion count within __ days after the end of the period. This account shall summarize premi- Although terms of art and industry jargon are ums, return premiums, allowances for off-putting to many, industries like the reinsur- commissions, losses paid, loss adjustment ance industry are littered with these expressions expenses paid, and salvage recovered. The and words. Yet, words like bordereau, once the account shall also reflect the balance due by meaning is known, are no longer mysterious either party. and are easily understood and put to common use. ❒ These monthly or quarterly reports are merely account statements summarizing the business Reinsurance Contract under the treaty and do not provide policy-lev- Wording Revisited el detail. Where the reinsurance contract does not prescribe detailed bordereau reporting, the reinsurer must audit periodically to test the business being ceded and to ensure compliance with the terms of the reinsurance contract.

Where bordereau reporting is required, the reinsurance contract will express the detailed information required. For example: Always read the contract—at least that is what The Company shall furnish the Reinsurer the experts say and best practices advise. The with the following: trouble with that sage advice is that sometimes the contract is not as clear as it could be. 1. Bordereau within 30 days after the last day of each month, payable within 60 Ambiguities, as we have discussed before, see days after the last day of each month. “Adventures in Contract Wording: The Effect of

6 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Ambiguous Reinsurance Contract Language,” to show that the payment was made under a lead to problems and sometimes disputes. policy that is reinsured by the reinsurance agreement and that the payment was proper within Who Has the Burden of Proof? the terms and provisions under both contracts. The burden then shifts to the assuming insurer When a contract dispute goes to court over an to prove that payment was improper or that ambiguity, one party has the burden of proving there is some other basis to refuse payment un- its case. The same is true in reinsurance arbitra- der the contracts. tions, but the rules are more relaxed, and most arbitrators don’t sweat the burden of proof is- In direct insurance disputes, it is well known sue. Nevertheless, the parties need to put forth that the insurance company seeking to avoid a what they can to prove their view of how the claim payment has to prove that an exclusion to contract should be interpreted. coverage applies. All the policyholder has to prove is that there is an insurance contract and Typically, the plaintiff or the petitioner has the there is a claim that falls within the coverage burden of proof. When the issue is proving the grants of the contract. It is the insurance com- existence of a contract, the burden is on the pany’s burden to prove that an exclusion pre- plaintiff to show that there is, in fact, a contract cludes coverage. between the parties. In the reinsurance context, things are no different. The party seeking to re- Similarly, in a reinsurance dispute, where the as- cover under the reinsurance contract typically suming insurer is claiming an exclusion under has the burden of proof. the reinsurance contract (or otherwise) applies, the burden falls on the party seeking to get out If a ceding insurer is seeking to collect reinsur- of the contractual obligation—the assuming in- ance recoverables from an assuming insurer, the surer—to prove facts to show that payment is ceding insurer has to prove that there is a real not required. contract between the parties and that the facts and circumstances demonstrate that the pay- Where one party seeks to terminate the reinsur- ment is required under the contract. Assuming ance contract, the party claiming the right to credible and sufficient proof is provided, or terminate has the burden to prove that termina- there is no issue about whether the parties en- tion is permitted and appropriate under the tered into a real contract, then the ceding insur- terms and provisions of the reinsurance agree- er must prove that it paid an underlying claim or ment. This is true even if, for example, the ced- expense that comes within the reinsurance con- ing insurer brings an arbitration seeking an arbi- tract and that a proper billing was delivered to tration award declaring that the assuming the assuming reinsurer in a timely manner. insurer’s attempt to get out of the contract by termination is ineffective and a breach of the re- Very often the dispute is not about the billing it- insurance agreement. Because the assuming in- self but whether the payment was a proper pay- surer is looking to avoid a contractual obliga- ment under both the underlying insurance con- tion, it becomes the assuming insurer’s burden tract and the reinsurance contract. Again, in the to prove that termination is permitted under the first instance, the ceding insurer has the burden reinsurance contract.

7 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

How To Prove the Contract terms and conditions to be able to understand how the contract operates. Proof might be In most cases, there is no real dispute about the found in the underlying insurance contract if contract. In court, the plaintiff will have to show the reinsurance was facultative. Alternatively, it through business records and appropriate testi- may be pieced together from correspondence mony that there is a contract. Alternatively, the (today, emails; back in the day, facsimiles or parties may stipulate to the existence of the cables). contract. Incorporated Terms In a reinsurance arbitration, the parties typically put the reinsurance contract in as an exhibit to Many contracts expressly incorporate terms and the prehearing briefs and use the contract provisions from other contracts or documents. throughout the proceeding. In most cases, the Reinsurance contracts may do this as well. This arbitration panel will ask the parties to provide may complicate determining the meaning of the reinsurance contract to the panel at the ear- specific terms and provisions of the contract. ly stages of the arbitration. Ambiguities can easily arise from incorporated wording. Because reinsurance disputes can involve multiple reinsurance contracts with multiple amend- A facultative certificate, which is typically a ments and attachments, and ones that are de- short form contract, may incorporate the terms cades old, coming up with an agreed-upon and conditions of the underlying insurance poli- contract set is not always easy. The older the re- cy it reinsures. Many reinsurance contracts ex- insurance contract, the more likely it is that it pressly state that the reinsurer must follow the will be missing amendments or schedules or form of the underlying contract. This is particu- that it will be unsigned. But, unless there is a re- larly true in reinsurance structures that are al dispute about the existence of the reinsurance meant to be back to back with the underlying in- contract or a particular amendment, small er- surance policy. rors or missing documents are not usually prob- lematic. An excess-of-loss reinsurance treaty might incorporate the terms and conditions of the un- Where there is a real dispute about whether the derlying reinsurance contract that reinsures the parties entered into the contract, then the pro- lower limits of the underlying policy. For exam- ponent of the contract will have the task of lo- ple, if a direct insurer issues a primary policy cating enough evidence to convince the arbitra- for $1 million and a following form excess pol- tion panel that the contract did come into icy for $2 million excess of the underlying $1 existence. This might require archive searches million primary policy, the direct insurer—now and assistance from the reinsurance intermedi- the ceding insurer—may structure its reinsur- ary if one was used to place the reinsurance. ance to follow the underlying pattern. It may purchase a facultative certificate for a portion To prove the contract, there will need to be of the primary policy and another, following enough documentary evidence and testimony form facultative certificate for a portion of the to show an offer and acceptance, and sufficient excess policy.

8 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Another example of incorporation in the rein- Often these provisions state that there is a limit surance context might occur is where the as- to incorporation. Obviously, there are terms suming insurer buys its own reinsurance and and provisions of the contract that are different retrocedes part of its assumed risk to another from the underlying document, so these provi- assuming insurer (a retrocessionaire). In that sions provide that the incorporation applies ex- case, the retrocessional contract may attach or cept as amended by the contract. incorporate the underlying reinsurance contract. Does Incorporation Solve the For an incorporation to be effective, the contract Ambiguity Problem? must make clear reference to the incorporated document and describe it in terms that clearly Incorporating terms and provisions from anoth- identifies the document. Some contracts go fur- er document is helpful in clarifying how to inter- ther than merely referring to another document. pret the main contract. But if the main contract Some contracts expressly attach the other docu- does not clearly specify what provisions take ment. With a provision expressly attaching an- precedence when there seems to be an overlap, other document and with the document actually then ambiguities arise. attached, there can be no doubt about the other documents applicability. But how it works in a A provision that says, “except as amended by specific context may not be as clear. this agreement, all terms and provisions of the other agreement apply” is only helpful if “this Dual Incorporation agreement” specifies what it is amending from the other agreement. When it does, the main Another way to make it clear that the terms of agreement will have language such as “section another document are incorporated is not just 2 of the referenced document is amended as fol- to attach it but to state expressly that all the lows.” Without that language, the parties are terms and provisions of the other document are left to fight over conflicting provisions. applicable to this contract as if those terms were contained in this contract. This has been called While the general rule is that a later-signed doc- dual incorporation by some courts. This has ument’s terms will prevail and a more-specific been used in some reinsurance contracts, and at provision will prevail, it is not always very easy least one court that has reviewed dual incorpo- to make the distinction. For example, if an in- ration provisions in a retrocessional context has corporated reinsurance agreement has an in- stated that it was sufficient to allow the underly- spection of records clause and the retrocession- ing contract’s arbitration provision to apply to al agreement that incorporates the underlying the retrocessional contract. agreement has its own inspection of records clause, which one prevails if there is a dispute The dual incorporation provision emphasizes between the retrocedent and the retrocession- that not only is the referenced document at- aire? tached and made a part of the contract but that all the terms and provisions of that document The answer may be that the provisions have to are applied to this contract as if those terms and be read together and reconciled; it all depends provisions were contained in this contract. on the language.

9 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Conclusion because of imprecise reinsurance contract language and what can be done to avoid this sce- There is no doubt that reinsurance contract nario. wording has improved markedly in recent years. Nevertheless, most reinsurance disputes involve To some, reinsurance contracts seem at once older contracts, and some of those contracts arcane and boilerplate—arcane because reinsur- have ambiguities. While the burden of proof of- ance terminology goes back hundreds of years, ten rests with the contract’s proponent where and boilerplate because “standard” clauses ap- the other party is claiming relief from compli- pear in contract after contract, year after year. ance, the burden of proof generally shifts. Like all contracts, however, it is crucial that a reinsurance contract set forth the intent of the Incorporated wording adds complexity to deter- parties clearly and precisely to avoid legal dis- mining the meaning of specific terms and provi- putes years later. sions of the contract. Lack of clarity may cause ambiguities to rise if it is not clear what provi- High quality cedents and reinsurers have con- sions of the main contract control over the in- tract wording specialists whose job it is to corporated provisions. make sure that the wording for that particular reinsurance contract properly expresses the The bottom line is the contract needs to be read parties’ intent. Sometimes, however, because in its entirety and in the context of the structure of the press of business, the volume of reinsur- of the agreement, any incorporated terms and ance contracts renewing at the same time, or provisions, and with consideration of the cus- by the use of reinsurance intermediaries to toms and practices of the industry. ❒ prepare draft contract wordings, reinsurance contracts are drafted using the old cut-and- Adventures in Contract paste method. Clauses may be carried over Wording: The Effect of from sample or older contracts that may have no relevance to or meaning in the contract be- Ambiguous Reinsurance ing drafted. Under these conditions, the intent Contract Language of the parties may not match the contract wording. And if the losses exceed expecta- tions, a dispute will arise.

Sloppy contract drafting breeds disputes, and disputes distract cedents and reinsurers from the business at hand. Ambiguities in reinsurance contracts also may result in a judicial interpretation of the contract that is contrary to the cus- Sloppy contract drafting breeds disputes, dis- tom and practice in the industry or one that was putes result in litigation, and it is dangerous in- never even contemplated by the parties. Clarity deed to leave it to the courts to determine the in reinsurance contract drafting, therefore, is ex- provisions of a reinsurance contract. This article tremely important to a long and stable relation- examines some of the problems that can occur ship between a cedent and its reinsurers.

10 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Ambiguity Breeds Disputes Had the parties made clear in the contract precisely what reinsurance protection the cedent There have been a number of reinsurance dis- could purchase without violating the net reten- putes over ambiguous reinsurance contract tion warranty, this issue would not have been terms. For example, in one case, a dispute raised in the dispute. While it is far from clear arose concerning whether the cedent’s use of that the use of quota share reinsurance by the quota share reinsurance to cover part of a loss cedent violated the net retention warranty, one that came within the cedent’s retention was a has to wonder how the court could equate “gen- breach of the cedent’s net retention warranty in eral excess of loss reinsurance contract” with a the reinsurance agreement [Commercial Union quota share reinsurance contract. Ins. Co. v Seven Provinces Ins. Co., 217 F3d 33 (1st Cir 2000)]. The facultative certificate is- Another issue arising out of the perceived ambi- sued by the reinsurer required that the cedent guity in reinsurance contract wordings is wheth- retain $225,000 out of the $450,000 excess of er declaratory judgment expenses are covered $50,000 amount reinsured. The retention, under reinsurance contracts. This issue has gen- however, could be reduced by “any general ex- erated case law and significant industry com- cess loss or excess catastrophe reinsurance.” mentary because of its economic impact on en- vironmental and other long-tail, continuous The language used in the net retention clause was exposure types of claims. extremely difficult to follow (and is not worth re- peating here). The cedent took the position that it In Affiliated FM Insurance Co. v Constitution properly reduced its retention by using its general Reinsurance Corp., 416 Mass 839 (1994), the quota share treaty to cover part of the loss with- Massachusetts Supreme Court found the lan- out a proportional reduction in the amount re- guage in the facultative certificate unclear on quired to be paid by the facultative reinsurer. whether the parties intended the contract to include litigation expenses for declaratory relief The court found that the net retention provision brought by an insured against its insurer to de- was ambiguous and allowed expert testimony to termine coverage. The word “expenses” was at help clarify whether the quota share treaty qual- the crux of this dispute. The court held that be- ified as a general excess of loss reinsurance con- cause “expenses” was a word with broad im- tract. Ultimately, the courts agreed with the ce- port and no fixed definition, it was ambiguous dent’s expert and held that the use of the quota in the context of the facultative certificate. Had share treaty to reduce the cedent’s net retention the certificate made clear how declaratory judg- did not violate the net retention clause. ment expenses would be handled, there would have been no dispute. All of this, of course, could have been avoided if the net retention clause was written more pre- Conflicts between Contract cisely. The ambiguity, according to the court, Provisions was the phrase “general excess of loss reinsurance contract,” which the court did not find to Other disputes have arisen because of a per- be a term of art in the reinsurance industry as ceived conflict between the arbitration and ser- was the phrase “excess of loss reinsurance.” vice-of-suit clauses in reinsurance treaties. The

11 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

typical arbitration clause makes arbitration the A slip is a short-form method of documenting exclusive means of dispute resolution between the main terms and conditions of a reinsurance the cedent and the reinsurer. Most reinsurance contract in advance of the preparation of the treaties—particularly ones involving international full contract wording. The slip itself stands as an reinsurers—also contain a service-of-suit clause, enforceable contract should the formal contract which provides that the reinsurer shall submit to not be drafted. While in most cases a formal re- the jurisdiction of any U.S. court at the request of insurance treaty will be signed by the parties, the cedent if the reinsurer fails to pay. certain reinsurance markets rely on slips and cover notes as the final expression of the par- Some reinsurers have argued that the dispute ties contractual arrangements. must go to court because the service-of-suit clause overrides the arbitration clause. Most re- Slip policies are fraught with potential ambigu- cently, an Ohio federal court rejected this argu- ities. If not drafted carefully, they often refer to ment and found that the service-of-suit clause underlying wordings that might not exist or ref- was meant to apply to litigation to compel arbi- erence specific forms that are no longer in use. tration or to confirm or vacate an arbitration We have seen slips in loss portfolio reinsurance award, and did not override the broad arbitra- contracts that refer to the arbitration clause “as tion clause in the reinsurance treaty [Credit in the original” when there is no “original” to re- Gen. Ins. Co. v John Hancock Mut. Life Ins. fer to. We have seen other slips where the par- Co., No. 1:99 VC 02690, 2000 U.S. Dist. ties express the reinsurance limits only, without LEXIS 9003 (ND Ohio May 30, 2000)]. clarifying the cedent’s retention.

The ambiguity here arises not from the lack of These drafting lapses lead to disputes, which clarity of particular phrases, but because provi- are more difficult to resolve because of the am- sions in the same contract appear to conflict. biguities in the contract. While some courts While the Ohio federal court did not find a con- have no trouble enforcing an arbitration provi- flict, other courts have held that the service-of- sion merely based on the words “arbitration suit clause overrides the arbitration clause where clause” in a slip [Allianz Life Ins. v American the arbitration clause is not broad. Often, con- Phoenix Life & Reassurance, Civ. No. 99-802 flicts between contract provisions occur when (DWF/AJB), 2000 U.S. Dist. LEXIS 7216 (D older agreements are marked up and edited. If Minn March 28, 2000)], it is dangerous indeed care is not taken to make sure that only the rele- to leave it to the courts to determine the provi- vant clauses are present and that no internal sions of a reinsurance contract. conflicts exist, disputes will arise, and courts may interpret the contract in a way the parties Concluding Thoughts did not contemplate. The law of contracts applies to reinsurance con- The Dangers of Short-Form tracts with equal force. While the rules of con- Contracts tract interpretation allow the use of extrinsic evidence to determine the parties’ intent should a Another area where ambiguities arise is when provision be found ambiguous, resorting to ex- the reinsurance contract is merely a slip policy. trinsic evidence is unnecessary if the contract is

12 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts devoid of ambiguity. It is better and less expen- agrees to write the business but then lays off all sive to be clear and precise when drafting a rein- or most of the risk to the party that really wants surance contract then to await an expensive ar- to assume those risks. bitration or litigation to find out what a third party thinks the parties originally intended. ❒ Sometimes the structure of the deal combines the use of a third-party managing agent that The Interplay between produces and underwrites the business for a ceding insurer, which in turn acts as a fronting Fronting and MGA insurer for a reinsurer. These hybrid structures Arrangements conflate the issues parties often confront when dealing with managing agency and fronting arrangements.

In “The Trouble with Giving Away the Pen” (June 2001) and “Up-Front about Reinsurance” (January 2004) reinsurance commentaries, we discussed some of the issues that may arise when contracting with a managing agent and Insurance and reinsurance programs take on the various rationales for creating a fronting ar- many structures. Some are straightforward tradi- rangement. This commentary will discuss the tional reinsurance arrangements. For example, a interplay between the two. ceding insurer produces a book of business through its agency force or through independent Overview of Insurance Business brokers and underwrites the business through its Production underwriting staff. Claims are then handled by the ceding insurer’s claims department. A rein- There are many ways insurance business is pro- surer or group of reinsurers contracts with the cured, produced, underwritten, and ultimately ceding insurer to provide quota share or excess- reinsured. Because there are many specialty of-loss reinsurance protection. lines of insurance, some of which are esoteric or highly specialized, very often they are under- Other structures involve business produced by written by specialty brokers or other third par- third parties. These third parties are often non- ties that contract with insurance companies to risk-bearing organizations that contract with the provide the insurance policies necessary to in- ceding insurer to produce a certain class or line sure that business risk. Sometimes the insurer is of business that is then subject to reinsurance actively engaged in the business and partici- protection. A different type of structure includes pates both economically and with the under- a ceding insurer that bears very little if any risk writing and claims handling. Sometimes the in- of loss and reinsures all or almost all of the risk surer merely acts as a pass-through or fronting to the reinsurer, which is the real party in inter- company for the business, which is ultimately est and assumes the economic risk of loss for reinsured to a specialty reinsurer created by the the business written. These are called fronting producer or an unaffiliated reinsurer that be- arrangements. Essentially, the ceding insurer comes the real party in interest.

13 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

The analogy is roughly similar to a market-mak- ance company partner or for a fronting insurer er in the securities world. Certain specialized that will allow the producing agent to write the stocks are traded between a few specialty secu- business on that insurer’s policies. Where the rities brokers who create a marketplace for the insurer is not a partner in the true sense (does securities for that industry. In insurance, certain not want to keep the business net), a fronting business is sourced and underwritten only by arrangement is generally created whereby the specialist brokers. Because these brokers typi- insurer is merely a pass-through for the busi- cally are not risk-bearing entities, they need to ness. The insurance policies produced are ulti- find an insurance company to supply the policy mately reinsured by the insurer that has the real on which the business will be written and a re- interest in the business. insurer or a group of reinsurers willing to assume the risk associated with the policies being The insurer with the real interest in the business written. It is not uncommon for brokers to de- may be a true independent partner with the velop new coverages and insurance products for producing agent or may be a captive risk-bear- new risks and then reach out to the risk-bearing ing insurer created by the producing agent. Very insurance market for insurers and reinsurers often, the producer-owned reinsurers of these willing to participate in the new underwriting fronting arrangements are incorporated out- venture. side the United States, where the capital and regulatory requirements have lower barriers to The Interplay between the entry. Fronting Company and the Agent In one scenario, the risk-bearing entity is a rein- The producer/agent of the business will typical- surer ultimately owned by the producing agent. ly contract with an insurance company as a In this situation, it is in the producing agent’s managing agent to produce the insurance busi- best interest to produce high-quality business in ness on the fronting insurance company’s poli- which the fronting insurer will receive its front- cies. If an agent is producing and underwriting ing fee and not have any real risk of being stuck business on behalf of an insurance company, with a book of poorly performing business with most states’ insurance laws require that an no live reinsurer. agency agreement must be entered into between the agent and the insurer. The regulatory In another scenario, the risk-bearing entity is climate for agents changed in the 1980s be- an independent insurer acting as a reinsurer. In cause of perceived abuses by some unscrupu- this situation, it is often the case that the pro- lous agents. These agency agreements have ducing agent’s only form of compensation is provisions that purport to protect the insurer the fee earned from producing and underwrit- from abuses by an underwriter who that has no ing the business plus any profit sharing on the skin in the game. profitability of the entire book of business. Here, the independent reinsurer must be vigi- If it is the producer/agent who is sourcing and lant to ensure that the producing agent is pro- underwriting the business (and owns the renew- ducing quality business and not just ramping als as many managing agents do), it is likely up the volume to earn a large commission and then that the producer will look for an insur- then disappear.

14 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

The reinsurer cannot rely on a fronting insurer count. The managing agency engaged an affili- to monitor the managing agent where the ate to handle the claims. fronting insurer is not retaining any risk. The fronting insurer is merely collecting a fronting The deal was structured based on a target loss fee as the business is all being reinsured to the ratio. After paying a small fronting fee from the reinsurer. If the fronting insurer was brought premiums collected, the managing agent re- into the deal by the managing agent, there is ceived 20.6 percent of the remaining premium even more reason to monitor the business as its compensation. The reinsurer received 10 carefully. percent of the premiums assuming the loss ratio target was not exceeded. The balance would What Can Go Wrong? pay losses, and if the loss ratio was lower than the target, the managing agent would receive At the outset, it is important to be clear that additional commission. most managing or producing agents do an excellent job in their specialty areas and do their We can stop the narrative here because it is very best to produce high-quality and profitable pretty clear what can go wrong. If the loss ratio risks. Nevertheless, where insurance companies were somehow manipulated, the reinsurer allow others to do the producing, underwriting, would not get its 10 percent, but the managing and claims handling, things can go very wrong. agent would get its 20.6 percent off the top. Al- so, if the funds meant to be put aside to cover In a recent case, an insurance company acting the target loss ratio were siphoned off, there as a reinsurer became the real party in interest would not be enough money to pay the losses. to a fronting deal created and produced by a managing agency and its affiliates. Essentially, In this case, the managing agent allegedly en- the agent allegedly diverted millions of dollars of tered into contracts with other affiliates and funds from the reinsurance arrangement to its paid those affiliates $50 million, which was nev- affiliates and then to its principals. See Lincoln er put aside for the anticipated losses. Addition- Gen. Ins. Co. v. U.S. Auto Ins. Servs., Inc., ally, the managing agent allegedly unilaterally 2015 U.S. App. 8172 (5th Cir. 2015). changed the formula used to calculate its commissions and artificially depressed the loss ratio In this case, the managing agency produced to inflate its own commissions. When the losses and underwrote auto insurance policies for a finally came in, the trust fund was depleted and third-party fronting company. The reinsurer re- the reinsurer had to fund all the claims. insured 100 percent of the business written. The agency agreement was between the front- Lessons Learned ing company and the managing agent. The managing agent issued the policies, collected Managing and monitoring a managing agent is ab- and handled the premiums paid, and handled solutely critical to avoiding an unintended loss. If the claims. Although there was a premium trust the real party in interest is a reinsurer behind a account, the managing agent had the power to fronting arrangement, the reinsurer must audit and manage the money and to retain its commission monitor the managing agent to make sure that the before depositing any funds into the trust ac- premiums are being allocated and deposited cor-

15 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

rectly and that the target loss ratio is being met. er, depending on the nature of the reinsurance The right to audit must be carefully crafted into the provided. reinsurance agreement where the managing agency agreement is solely between the fronting ceding Claims are a natural and expected outcome of insurer and the managing agent. any insurance relationship. This is, of course, true in reinsurance relationships as well. But is a Although modern managing agency agreements claim for insurance purposes a claim for reinsur- provide statutory and contractual protections ance purposes? The answer is, it depends. against managing agency abuses, there is no sub- stitute for boots on the ground (or at least virtual Traditional Insurance Company boots accessing premiums and claims systems in Claims Responsibilities real time). It is important for the real party in interest to examine any third-party service contracts Under a traditional third-party liability insur- entered into (or better, proposed to be entered in- ance contract, the insurance company has the to) by the managing agent to avoid self-serving duty to defend the insured against any claims contracts with affiliated companies that merely in- brought against the insured that arguably fall crease the fees paid to the managing agent. within the scope of the insurance contract. Ad- ditionally, the insurance company has a duty Frequent reporting, auditing, and spot-checking to indemnify the insured for payments the in- are critical to maintaining a healthy managing sured must make to compensate claimants for agency arrangement that works for all parties. damages sustained as a result of the insured’s Where there is a fronting insurer involved, it is actions that are covered by the insurance poli- critical to make sure that the reinsurer—the real cy. Courts have held that the duty to defend is party in interest—has all the rights to receive re- broader than the duty to indemnify, so that ports and monitor and audit the entirety of the loss adjustment expenses incurred in defending fronting and managing agency arrangement. ❒ against a claim may be the largest loss cost where there is a question as to whether the If It Looks Like a Claim, and claim is covered by the policy.

Sounds Like a Claim, Is It a Similarly, under a traditional first-party insur- Claim for Reinsurance ance contract, the insurance company is re- Purposes? sponsible to indemnify the insured for all damages sustained to covered property or life or health risks that come within the scope of the coverage of the insurance policy. The insurance company has a duty to investigate and adjust claims in a timely and good faith manner and generally cannot disclaim coverage without providing very specific reasons.

This article explains why a claim to an insur- All insurance policies contain notice provisions ance company may not be a claim to a reinsur- by which the insured must notify the insurance

16 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts company of any claims brought against the in- Most reinsurance contracts grant the right, but sured. Many policies require that the insured not the duty, of the reinsurer to associate in the provide notice of any potential claim, even if the defense of a claim by retaining its own counsel insured has yet to receive a demand letter or to participate in the case. This is a right that is summons and complaint. Timely notice usually rarely exercised, as reinsurers prefer to preserve is required, and there are numerous cases dis- the lack of contractual privity (direct contractual cussing the consequences of the failure of an in- relationship) between reinsurers and the under- sured to notify its insurer of a claim in a timely lying insureds to avoid direct actions by insureds manner. against reinsurers.

Generally, when an insurance company re- Reinsurers also have claim departments, but ceives notice of a claim or potential claim, it they are not generally involved in the day-to-day sets up a claim file and will post an initial re- adjustment of claims, and are much smaller serve for that claim. Depending on the insur- than the claims departments of insurance com- ance contract, the insurer likely will engage panies. The reporting of claims to a reinsurer counsel to defend the insured in a liability case and whether that report is considered a claim by (or accept the insured’s selection of counsel) the reinsurer will depend on the terms of the re- and may engage separate coverage counsel if porting clause of the reinsurance contract. there is a question about whether the policy covers the claim. The claims examiner will in- On proportional or quota share reinsurance vestigate the claim, often with the assistance of treaties, generally claims are reported in bulk on professional adjusters, and will negotiate any a periodic accounting basis. In these circum- settlements. The insurance company’s claim stances, the reinsurer will not know about indi- reserve may change over time as more infor- vidual claims unless the reinsurer exercises its mation is obtained and as the claim adjuster’s right to audit the reinsured and examine the evaluation of the claim changes. claims files itself. As these claims are reported on an accounting basis, they generally are han- Reinsurance Claims dled by accounting staff and not by claims ex- Responsibilities aminers at the reinsurer.

Generally, reinsurers have no duty to defend, On excess-of-loss reinsurance treaties, claims do not appoint defense counsel for the insured, generally are reported on a periodic accounting and are merely required to reimburse their rein- report or bordereaux, which provides claim lev- sureds for payments made by their reinsureds el detail about individual claims over a certain on the business that is reinsured. The trigger attachment point. For example, if the treaty is for payment by a reinsurer is often actual pay- $500,000 excess of $250,000, claims that ment by the reinsured of a claim either in set- breach the $250,000 attachment point will be tlement or as a judgment. Reinsurance con- reported to the reinsurer for payment. Depend- tracts are contracts of indemnity, and ing on the reporting requirements of the treaty, generally, unless the insurance company has smaller claims may never be reported to the re- paid or is required to pay, the reinsurer has no insurer because they will never become the rein- obligation to pay the claim. surer’s responsibility.

17 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

On facultative reinsurance, where the reinsurer the mere report of a claim or incident as a ance is of a specific policy and risk, all claims af- “claim” for its purposes. While the reinsured fecting the reinsured policy will be reported in- and reinsurer are often aligned for claims pur- dividually to the reinsurer, depending on the poses, the reinsurer is only concerned with attachment point of the facultative certificate claims that are likely to affect its reinsurance and and the certificate’s reporting requirements. that are within the scope of the reinsurance contract. Generally, the reporting clause in the reinsurance contract requires the reinsured to report all claims If a reinsurer is providing excess-of-loss protec- to the reinsurer that the reinsured believes will af- tion for claims in excess of $250,000, a claim fect the reinsurance contract. This generally of $10,000 will not hit its radar screen. Particu- means that if the reinsured reserves a claim for larly in high frequency lines of insurance, like an amount that exceeds the attachment point of workers compensation or private passenger au- the reinsurance, that claim should be reported. to, reinsurers do not want reports and paper- work on claims that are never going to reach Some reinsurance contracts have more specific their layers. These claims are not claims for pur- reporting triggers based on reserves exceeding a poses of reinsurance unless the reinsurance specific amount (e.g., the reinsured shall report contract provides aggregate coverage for these all claims to the reinsurer where the posted re- claims. serve exceeds 50 percent of the limit of liability covered by this contract) or by the nature of the Moreover, what may be a claim to the insur- claim or injury. Each reinsurance contract is dif- ance company may not be a claim to the rein- ferent and the reporting and claims payment surer if the coverage provided by the reinsur- clauses must be examined carefully to understand ance policy is not concurrent with the when claims must be reported to reinsurers. underlying coverage. For example, if the reinsurance provided is limited to boiler and ma- Reinsurance claims examiners handle a much chinery coverage of an all-risks policy, claims larger number of claims than claims examiners outside the specific boiler and machinery cov- in insurance companies because they are not in- erage will not be considered a claim by the re- volved in the day-to-day adjustment of the insurer. It is important for the insurance com- claims or supervision of defense counsel. The pany’s claims examiners to understand the reinsurer’s claims department will often contact available reinsurance protection and to cede the reinsured to obtain periodic updates on the the losses to the proper reinsurers in a timely claim, provide input on technical claims issues, manner. and monitor the reinsured’s claim activities for compliance with the reinsurance contract. Timeliness of reporting claims to reinsurers is also important. Some notice clauses require When Is a Claim a Claim for reporting within a certain time frame as a con- Reinsurance Purposes? dition precedent to coverage. Generally, the courts have found that late notice to a reinsur- Unless a claim is likely to affect the reinsurance, er will not excuse payment of the claim by the a reinsurer’s claims department may not consid- reinsurer without showing specific prejudice,

18 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts but not all courts agree, and it often depends Playing the Name Game— on the notice clause of the reinsurance con- An Update on Cut-Through tract. Clauses Cash Calls

Many reinsurance contracts provide for an exception to the normal reporting and payment of reinsured losses when extraordinary events occur. When a loss occurs of a certain magni- tude, the reinsurance contract may permit the insurance company to make a special request In our March 2001 article, “Cut-Through Provi- to the reinsurer for immediate payment of the sions in Reinsurance Agreements,” we de- claim, called a cash call, to reimburse the in- scribed the nature of cut-through clauses and surance company for its payment to its in- some of the business reasons why cut-through sured. clauses exist. In this commentary, we take another look at cut-through clauses and how they A recent example of a cash call is the request by have been interpreted by the courts. the property insurers of the World Trade Center to reinsurers to cover significant immediate pay- Because a reinsurance agreement is a contract ments made to the leaseholder and the Port Au- of indemnity between a ceding insurer and a re- thority to pay for the immediate needs following insurer, a contractual relationship exists only be- the collapse of the Twin Towers. While reinsur- tween those two parties. Generally, no privity ers may dispute aspects of the claim, often cash of contract is enjoyed by the original insured (or calls are paid under a reservation of rights in reinsured in a retrocessional relationship), as it catastrophic events so that the immediate needs has no contract with the reinsurer. of the insureds and insurers are satisfied without further disruption or loss. The exception to this general rule occurs when the reinsurer and the ceding insurer contract Conclusion around the lack of privity between the original insured and the reinsurer by express language in The claims-handling responsibilities of insur- the reinsurance contract. This language in a re- ance companies and reinsurers are different. insurance contract is known as a “cut-through” Reinsurers are only concerned about claims clause. A cut-through clause allows a party that that are likely to affect their reinsurance cover- is not in privity with the reinsurer to have rights age and that fall within the scope of that cov- against the reinsurer as a part of the agreement erage. The reinsurance contract provides for between reinsurer and ceding insurer. when an insurance company should report a claim to the reinsurer. A claim to an insurance The Cut-Through Clause company may not be a claim to a reinsurer, depending on the nature of the reinsurance pro- A cut-through clause is generally tailored to re- vided. ❒ spond to specific events written into the rein-

19 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

surance contract. It allows the original insured came insolvent. The claim arose out of the fol- to take direct action against the reinsurer lowing language in the reinsurance contract: where these specified events prevent the original insurer from paying the claims of its policy- [T]he parties to this Reinsurance intend that holder (the original insured). Cut-through claus- Reinsurer, through the Claims Administrator, es can be particularly useful in situations shall pay all amounts … due Insureds and where, to secure business, the ceding insurer other persons as and when due directly on needs to provide extra assurance to its policy- behalf of the Reinsured…. holders. Many large commercial insureds may not engage an insurer unless they have some The obligee argued that this wording necessari- assurance that the reinsurer standing behind ly implied that the reinsurer had granted cut- the insurer will be liable to the original insured through rights to all original insureds against the in the event the ceding insurer is unable fulfill reinsurer. In affirming the district court, the its policy obligations. Second Circuit Court of Appeals ruled that this clause did not constitute a cut-through clause. Additionally, certain insurance programs are The court stated that “New York law recognizes structured in such a way that the reinsurer is, for an exception if the reinsurance agreement con- all intents and purposes, the real insurer-in-in- tains a so-called ‘cut-through’ provision granting terest and the ceding insurer is merely fronting policyholders a direct right of action against re- the deal. This may happen because of licensing insurers, which is apparent on its face.” Despite issues affecting the reinsurer’s ability to issue the apparent provision for payment to the origi- policies in a given territory, capital constraints, nal insured, the court found that the provision or brand recognition and penetration. needed to specifically name those insureds to which payments would be made. Recent Court Rulings Involving Cut-Through Clauses This seemingly minor difference was determined to be the distinguishing factor between While most states recognize the validity of cut- the contract in this case and the contract con- through clauses, some caselaw suggests that taining substantively similar language that the cut-through clauses must be precisely tailored in court found to be a cut-through clause in Trans- order to be effective. Indeed, if any language Resources, Inc. v. Nausch Hogan & Murray, proffered as a cut-through clause is not precisely 298 A.D.2d 27 (1st Dept. 2002). The court worded, courts have shown a clear preference said the language in Trans-Resources included against finding the clause to be a valid cut- the agreement of the reinsurer “to pay directly through clause. to the named insured,” while the language above provided that the reinsurer “shall pay all An excellent example of how the courts inter- amounts due Insureds.” This latter language, pret cut-through clauses is the decision in Juru- the court held, did not specify to whom the pay- pa Valley Spectrum, LLC v. National Indem. ments will be made. Co., 555 F.3d 87 (2d Cir. 2009). In Jurupa, the obligee of surety bonds sued the surety’s rein- Moreover, Article 14 of the reinsurance contract surer to collect on the bonds after the surety be- provided expressly that:

20 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

[n]othing … expressed or implied,… shall be against the reinsurer. Rather, the decision in Ju- construed to confer upon … any person [oth- rupa serves to advance the idea that, to allow er than the parties] … any rights or remedies the original insured rights against a reinsurer, a under … this reinsurance. clear intent must be manifest in the specific language of the contract itself. This language, said the court, further supported the view that the reinsurance contract did not In Trans-Resources, the reinsurer attempted to provide for a cut-through. use fairly standard language to avoid an alleged cut-through clause. The reinsurance contract The specificity the Second Circuit sought, which had a provision stating that the reinsurer “shall required the reinsurance contract to name the have no obligation to the original insured or direct insured to be paid via a cut-through anyone claiming under the policy(ies) rein- clause, is an example of the type of detailed sured.” The court, however, refused to overlook construction required for any cut-through clause language in the contract’s cover note obliging to be effective. While there are differences be- the reinsurer “to pay directly to the named in- tween the clauses in Jurupa and Trans Re- sured … with respect to any claim under said sources, this should not take away from the im- policy” and stating that this clause “stipulates portance of careful construction of cut-through direct liability and creates a direct procedural clauses to assure their effectiveness. The court’s privity as between the original insured and the message in Jurupa is clear: particular phrasing reinsurer.” of any clause creating additional rights for third parties in reinsurance contracts is crucial for the When you compare Trans-Resources to Juru- validity of the clause, especially if the wording is pa, it becomes clear that the major difference to be construed to overcome additional lan- between the wordings of the purported cut- guage in the agreement stating that: through clauses in both cases is the specificity in which the party receiving the reinsurance [n]othing [herein], express or implied, … shall payments was named. The court in Trans- be construed to confer upon … any person Resources found that a cut-through clause exist- … (other than the parties hereto or their per- ed because the policyholder (the named insured) mitted assigns or successors) any rights or was clearly named as the recipient of direct pay- remedies under … this reinsurance. ments from the reinsurer if the ceding insurer could not pay. Although this clause represented Thus, the issue of specifically naming the in- a fairly standard “insolvency clause” that is sured to be paid in the event of insolvency, and found in many reinsurance contracts, the deci- not the disclaimer language, was the primary is- sion in Trans Resources indicates the impor- sue resulting in the court’s finding that no cut- tance of specific construction of cut-through through clause existed in Jurupa. clauses by expressly naming the policyholder that will be paid upon the ceding insurer’s de- Yet, courts have not backed away from the gen- fault. eral rule that reinsurance contracts can still effectively contract around the traditional tenet The specificity of naming the party to whom di- that there is no right of the original insured rect payments will be made is often based on

21 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

statutory requirements. For example, in Penn- receiver, … except (a) where this Agreement sylvania, the statute provides that: specifically provides another payee of such reinsurance in the event of … insolvency or The amount recoverable by the liquidator (b) where the Reinsurers, with the consent of from reinsurers shall not be reduced as a re- the direct insured or insureds, have assumed sult of delinquency proceedings, regardless of such policy obligations of [the cedent] as di- any provision in the reinsurance contract or rect obligations of themselves to the payees any other agreement. Payment made directly under such policies in substitution for [the ce- to and insured or other creditor shall not di- dent’s] obligation to such payees. Then, and minish the reinsurer’s obligation to the insur- in that event only, [the cedent] … is entirely er’s estate except where the reinsurance con- released from its obligation and the Reinsur- tract provided for direct coverage of an ers will pay any loss directly to the payees un- individual named insured and the payment der such policies. was made in discharge of that obligation. The court found that the reinsurer functioned as 40 P.S. § 221.34. the direct insurer (it was a fronting situation) and that provision (b) was included in the reinsur- This statute formed the basis for the guidelines ance contract to provide the insureds direct ac- established by the court supervising the Reliance cess to the reinsurers in the event of the ceding Insurance Company liquidation in Pennsylvania. insurer’s insolvency. The rationale behind the See Koken v. Reliance Ins. Co., No. 269 M.D. cut-through provision in the insolvency clause, 2001 (Apr. 26, 2002). These guidelines set forth as expressed by the court, was to give the in- the circumstances under which direct payments sureds comfort that if something happened to by reinsurers to insureds would be allowed—es- the insurer, the insureds would be able to obtain sentially the rules for determining the validity of coverage directly from the reinsurers. cut-through clauses for reinsurers of Reliance. In rejecting the rehabilitator’s attempt to give In Koken v. Legion Ins. Co., 831 A.2d 1196 very narrow meaning to the exception provision (Pa. Commw. 2003), the court noted the Reli- in § 221.34, the court in Koken v. Legion stat- ance guidelines were instructive in considering ed that it is difficult to make any generalizations cut-through clauses in the Legion Insurance about cut-through endorsements and how they Company insolvency, but were not binding. In ought to appear. Expert testimony cited by the Koken v. Legion, the court addressed several court acknowledged that cut-through clauses claims by several insureds claiming direct access are distinctive and vary depending on the juris- to reinsurance proceeds. One insured claimed diction and the intent of the parties. that the reinsurance contract between the ceding insurer and the reinsurer had an express cut- Conclusion through right. The insolvency clause in the reinsurance contract provided as follows: It is clear from the ruling in Jurupa that the precise wording of a cut-through provision … The reinsurance will be payable by the Re- must clearly indicate its function in allowing a insurers directly to [the cedent], its liquidator, third party to the reinsurance contract the

22 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts right to direct access to the reinsurance, as well policies and billing the correct reinsurers for their as sufficiently naming the party to who pay- share of those losses. ment will be made. Yet, jurisdictional differences, statutory distinctions, and the intent of the When the Settlement Is Done parties may allow for enforcement of a cut- through clause that does not meet the Jurupa At some point during the evolution of a claim, it standards. If what the parties intend is that the comes to an end. Either the claim is settled, the underlying insured should have direct access to claim is dismissed, a judgment is rendered by a the reinsurance should the ceding insurer be- court, or an award is issued by an arbitrator. come insolvent, then the provision should be While expenses may have been preliminarily allo- drafted precisely and clearly to effect that in- cated to specific policies and even ceded to spe- tent. ❒ cific reinsurers during the life of the claim, once the claim is finalized by settlement or judgment Allocation in the Mind of the and the checks are cut, the insurer has to make a Ceding Insurer final determination on how the claim—and its actual expenses and indemnity payments—will be allocated to its insurance policies.

In a normal case where there is a single claim that occurred on a specific date, there typically is only one policy to which the claim can and should be allocated. Allocating a settlement to the only possible responsible policy is generally When a ceding insurer resolves a long-tail claim noncontroversial. That determination is general- or series of long-tail claims (e.g., asbestos) ly made up front (as part of the coverage deter- through a settlement, policy buy-back, commu- mination), and, depending on the terms of the tation, or some other mechanism (which could reinsurance contract covering that policy, notice include a judgment after trial), what should it, of the claim to the reinsurers should not be that must it, or can it consider when deciding how to difficult to accomplish. allocate the settlement to multiple policies over multiple years? But when the claim is a long-tail claim that spans many years and many possible policies, We have written and commented a fair amount the allocation decision may become more art on the follow-the-settlements doctrine and its ap- than science. This is the case with asbestos and plication to allocation of a loss to insurance and other similar latent bodily injury claims. De- reinsurance contracts. See our Reinsurance cades go by and the vagaries of state law may Commentaries, “Reinsurance and Emerging cause many policies to respond to the claims. Risks” (June 2013), “Follow-the-Fortunes Updat- Policies may or may not exist, insureds may ed” (April 2004), and “Understanding Reinsur- have gaps in coverage, and carriers may have ance Terminology—Follow-the-Fortunes” (Octo- gone insolvent over time. When claims go back ber 2001), for example. Here, we examine many decades, the ability to locate all responsi- allocating long-tail losses to the correct insurance ble policies is a difficult task.

23 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

But ultimately, when the claim is resolved, the What’s a Reinsurer To Do? settling insurance company has to decide how to allocate that settlement to the policies it be- The conundrum for the reinsurer, sometimes lieves must legitimately respond to the claim. being faced with a billing after decades of limit- And once the policy allocation decision is made, ed—if any—information about a claim, is how to then the insurer—now the ceding insurer—will determine if the reinsurance allocation was do- also have to determine how to allocate that set- ne in an objectively reasonable manner and in tlement to its reinsurance contracts and bill its good faith. Reinsurers know that some courts in reinsurers for their share of the settlement. the United States imply the follow-the-settlements doctrine even if the applicable reinsur- Objectively Reasonable ance contracts do not have follow-the-settle- Settlements and Objectively ments language. They know that under the Reasonable Allocations follow-the-settlements doctrine, reinsurers cannot second-guess the good faith claims determi- We know from the caselaw that the underlying nations of the ceding insurer. They also know settlement itself must be objectively reasonable that many courts in the United States have ap- and businesslike. Under most notions of proper plied the follow-the-settlements principle to allo- business behavior and good faith, only settle- cation. ments that are reasonable and businesslike and that fall within the terms of the insurance policy The cases provide words like “objective reason- are settlements that a reinsurer would expect to ableness” and “businesslike manner” when dis- receive. cussing these principles in the context of allocation. But each case is fact-specific, and The cases teach us that the claims personnel determining the objective reasonableness and must handle the claim without regard to reinsur- good faith of an allocation will depend on the ance and must act in good faith in resolving the facts. As the New York Court of Appeals said in claim. The cases also teach us that when the U.S. Fid. & Guar. Co. v. American Re-Ins. claim has to be allocated among multiple insur- Co., 2013 N.Y. LEXIS 112, 20 N.Y.3d 407 ance policies, that allocation also has to be ob- (2013), a ceding insurer’s allocation “must be jectively reasonable and made in good faith. So one that the parties to the settlement of the un- too must the reinsurance allocation be objec- derlying insurance claims might reasonably have tively reasonable and made in good faith. In arrived at in arm’s length negotiations if the re- fact, merely following the allocation of the un- insurance did not exist.” derlying polices is not, in and of itself, sufficient to establish the reasonableness of the reinsur- Most reinsurers want to pay legitimate claims ance allocation. quickly. But to pay quickly, reinsurers need to receive sufficient information to satisfy them When, in the ceding insurer’s mind, all are done that the claim came within the underlying con- in a businesslike manner, are objectively reason- tract, was resolved in good faith, and came able, and made in good faith, the ceding insurer within the terms of the reinsurance contract. will expect nothing less than timely payment of Sometimes it is hard to get that information a properly presented reinsurance billing. even on a single claim paid under a single poli-

24 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts cy, let alone for 10 or 20 years of policies that This comment is consistent with some other are over 30 or even 50 years old, addressing courts’ pronouncements when discussing objec- the insured’s liability for manufacture or use of tive reasonableness and good faith. In U.S. Fid. asbestos products. & Guar. Co., the court said that “[r]easonable- ness does not imply disregard of the cedent’s Recent caselaw provides reinsurers, with the own interests. Cedents are not the fiduciaries of right facts and circumstances, some opportunity reinsurers, and are not required to put the inter- to question whether an allocation was made ests of reinsurers ahead of their own.” The with objective reasonableness and in good faith. court concluded that the ceding insurer’s motive But that opportunity cannot be squandered “should generally be unimportant. When several with fishing expeditions; there has to be a legiti- reasonable allocations are possible, the law, as mate basis for inquiry. And, based on the case- several courts have recognized, permits a ce- law, that opportunity is limited. The mere fact dent to choose the one most favorable to itself.” that the allocation decision has resulted in a significant reinsurance recovery claimed by the As the courts appear to see it, the ceding insur- ceding insurer may not be enough for a court to er must address the claim settlement neutrally, question the allocation decision. as far as reinsurance is concerned; act in good faith; and proceed in a reasonable manner that To Maximize or Minimize would be viewed as objectively reasonable by a Reinsurance third party without consideration of reinsurance. In doing so, the ceding insurer does not In a recent case, a court did what many courts have to—and should not have to—pick an alloca- have done, which is to uphold an allocation of tion methodology that minimizes its reinsurance an asbestos settlement under the follow-the-set- recovery. tlements doctrine (Utica Mut. Ins. Co. v. Clear- water Ins. Co., 2016 U.S. Dist. LEXIS 6219 So what happens if the ceding insurer actually (N.D.N.Y. Jan. 20, 2016)). In upholding the picks an allocation method that also happens to ceding insurer’s allocation as a reasonable set- maximize its reinsurance recovery? All things tlement decision, the court commented that a being equal, if the theory holds, as long as the ceding insurer was not required to pick an allo- allocation was done in an objectively reasonable cation that minimized reinsurance recovery. manner and in good faith, many courts will sus- tain the allocation determination based on fol- Fair enough—objective reasonableness and low-the-settlements principles applied to alloca- good faith should not weigh in favor of either tion. Where there are multiple reasonable the ceding insurer or the reinsurer. Thus, in allocations possible, as the New York Court of making an allocation determination, the ceding Appeals said in U.S. Fid. & Guar. Co., the ced- insurer should not be forced to pick one out of a ing insurer could choose the one most favorable number of reasonable alternatives that minimiz- to itself. es its reinsurance recovery if, in making its settlement and allocation determinations, it must Whether the follow-the-settlements doctrine do so with a blind eye toward its reinsurance even applies to allocation is a completely differ- protections. ent question, which, in the United States, ap-

25 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

pears to have been answered by most courts in Interplay of Loss Portfolio the affirmative. But assuming that it does apply, Transfers and Other the test of objective reasonableness and good faith will depend on the specific facts involved Reinsurance Contracts in the settlement and allocation.

Where the evidence shows that the ceding insurer was focused on reinsurance recoveries above all else when settling a long-tail loss and also had the same focus when allocating that loss to its policies and its reinsurance protections, the reinsurer may have a legitimate beef that should be taken up by the courts. But get- ting that kind proof is no small task. In the more usual case where claims professionals go Let’s say you work for an insurance company about their business as they should, an alloca- that issued a portfolio of policies some years tion that results in the maximization of reinsur- ago but no longer writes that type of policy or ance recoveries may not be so easy to strike business. And say that this legacy business is a down. drain on the insurance company’s administration and the company would much rather have Conclusion its administrative and claims people working on business that the company currently writes and Long-tail claims, such as bodily injuries from supports. exposure to asbestos, have run havoc on many in the insurance industry. Policy-issuing What can you do to address this problem? companies that issued polices half a century ago have been called on to pay losses for What Is a Loss Portfolio these exposures. The tasks of addressing Transfer? these exposures and allocating settlements to the proper policies, and then allocating to and For decades, insurance and reinsurance compa- billing the correct reinsurers for their share of nies have used loss portfolio transfers (LPTs) to those exposures, are complicated and com- address the issue of legacy business no longer plex tasks. core to the company. The IRMI Insurance Glossary of Risk Management and Insurance But if a ceding insurer faced with settling these Terms defines an LPT as: types of exposures allocates its good faith settlements in a businesslike and objectively rea- A financial reinsurance transaction in which sonable manner, the fact that the ceding insur- loss obligations that are already incurred and er’s allocation results in the maximization of will ultimately be paid are ceded to a reinsur- its reinsurance recoveries may provide little er. In determining the premium paid to the re- support to a reinsurer’s challenge to that allo- insurer, the time value of money is consid- cation. ❒ ered, and the premium is therefore less than

26 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

the ultimate amount expected to be paid. The times from a press release or at a market cedent’s statutory surplus increases by the dif- conference), they may not be thrilled. ference between the premium and the amount that had been reserved. An insurer The existing reinsurers have no contractual rela- seeking to withdraw from writing workers tionship with the LPT reinsurer. Yet, it’s the compensation coverage in a given state LPT reinsurer that will now be administering could, for example, use a loss portfolio trans- the claims ceded to the existing reinsurers. Re- fer to meet its obligations under policies it has serving may change, claims handling may written, without the need to continue the change, administrative and accounting relation- day-to-day management of the claims resolu- ships will change, and motivations will change. tion function. Not quite the original bargain entered into by the existing reinsurers. An LPT is a great way to move a legacy book of business off the balance sheet. LPTs often are Many LPTs, if not all, are structured to be net of used for direct written business as well as for as- third-party reinsurance. This means that the lia- sumed reinsurance business. As described in bilities transferred to the LPT reinsurer are only the definition above, an LPT allows an insurer those that should remain after existing reinsur- or reinsurer to meet its policy obligations on its ance has paid its share of the liabilities on the original policies without being responsible for original business ceded. This also means that the management of the ongoing claims. The the existing reinsurers have to fulfill their con- LPT reinsurer generally manages the claims and tractual obligations to the original ceding insurer is responsible for the administration of the busi- even if the loss advices and requests for pay- ness. While the ceding insurer is still on the reg- ments are now coming from a new party with ulatory and contractual hook for those original whom the existing reinsurers have no contractu- policies, it is really the LPT reinsurer that is eco- al relationship. nomically and administratively the real party of interest. Of course, if the ceding insurer is not highly rated or is mostly in runoff, the existing reinsurers The Odd Reinsurer Out may welcome an LPT, especially if the LPT reinsurer is strong and well managed. Timely set- What is often forgotten when considering an tlements and administration cost less money LPT transaction, however, is the interplay be- than a poorly managed runoff for all parties. tween the proposed LPT and the existing rein- The existing reinsurers may be more comfort- surance contracts reinsuring the original poli- able dealing with a new administrator than the cies. This is especially so when the LPT is of an original ceding insurer if there were significant assumed reinsurance book of business rather problems in claims administration and handling. than direct insurance. The Effect of an LPT on Existing Existing reinsurers and retrocessionaires are not Reinsurance Contracts always in the loop while an LPT is being negoti- ated between the ceding insurer and the LPT re- The LPT may have an effect on various contract insurer. When they learn about an LPT (some- provisions in existing reinsurance contracts.

27 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts

Consideration should be given to whether the question is whether that is, in fact, true. Of existing reinsurance contracts have antiassign- course, review of each relevant reinsurance ment provisions, retention warranties, or other contract is necessary to determine whether an provisions precluding cessions of retained busi- LPT changes or affects anything about existing ness. reinsurance or retrocessional relationships.

For example, if the original reinsurance includes In a recent case, a New York federal court con- a broad quota share treaty with a requirement firmed a final arbitration award between a ret- that the ceding insurer maintains its percentage rocedent and its retrocessionaire. In Continen- share, an LPT of the entire reinsured portfolio tal Ins. Co. v. AXA Versicherung AG, No. 18- might result in a breach of the original reinsur- CV-7349 (VEC), 2019 U.S. Dist. LEXIS 583 ance contract. Similarly, if there are excess-of- (S.D.N.Y. Jan. 2, 2019), a retrocessionaire ar- loss contracts that contain retention warranties gued that it was no longer bound by its quota or have provisions that preclude assignment of share retrocessional agreement with the retroce- the ceding insurer’s retention, an LPT of the en- dent after the retrocedent entered into an LPT tire retained portion of the book may invalidate with a third party on the same business. The the excess-of-loss contract. arbitration panel’s final award determined that the LPT did not relieve the retrocessionaire of Clearly, the LPT reinsurer has no interest in los- its responsibility to make retrocessional paying the value of the existing reinsurance. The ments to the retrocedent. The court confirmed LPT reinsurer wants the LPT to cover only the final arbitration award. those liabilities net of existing reinsurance. The failure to carefully evaluate existing reinsurance The details of the underlying dispute were not and then obtain buy-in from existing reinsurers available in the decision, and the arbitration in- can result in the LPT turning into something it formation is confidential, so we don’t know was not meant to be and result in what should whether there was a retention warranty, antias- be preventable disputes. signment clause, or special termination provision in the quota share retrocessional agree- Some reinsurance contracts also have special ment. All of these cases are very fact-specific, termination provisions. These provisions are and as they say, the devil is in the details. customized to each reinsurance transaction. There are special termination provisions that In addition, while this decision did not involve trigger if the original ceding insurer transfers its the merits of the dispute (the petition to confirm liabilities to another reinsurer. An LPT may trig- was unopposed), it is pretty clear why the arbi- ger that kind of special termination provision. tration panel ruled the way it did.

Can an Original Reinsurer Walk The retrocedent remains responsible under its Away after an LPT? existing reinsurance and retrocessional agreements unless the LPT contains a novation Some reinsurers and retrocessionaires may view agreement or a separate novation agreement their ceding insurer’s LPT of an entire book of accompanies the LPT, which replaces the ret- business as a “get out of jail free card.” The rocedent with the LPT reinsurer as a matter of

28 Why Reinsurance Matters, and Other Must-Know Reinsurance Concepts contract. While the retrocedent’s administrative might trigger upon the retrocedent entering into and accounting obligations were shifted to a an LPT. Each circumstance is different and must new reinsurer under the LPT, the retrocedent be reviewed completely to determine if an LPT remained on the hook under the existing retro- has any effect on the liabilities under existing re- cessional contract in case the LPT reinsurer fails insurance or retrocessional contracts. to perform in the future. Conclusion While these principles are more relevant to assumed business than ceded business, the same Determining how existing reinsurance contracts principles apply. An LPT generally does not al- will interact with an LPT is a critical step to ter an existing reinsurance or retrocessional avoiding significant problems and future dis- contract unless the original reinsurer or retro- putes. While it is easy to think that an LPT can- cessionaire has agreed to the transfer of all obli- not affect existing reinsurance contracts be- gations itself in the form of a novation. cause it is a separate and unrelated contract, retention warranties, antiassignment provisions, There are many scenarios where the outcome and special termination clauses in existing rein- may differ because of specific contract wording. surance contracts could be triggered by an LPT. For example, the existing reinsurance or retro- Keeping all parties, including existing reinsur- cessional contract could have had a retention ers, in the loop while negotiating an LPT warranty or special termination provision that should avoid unwanted surprises. ❒