Chapter 40 UNDERSTANDING REINSURANCE

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1 Chapter 40 UNDERSTANDING REINSURANCE I. OVERVIEW * by David M. Raim and Joy L. Langford Scope Key Practice Insights Master Checklist II. APPRECIATING PURPOSE OF REINSURANCE Types of Reinsurance 40.04[1] Facultative vs. Treaty 40.04[2] Proportional vs. Non-proportional 40.04[3] Catastrophe Reinsurance 40.04[4] Finite Reinsurance 40.04[5] Fronting Arrangements Lack of Privity of Contracts 40.05[1] Know General Rule 40.05[2] Consider Cut-Throughs III. CONSIDERING REINSURANCE REGULATION Credit for Reinsurance Letters of Credit Insolvency Clause IV. CONSIDERING INSURER S OBLIGATIONS TO REINSURERS IN CASE OF CLAIM Consider Insurer s Notice Obligations 40.09[1] Know What Notice Clause Requires

2 New Appleman Insurance Practice Guide 40.09[2] Reinsurer s Assertion of Late Notice As Defense to Payment of Its Reinsurance Obligations 40.09[2][a] 40.09[2][b] Jurisdictions Requiring Proof of Prejudice Jurisdictions Recognizing Late Notice As Defense Regardless of Ability to Prove Prejudice Consider Reinsurer s Right to Access Insurer s Records 40.10[1] Consider What Access to Records Clause Requires to Be Made Available to Reinsurer 40.10[2] Consider Whether Insurer s Disclosure of Privileged Documents to Its Reinsurer Constitutes Waiver As to Third Parties, Including Its Insureds 40.10[2][a] Common Interest Doctrine 40.10[2][b] Disclosure Made Prior To Insurance Coverage Litigation 40.10[2][c] Disclosure Made During Course of Insurance Coverage Litigation 40.10[2][d] Disclosure Made After Resolution of Insurance Coverage Litigation But Prior to Institution of Arbitration or Litigation Between Cedent And Reinsurer 40.10[2][e] Disclosure Made During Course of Reinsurance Litigation 40.10[2][f] Use of Confidentiality and Common Interest Agreements 40.10[3] Consider Reinsurer s Ability to Compel Production of Cedent s Privileged Documents 40.10[3][a] Consider Whether Inclusion of Access to Records Clause Constitutes Waiver 40.10[3][b] Know When Privileged Documents Are In Issue Therefore Requiring Production by Cedent 40.10[3][c] Consider Application of Common Interest Doctrine to Compel Production of Cedent s Privileged Documents 40.10[3][c][i] Prior to Dispute Between Cedent and Reinsurer 40.10[3][c][ii] During Reinsurance Dispute Between Cedent and Reinsurer 40.10[4] Understand When Insured Is Entitled to Discover Its Insurer s Reinsurance Information Consider Reinsurer s Rights Under Right to Associate Clause or Claims Control Clause 40-2

3 Understanding Reinsurance V. CONSIDERING REINSURER S OBLIGATIONS Determine Extent of Coverage Consider Obligation to Reimburse Insurer for Declaratory Judgment Expense Consider Obligation to Reimburse Insurer for Extra- Contractual Obligations and Excess of Policy Limits ( ECO/ XPL ) Damages VI. CONSIDERING DUTY OF UTMOST GOOD FAITH OR UBERRIMAE FIDEI Consider Insurer s Duty to Disclose to Reinsurer All Material Facts About Risk Being Reinsured Consider Application of Duty of Utmost Good Faith Beyond Disclosure at Inception of Reinsurance Relationship 40.16[1] Application of Duty of Utmost Good Faith to Parties Conduct During Life of Reinsurance Contract 40.16[2] Application of Duty of Utmost Good Faith to Underwriting and Administration of Ongoing Business 40.16[3] Application of Duty of Utmost Good Faith to Obligation to Give Notice of Claim 40.16[4] Application of Duty of Utmost Good Faith to Reinsurer to Pay Under Reinsurance Agreement VII. CONSIDERING FOLLOW THE FORTUNES/FOLLOW THE SETTLEMENTS Understand Distinction Between Follow the Fortunes and Follow the Settlements Consider Reinsurer s Preclusion from Second-Guessing Reinsured s Good Faith Claims Decisions Consider Application of Follow the Fortunes/Follow the Settlements to Allocation Decisions VIII. CONSIDERING BROKERED MARKET Brokered vs. Direct Market Understand Which Entity Broker Represents 40-3

4 New Appleman Insurance Practice Guide IX. CONSIDERING REINSURANCE ARBITRATION Consider Obligation to Arbitrate Neutral Panel or Party Advocate System Strict Rule of Law vs. Obligations Pursuant to Honorable Engagement Discovery in Arbitration Summary Disposition in Arbitration Reasoned Awards Know When to Move to Vacate or Affirm Arbitration Award ARIAS Forms X. FORMS BRMA Reinsuring Clause Form 44 C (Quota Share Agreement) BRMA Reinsuring Clause Form 44 B (Surplus Share Agreement) BRMA Reinsuring Clause Form 61 C (Excess of Loss Agreement) BRMA Unauthorized Reinsurance Clause Form 55 A BRMA Insolvency Clause Form 19 M BRMA Offset Clause Form 36 A BRMA Loss Notice Clause Form 26 B Notice of Loss Clause Incorporating Right to Associate BRMA Loss Notice Clause Form 26 A BRMA Access to Records Clause Form 1 B BRMA Confidentiality Clause Form 69 D BRMA Claims Cooperation Clause Form 8 A BRMA Excess of Original Policy Limits Clause Form 15 A BRMA Extra Contractual Obligations Clause Form 16 D BRMA Intermediary Clause Form 23 A BRMA Arbitration Clause Form 6 A BRMA Arbitration Clause Form 6 E ARIAS-U.S. Umpire Questionnaire Sample Form

5 I. OVERVIEW Scope. In essence, reinsurance is insurance for insurance companies. It is a contractual arrangement under which an insurer secures coverage from a reinsurer for a potential loss to which it is exposed under insurance policies issued to original insureds. The risk indemnified against is the risk that the insurer will have to pay on the underlying insured risk. Because reinsurance is a contract of indemnity, absent specific cash-call provisions, the reinsurer is not required to pay under the contract until after the original insurer has paid a loss to its original insured. Reinsurance enhances the fundamental financial risk-spreading function of insurance and serves at least four basic functions for the direct insurance company: increasing the capacity to write insurance (under prevailing insurance-regulatory law); stabilizing financial results in the same manner that insurance protects any other purchaser against spikes from realized financial losses; protecting against catastrophic losses; and financing growth. The reinsurance relationship is structured in the following manner: original insured > insurer > reinsurer. The insurer is called, for reinsurance purposes, the cedent (or cedant). There is typically no contractual relationship between the reinsurer and the original insured. Reinsurance may, but need not, dovetail with the scope of the original insurance. Basically, all of the risks that are insured can be reinsured, unless contrary to public policy under the relevant governing law for the reinsurance contract. This chapter principally discusses how insurance claims and coverage litigation can evolve into reinsurance claims and in that context presents the most common legal issues that arise from reinsurance relationships. The coverage afforded insurers through the most commonly purchased types of reinsurance is explained to provide a context for most reinsurance claims. Certain aspects of reinsurance regulation are set forth to illustrate the role of reinsurance in the entire insurance scheme and the payment of policyholder claims. Also described are the special rights and obligations of cedents and reinsurers as between them and important aspects of reinsurance arbitration (the common form of dispute resolution), both of which strongly influence reinsurance recoveries. This chapter provides a background in reinsurance and explains how an insured s relationship with its insurer fits within the context of the entire reinsurance scheme. Reinsurance, like many areas of business law, has a language of its own. The insurance company purchasing reinsurance is called the ceding company (or the cedent (or cedant ), reinsured or ceding insurer ) because it cedes or transfers part of the risk. The company selling 40-5

6 40.01 New Appleman Insurance Practice Guide reinsurance is called the reinsurer. Typically, these are the only parties to the reinsurance agreement; all rights and obligations run only between them. The reinsurance contract does not change the direct, or original, insurer s responsibility to its policyholder (the original insured or policyholder ), and the insurer must fulfill the terms of its policy whether or not it has reinsurance or whether or not the reinsurer is rightly or wrongly refusing to perform. The liability or risk ceded is called a cession, and the original policy that the cedent issues to a policyholder is referred to as direct insurance. A reinsurer also can purchase its own reinsurance protection, and such reinsurance of reinsurance is called a retrocession. A reinsurer that transfers all or part of its assumed reinsurance is called a retrocedent, and the company reinsuring this risk is called the retrocessionaire. Retrocessions need not incorporate the original reinsurance and often do not. (Retrocessionaires in turn can purchase reinsurance again, ad infinitum.) Reinsurance relationships can be simple or complex. A cedent can cede certain loss exposures under one contract or purchase several contracts covering different aspects or portions of the same policy to achieve the desired degree of coverage. A layering process involving two or more reinsurance agreements is commonly employed to obtain sufficient monetary limits of reinsurance protection. When a claim is presented, the reinsurers respond in a predetermined order to cover the loss. The reinsurance relationship is evidenced by a written contract reflecting the negotiated terms. Although reinsurance contracts between different cedents and reinsurers can include clauses with similar purposes, the wording of particular provisions varies significantly, depending on the parties specific needs, customs and practices. Sample clauses are provided where instructive. Payments that are due pursuant to a reinsurance agreement are considered an asset of the cedent; in contrast to other types of contingent payments, the applicable regulatory regime may permit the cedent to count a reinsurance recoverable as a present asset on its own balance sheet. Reinsurance is payable only after the cedent has paid losses due under its own insurance agreements. However, most U.S. reinsurance contracts include an insolvency clause, which allows the receiver of an insolvent insurer to collect on reinsurance contracts as if the insolvent insurer had paid the claim in full even if it did not [see below discussing the insolvency clause]. Reinsurance should not be confused with other commercial arrangements. It is not co-insurance, where separate insurers assume shares of the same insurance risk. Nor is it a novation as between the original insured and its 40-6

7 Understanding Reinsurance insurer or substitution of one insurer for another. A reinsurance agreement does not establish a partnership between the insurer and the reinsurer or a separate joint venture as between them, although some pro rata contracts provide that the parties share proportionally in the premiums collected by the cedent and in losses paid by it. Reinsurance ordinarily does not confer third-party beneficiary status on the original insured. Absent a cutthrough clause or similar modification [see below for discussion of these exceptions], there is no privity of contract between the insurance policyholder and the reinsurer. In the absence of language in the reinsurance agreement granting the original insured rights against the reinsurer or unusual factual circumstances, attempts by original insureds to sue reinsurers directly generally fail; claimants against the original insureds similarly are unsuccessful in bringing suit directly against reinsurers, even where, in direct-action states or in other circumstances, the claimant might be able to sustain an action against the original insurer (cedent). Underlying claims and coverage litigation can trigger reporting and notice obligations of cedents to reinsurers. Reinsurers that potentially owe indemnity may commence investigations, monitor claims, and establish claim reserves. Counsel for original insureds in coverage litigation sometimes seek production of communications generated between the cedent and reinsurer on the grounds that insurance covering a defendant is generally discoverable (even though in the circumstance the insurance is reinsurance), or for more narrowly tailored purposes such as to collect evidence that the original insurance policy existed at one time even if it is no longer is available. In some instances, the disclosure of cedent/ reinsurer communications can potentially be detrimental to the cedent s coverage position vis-a-vis its insured. Typical reinsurance claim issues that are discussed here include: reporting and notice obligations; defenses stemming from interpretation of the reinsurance wording to the indemnity sought; cooperation and claimhandling obligations; and defenses seeking rescission of the reinsurance contract including nondisclosure and misrepresentation with respect to the details of risk. The nature of the reinsurance relationship especially the notion of utmost good faith or uberimae fidei may provide a gloss on how certain issues get resolved in the reinsurance context that may differ from how similar issues are resolved in the ordinary insured-insurer context. Other common issues addressed here include the reinsurer s obligations to indemnify the insurer for declaratory judgment expenses incurred in defending or prosecuting coverage litigation against the original insured, and payments by insurers in excess of policy limits or payments of extracontractual damages. 40-7

8 40.02 New Appleman Insurance Practice Guide Reinsurance claims generate certain legal issues distinct from issues that typically arise in the context of direct insurance. Rules found in insurance law in different arenas may not apply or may apply with different nuances in the context of reinsurance disputes, and the duties and obligations between a cedent and reinsurer may differ from those between an original insurer and policyholder, considering some of the differences in the relative sophistication and bargaining power, custom and practice, or different aspects in which one party is largely dependent upon another. Several important distinctions between the resolution of insurance and reinsurance disputes are examined in this chapter, including the effect of the bilateral duty of utmost good faith, which is perhaps unique to reinsurance agreements. Reinsurance disputes also are distinguished by their typical resolution through arbitration, rather than courtroom litigation. Among other differences, in typical U.S. arbitrations, the availability and weight of legal precedent is less predictable and meaningful than in litigation in the courts. Arbitrators may not be bound by strict legal rules and do not always strictly apply contract law and other legal principles to reinsurance agreements; indeed, some reinsurance contracts eschew reliance upon legal rules in favor of construing the reinsurance relationship memorialized by the reinsurance contract as principally an honorable engagement pursuant to industry custom and practice. Lexis.com Searches: To find statistics on reinsurance premiums, try this source: RDS TableBase. Enter this search: PUB(Reinsurance). To find articles on specific cases involving reinsurance, try this source: Reinsurance: Mealey s Litigation Report. Enter specific search terms or date ranges Key Practice Insights. The parties to reinsurance contracts are typically sophisticated insurers transferring the financial risk assumed in insuring businesses, homes, cars and individuals. Note that sometimes reinsurers create the instrument that is to be sold to an insured and then look for a middleman (cedent) to (i) issue the policy to the insured and (ii) purchase the corresponding reinsurance. Indeed, in such transactions, sometimes the cedent will 100 percent reinsure the risk undertaken to the policyholder, in exchange for a ceding commission deducted from the premium collected from the direct insured, which is ultimately passed on to the reinsurer. There are no standard reinsurance contracts, although many include commonly used provisions and clauses sometimes required by state law. Each reinsurance treaty or facultative certificate reflects the special needs of the parties with respect to the type and amount of risk covered, the 40-8

9 Understanding Reinsurance calculation of the premium, the role of the reinsurance intermediary, the method and timing of notice and submission of claims, various reporting obligations, and resolution mechanisms for potential disputes. Reinsurance contracts therefore are often complex and unique and must be carefully drafted and, in the event of dispute, carefully interpreted. Lawyers practicing in the reinsurance field must become familiar with the specialized business of reinsurance, including the purposes and types of reinsurance and the financial goals and consequences typically involved. Practitioners also must be knowledgeable about the meaning, use and legal effect of commonly employed reinsurance contract provisions, including insolvency, access to records, claims control, notice, extracontractual obligations ( ECO ), excess of policy limits ( XPL ), follow the fortunes/settlements, intermediary and arbitration provisions. Attorneys also should carefully review complete versions of reinsurance wordings, including endorsements and amendments. (Indeed, sorting out which is the governing wording particularly when insurers operating in different markets or in different countries are involved can prove tedious and time consuming.) Although regulation of the reinsurance industry in the United States is more limited than that of the insurance industry in general, lawyers should be mindful of the insurer s statutory licensing, solvency and accounting requirements. Attorneys should understand how insurers must account for finite risk reinsurance, as this subject recently has attracted significant regulatory attention. Also of particular concern are fronting arrangements and cut-through endorsements, which may not be allowed or may be subject to special regulations in certain jurisdictions. Reinsurance disputes are typically resolved through arbitration, and practitioners should be familiar with arbitration law, particularly the Federal Arbitration Act ( FAA ) and statutory law applicable to nonadmitted reinsurers and the availability of pre-answer or pre-judgment security. Of course, counsel handling a dispute should be familiar with how reinsurance arbitrations are generally handled. A thorough knowledge of the reinsurance industry is needed as many issues are decided based upon the custom and practice in the industry (especially where the arbitration panel is comprised of non-lawyers, as is often the case). Lawyers also should know that leading industry and professional organizations offer practice guides, forms, and other resources useful for reinsurance arbitrations (such as lists of professional trained reinsurance arbitrators). 40-9

10 40.03 New Appleman Insurance Practice Guide Master Checklist. Understand whether the reinsurance contract at issue is a facultative certificate or a treaty. Discussion: 40.04[1] Understand whether the reinsurance at issue is proportional or non-proportional. Discussion: 40.04[2] Forms: Become familiar with specific types of reinsurance such as catastrophe reinsurance, clash cover and finite reinsurance. Discussion: 40.04[3]-40.04[4] Understand how insurers must account for finite risk reinsurance under applicable regulations. Discussion: 40.04[4] Determine all of the parties responsibilities and liabilities in a fronting arrangement, including any obligation to monitor a managing general agency. Discussion: 40.04[5] Confirm that fronting is permissible in the jurisdiction where the arrangement is executed. Discussion: 40.04[5] Determine if special circumstances exist which may provide grounds for a policyholder of the ceding insurer to assert a direct action against the reinsurer. Discussion: 40.05[1] Research the legality and enforceability of cut-through clauses (or assumption of liability endorsements) contained in insurance contracts covered by reinsurance. Discussion: 40.05[2] Understand the credit for reinsurance laws governing your reinsurance transaction

11 Understanding Reinsurance Discussion: Confirm that a letter of credit obtained by a ceding company that intends to take financial statement credit for reinsurance placed with a non-admitted reinsurer complies with statutory requirements. Discussion: Ensure that an adequate insolvency clause is included in the reinsurance contract if required in your jurisdiction. Most states require that the reinsurance contract include an insolvency clause for the ceding insurer to take credit for reinsurance on its financial statement. Discussion: Form: Understand the effect of an offset clause, or any applicable common law or statutory set-off rights, on the rights and obligations under the reinsurance agreement. Discussion: Form: Understand the requirements of the reinsurance contract s notice provision. Discussion: 40.09[1] Forms: Determine whether, in your jurisdiction, the reinsurer must demonstrate prejudice in order to successfully assert a late notice defense. Discussion: 40.09[2] Understand the effect of an access to records clause in the reinsurance agreement. Discussion: 40.10[1] Form: If your client is the ceding insurer, beware the consequences of 40-11

12 40.03 New Appleman Insurance Practice Guide disclosing privileged information to reinsurers pursuant to an access to records clause. Discussion: 40.10[2] Research the applicability in your jurisdiction of the common interest doctrine to a cedent s disclosure of privileged communications to its reinsurer. Discussion 40.10[2] Determine whether the parties to a reinsurance contract should execute a confidentiality or common interest agreement to try to preserve applicable privileges or immunities against disclosure to third parties. Discussion: 40.10[2][f] Understand the circumstances under which a reinsurer can compel disclosure of its cedent s privileged communications. Discussion: 40.10[3] Understand the circumstances under which an insured will be entitled to discover its insurer s reinsurance information. Discussion: 40.10[4] Become familiar with the rights and obligations presented by right to associate and claims control clauses in reinsurance contracts. Discussion: Forms: Draft the reinsuring or business covered clause of the reinsurance agreement carefully to avoid disputes concerning the scope of coverage. Discussion: Understand whether the reinsurance contract wording (in many cases the definition of allocated loss expenses ) obligates the reinsurer to reimburse its cedent for declaratory judgment expenses. Discussion: Understand the coverage provided by excess of policy limits 40-12

13 ( XPL ) and/or extra-contractual obligations ( ECO ) clauses in the reinsurance contract. Discussion: Understanding Reinsurance Forms: Understand the duty of utmost good faith that is central to the relationship between cedent and reinsurer. Discussion: If your client is the cedent, determine the facts that must be disclosed during the underwriting process. Discussion: If your client is the cedent, ensure that all proper and businesslike steps are taken in underwriting the underlying business and in settling claims. Discussion: 40.16[2] Understand the effect of follow the fortunes or follow the settlements wording in the reinsurance contract. Discussion: Cross References: Determine the extent to which follow the fortunes or follow the settlements language in the reinsurance contract requires a reinsurer to follow its cedent s allocation and aggregation decisions as respects it direct insurance obligations. Discussion: Understand the obligations of the reinsurance intermediary. Discussion: Determine whether, and for what purposes, the reinsurance broker or intermediary is the agent of the ceding company, the reinsurer, or both parties. Discussion: Form:

14 40.03 New Appleman Insurance Practice Guide Understand what disputes are arbitrable under the reinsurance contract s arbitration clause. Discussion: Forms: In drafting reinsurance agreements, counsel should determine whether the scope of the arbitration clause in the reinsurance contract is intended to be broad or narrow. Discussion: Forms: Arbitration counsel should consider whether non-signatories to the arbitration agreement may be forced to arbitrate. Discussion: Consider whether or not to include consolidation and joinder provisions in an arbitration agreement, or whether to request consolidation once arbitration has commenced. Discussion: Form: Consider what procedures should be included in the arbitration provision concerning the selection of arbitrators and/or umpires, what qualifications the arbiters should have, and whether the arbiters should be neutral or non-neutral. Discussion: Make certain that your client appoints its arbiter on a timely basis. Discussion: Become familiar with the standards and procedures for selecting arbitrators and the lists of qualified individuals published by arbitration and reinsurance organizations. Discussion: Form: Understand the effect of any honorable engagement wording in the 40-14

15 reinsurance agreement. Discussion: Understanding Reinsurance Form: Counsel drafting a reinsurance contract should determine whether specific discovery procedures should be included in the reinsurance contract s arbitration provision and, if so, whether they should incorporate any procedures published by reinsurance or arbitration organizations. Discussion: Counsel should determine how and whether a reinsurance intermediary can be required to participate in the discovery process in the event of a reinsurance arbitration. Discussion: Arbitration counsel should consider whether to submit a motion for summary disposition of a reinsurance claim or dispute. Discussion: Arbitration counsel should consider whether to move to confirm a favorable arbitration award in court. Discussion: Arbitration counsel should consider whether grounds exist to move to vacate an arbitration award in court. Discussion: Arbitration counsel should consider whether there are grounds to request a court to modify or correct an arbitral award. Discussion: Become familiar with the forms provided by ARIAS. Discussion: Form:

16 II. APPRECIATING PURPOSE OF REINSURANCE Types of Reinsurance [1] Facultative vs. Treaty. There are two basic types of reinsurance: treaty and facultative. Facultative reinsurance is a contract only covering all or part of a single specific policy of insurance. For each transaction sought to be reinsured, the reinsurer reserves the faculty to accept or decline all or part of any insurance policy presented, and the cedent chooses whether to secure reinsurance for a particular policy. The reinsurer and cedent negotiate the terms for each facultative certificate. Facultative reinsurance is commonly purchased for large, unusual or catastrophic risks. Reinsurers thus must have the necessary resources to underwrite individual risks carefully. ( Treaty reinsurance, discussed further below, involves a preexisting commitment by the reinsurer to cover a predetermined class and amount of coverage that will be sold by the insurer-cedent.) Other uses of facultative reinsurance include: 1. When an insurer is offered a risk that exceeds its standard underwriting or reinsurance limits for that class, facultative reinsurance can permit the ceding company to accept the risk. 2. Insurers can fill gaps in coverage caused by reinsurance treaty exclusions by seeking separate facultative coverage for a specific policy or group of policies. 3. A reinsurer can issue facultative reinsurance to participate in a market in the short term to minimize risk and take advantage of favorable rates. 4. A treaty reinsurer may purchase facultative reinsurance to protect itself and its treaty reinsurers. Insurers sometimes purchase both facultative and treaty reinsurance to cover the same risk. Unless there are contract terms to the contrary, the facultative reinsurance will perform first and completely before any of the treaty reinsurance performs. Sometimes the facultative reinsurance only applies to the ceding company s net retention; other times facultative coverage also inures to the benefit of the treaty reinsurers. Ideally, the wording of the facultative certificate will make this clear. As a general matter, whether the facultative reinsurance inures to the benefit of the treaty reinsurers will depend on whether the treaty reinsurers paid a portion of the premium for the facultative 40-16

17 Understanding Reinsurance 40.04[1] coverage. If not, the facultative reinsurance likely will not inure to the treaty reinsurers benefit. Facultative certificates are often one or two page documents. The front of a typical contract identifies the parties, the underlying policyholder and policy number reinsured, amounts of the policy ceded and retained, the type of reinsurance (proportional or nonproportional) and the premium. The back of each certificate usually contains the following provisions: notice of loss; net retention; coverage for loss adjustment expenses; claims handling; cancellation; insolvency; tax; offset and intermediaries. Many facultative certificates do not include an arbitration provision [see below for a discussion of arbitration clauses in reinsurance agreements]. Treaty reinsurance, the most common form of reinsurance, covers some portion of a defined class of an insurance company s business (e.g., an insurer s products liability or property book of business). Reinsurance treaties cover all of the risks written by the ceding insurer that fall within their terms unless exposures are specifically excluded. Thus, in most cases, neither the cedent nor the reinsurer has the faculty to exclude from a treaty a risk that fits within the treaty terms. Therefore, treaty reinsurers rely heavily on the cedent s underwriting. Treaty relationships are often long-term; treaties sometimes are renewed automatically unless a change in terms is requested. A typical treaty can include thirty or forty articles or clauses which describe the class or classes of business covered, the type of treaty (proportional or non-proportional), the amount of reinsurance provided and details about the parties obligations with respect to treaty operation. Cross Reference: For a thorough discussion of the distinction between facultative and treaty reinsurance, see Compagnie de Reassurance D Ile de France v. New England Reinsurance Corp., 825 F. Supp. 370 (D. Mass. 1993), aff d in part and rev d in part, 57 F.3d 56 (1st Cir. 1995). z Strategic Point: Reinsurance treaties that run consecutively for many years can present certain difficulties in terms of claims processing. Contracts are often amended by endorsements which can add or delete reinsurers, change premium or ceding commission rates or add, delete or alter important contract terms. These changes may be retroactive to contract inception or have a different effective date. Practitioners evaluating indemnity under reinsurance treaties must take care to review complete versions of 40-17

18 40.04[2] New Appleman Insurance Practice Guide the wordings, including endorsements and amendments [2] Proportional vs. Non-proportional. Proportional or pro-rata reinsurance is characterized by a proportional division of liability and premium between the ceding company and the reinsurer. The cedent pays the reinsurer a predetermined share of the premium, and the reinsurer indemnifies the cedent for a like share of the loss and the expense incurred by the cedent in its defense and settlement of claims (the allocated loss adjustment expense or LAE ). According to the percentage agreed, the cedent and reinsurer share the premium and losses from the business reinsured. Proportional reinsurance spreads the risk of loss and creates a broad identity of interests between the cedent and the reinsurer, which effectively co-venture in relationship to their relative shares of the risk, even though only the cedent has contractual privity with the direct insured. The two most common types of proportional reinsurance are quota share and surplus share reinsurance. Under quota share reinsurance, the reinsurer assumes an agreed percentage of each risk from the first dollar, up to any limit assigned. For example, if there is a $100 loss under a 40 percent quota share reinsurance contract, the cedent would bear $60 of that loss and the reinsurer concurrently would bear $40 of that loss. The percentage always reflects the percentage of loss borne by the reinsurer. The portion of the risk that the reinsurer assumes is called the ceded risk, and the portion that the cedent keeps is referred to as the reinsurance retention. Although it is not a partnership, quota share reinsurance presents a greater identity of interests between the ceding insurer and the reinsurer than does excess of loss reinsurance (discussed below). Surplus share is similar to quota share reinsurance in that premiums and losses are shared on a proportional basis, but differs in that the portion of the reinsured policy the direct insurer retains is expressed as a fixed monetary amount, and the reinsurance may or may not apply from the first dollar (i.e., the reinsurance may apply only in excess of the fixed dollar amount or the cedent and reinsurer may together share losses as they are incurred until the cedent incurs an amount equal to its overall retention). Premium is shared based on the ratio of retained liability, and the reinsurer agrees to pay the same pro rata portion of any loss and expense incurred by the cedent. Examples: Where the policy limit is $150,000, and the cedent s retention is $25,000, the amount ceded to the reinsurer is $125,

19 Understanding Reinsurance 40.04[2] and the ratio of what is ceded to what is retained is 5:1. Losses therefore will be shared in that proportion. For a loss of $100,000, the cedent is responsible for $16,667 and the reinsurer pays five times more, or $83,333. In addition, in surplus share reinsurance contracts, the proportion of premium and liability ceded can vary, at the cedent s option, from risk to risk. Although it can be advantageous for the direct insurer to vary the percentage of premium and liability ceded for each risk, these variations make a surplus share contract more difficult to administer than a simple quota share. Under non-proportional or excess of loss reinsurance (sometimes referred to as XL or XOL ), the reinsurer s liability is not triggered until the cedent s losses exceed a specified monetary amount, called the retention. If losses to the ceding company are less than the retention, the reinsurer owes nothing. The reinsurance agreement will include a limit of liability for each claim above which the reinsurer is not obligated to pay. Excess of loss reinsurance can be provided on an individual risk, an occurrence or an aggregate basis, and is typically placed in layers. Non-proportional reinsurance tends to cost less than does quota share reinsurance because the reinsurer does not participate in every loss. However, because the level of risk under non-proportional reinsurance depends on the nature of the reinsurance undertaking, there is a great deal of uncertainty with this coverage. In addition to the underlying risk, reinsurers must consider the layer of coverage on which it will participate. Whether a potential cedent seeks to obtain or place coverage on a first dollar basis versus excess of loss reinsurance depends on several factors, including the cedent s anticipated loss profile. For example, if the cedent expects to incur frequent losses at low levels, it may make economic sense for the cedent to secure quota share reinsurance, so it has some protection for even the smallest losses. In contrast, if the cedent expects to have infrequent losses at significant levels or wishes to guard against risk of a significant loss, it may choose to purchase excess of loss coverage. z Strategic Point Reinsurer: Because non-proportional reinsurance is characterized by unpredictability and potentially high losses, XOL reinsurers may incur a disproportionate share of total losses. This is especially problematic with respect to long tail lines of insurance where the incidence of loss and determination of damages can extend well beyond the period in which the insurance or reinsurance is in force. In such cases, premiums may 40-19

20 40.04[3] New Appleman Insurance Practice Guide be received long before liability is manifested or developed, and liability may be difficult to estimate because it is determined by the prevailing legal or economic environment in the future. (On the other hand, the reinsurer is able to hold on to the premium paid by the cedent for a longer period, offering it the opportunity to earn out losses through investment return.) Examples of long-tail lines of insurance include malpractice, products liability, and errors and omissions. Cross Reference: For discussion of the advantages and disadvantages of proportional and non-proportional reinsurance contracts, see Eric Mills Holmes, Appleman on Insurance 2d Cross References: For an example of a reinsuring clause for a quota share reinsurance agreement, see below. For an example of a reinsuring clause for a surplus share reinsurance agreement, see below. For an example of a reinsuring clause for an XOL reinsurance agreement, see below [3] Catastrophe Reinsurance. Catastrophe reinsurance is a form of excess of loss reinsurance which, subject to a specific limit, indemnifies the cedent for the amount of loss in excess of its retention with respect to an accumulation of individual losses affecting multiple policies resulting from a catastrophic event. Rather than single large losses, even an unexpected number of such losses within the reinsurance policy term, catastrophe coverage principally provides protection for the cedent against the concentration of several losses, each of which may stem from different direct insureds but which altogether arise from a common event (or closely related series of events). The reinsurance contract is typically called a catastrophe cover. Catastrophe reinsurance can be provided on an aggregate basis with coverage for losses over a certain amount for each loss in excess of a second amount in the aggregate for all losses in all catastrophes occurring during a certain time period (often one year). Catastrophe cover is typically secured to protect the cedent against an intolerable accumulation of actual loss and to stabilize its underwriting experience. Another variant of reinsurance purchased by insurers is clash cover, which requires two or more coverages or policies issued by the reinsured to be involved in a loss, for coverage to apply. This reinsurance typically attaches above the limits of any one policy. Clash covers are often catastrophe covers

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