Matthew Gaul, Leah M. Quadrino, John P. Fielding, Mary K. Martin, Sarah D. Gordon, Kate Riggs, Christopher Dougherty, and Kate Jensen

Transcription

1 RECENT DEVELOPMENTS IN EXCESS INSURANCE, SURPLUS LINES INSURANCE, AND REINSURANCE LAW Matthew Gaul, Leah M. Quadrino, John P. Fielding, Mary K. Martin, Sarah D. Gordon, Kate Riggs, Christopher Dougherty, and Kate Jensen I. Excess Insurance: Case Law Developments A. Exhaustion B. Annualization of Limits C. Insolvent Insurers II. Surplus Lines Insurance: The Implementation of the Nonadmitted and Reinsurance Reform Act A. Regulation by the Home State of the Insured B. Treatment of Surplus Lines Premium Tax Policy Endorsements Allocation Categorizing the States a. Pro-Rata States b. 100% Retention States c. NIMA States d. SLIMPACT States C. Surplus Lines Insurer Eligibility Standards D. Commercial Purchaser Exemption E. Surplus Lines Broker Licensing Matthew Gaul is a partner in Steptoe & Johnson LLP s New York office. Leah M. Quadrino is of counsel in Steptoe s Washington, D.C., office and chair-elect of the Excess, Surplus Lines and Reinsurance Committee. John P. Fielding and Mary K. Martin are also of counsel in Steptoe s Washington, D.C., office and Sarah D. Gordon, Kate Riggs, Christopher Dougherty and Kate Jensen are associates in Steptoe s Washington, D.C., office. 185

2 186 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) III. Reinsurance A. Regulatory Developments B. Case Law Developments The Honorable Engagement Clause Broker Duties The Follow-the-Fortunes Doctrine Contract Interpretation: Notice Requirements and Retention Warranties Discovery Developments in Arbitration a. Arbitration of Disputes and Gateway Questions b. Challenges to Arbitrator Selection and Qualifications c. Post-award Challenges This article addresses key regulatory and case law developments across three diverse areas of the insurance industry: excess insurance, surplus lines insurance, and reinsurance. The article covers developments from October 1, 2010, through September 30, i. excess insurance: case law developments Significant developments affecting excess insurance occurred in the areas of exhaustion, annualization of limits, and insolvency. Key cases are discussed below. A. Exhaustion One of the flashpoint issues among cases addressing the principle of exhaustion was how settlements of underlying policy limits impact whether the excess policies above them are triggered. As is frequently the case, each decision turned on the specific policy language at issue and the law of the applicable jurisdiction. The Supreme Court of California recently granted review of a continuous loss case, where the court of appeal had applied the horizontal exhaustion rule and found that an excess carrier s liability attached only after all available primary insurance ha[d] been exhausted. 1 In Kaiser Cement & Gypsum Corp. v. Insurance Co. of the State of Pennsylvania, 2 Kaiser Cement 1. Kaiser Cement & Gypsum Corp. v. Ins. Co. of the State of Pa., 126 Cal. Rptr. 3d 602, 614 (Cal. Ct. App. 2011). 2. Kaiser Cement & Gypsum Corp. v. Ins. Co. of the State of Pa., 264 P.3d 32 (Cal. 2011) (granting review and deferring further action pending consideration and disposition of a related issue in State of California v. Continental Insurance Company ).

3 Excess, Surplus Lines, and Reinsurance Law 187 had sought coverage for underlying asbestos claims under a 1974 excess policy. The excess policy provided indemnity for the policyholder s ultimate net loss in excess of the retained limit hereinafter stated. 3 The court of appeal held that, under the retained limit definition in the policy, underlying insurance includes scheduled insurance, as well as any other collectible primary insurance. 4 In other words, the court of appeal found that Kaiser Cement s 1974 excess policy was not only excess to the 1974 primary policy below it, but to all other collectible primary insurance that Kaiser Cement had. At the time of this writing, a decision from the California Supreme Court, which has granted review of this decision, has not yet been rendered. In Stonewall Insurance Co. v. The Superior Court of Los Angeles County and Fuller-Austin Insulation Co., a California court of appeal found that exhaustion of an insurance policy may occur as a result of a settlement for less than the policy s limit of liability. 5 During the first trial of the Fuller-Austin case, the court found that Fuller-Austin s umbrella policies were exhausted as a result of the insurers settlement payments, although they were for less than the policy limits. 6 In light of an upcoming retrial, Fuller-Austin filed a motion in limine to prevent Stonewall, an excess insurer, from arguing that the umbrella policies were not exhausted. 7 The California appellate court affirmed the trial court s order granting Fuller-Austin s motion. In so ruling, the court declined to follow Qualcomm v. Certain Underwriters at Lloyd s, London, 8 which had held that a settlement for less than the limits of a primary policy did not trigger excess coverage. The Fuller-Austin court distinguished Qualcomm on the following grounds: (1) waiver was not an issue in Qualcomm, whereas it was here; (2) Qualcomm involved one primary policy and one excess policy while the case at bar addressed numerous policies and policy periods; and (3) unlike in Qualcomm, public policy favoring settlements was important because the instant case involved the settlement of numerous asbestos claims. 9 In another exhaustion-by-settlement case, Trinity Homes LLC v. Ohio Casualty Insurance Co., a general contractor sued its primary and umbrella insurers for coverage in a defective construction case. 10 The general contractor argued that the umbrella policy had been triggered by virtue 3. Kaiser Cement, 126 Cal. Rptr. at Id. at WL (Cal. Ct. App. Nov. 1, 2010). 6. Id. at *1. 7. Id. 8. Id. (citing Qualcomm v. Certain Underwriters at Lloyd s, London, 73 Cal. Rptr. 3d 770 (Cal. Ct. App. 2008)). 9. Id. at * F.3d 653 (7th Cir. 2010).

4 188 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) of a settlement between the general contractor and its primary insurers. The primary insurers paid at least seventy-five percent of the primary policy limits and the general contractor paid the difference on each primary policy. 11 The U.S. Court of Appeals for the Seventh Circuit, applying Indiana law, found that while the umbrella policy clearly required that the underlying CGL coverage be unavailable either by exhaustion or denial of coverage, the policy language was ambiguous as to whether the full primary policy limit had to be paid by the primary insurer alone in order to trigger the umbrella. 12 As a result, the court found that the settlement, in conjunction with additional funds from the insured, exhausted the primary policies and triggered the umbrella policy. 13 Similarly, in Citigroup, Inc. v. Federal Insurance Co., the U.S. Court of Appeals for the Fifth Circuit examined whether, under Texas law, excess coverage attached as a result of the policyholder s settlement with its primary insurer for less than the primary policy limits. 14 Unlike in Trinity Homes, the policyholder here, Citigroup, did not pay the difference between the settlement amount ($15 million) and the primary policy limits ($50 million). Citigroup argued that its excess policies ambiguously defined exhaustion, and, as a result, its settlement with the primary insurer exhausted the primary policy and required Citigroup s excess insurers to cover the underlying claims. 15 The excess policies at issue used the following terms in describing how much of the primary policy limits must be paid before excess coverage attached: full amount, total limit, and all of the limit(s) of liability. 16 The Fifth Circuit rejected Citigroup s argument, holding that the plain language of the policies dictate that the primary insurer pays the full amount of its limits of liability before excess coverage is triggered. 17 In JPMorgan Chase & Co. v. Indian Harbor Insurance Co., a New York trial court applying Illinois law and addressing multiple pending motions reached a similar conclusion as the Fifth Circuit in Citigroup. 18 Contending that its excess insurers wrongfully failed to indemnify it, JPMorgan sought reimbursement from the insurers for payments that it made to defend and settle certain underlying professional services claims. 19 JPMorgan had settled its coverage claims against lower-layer excess carriers without 11. Id. at Id. 13. Id F.3d 367 (5th Cir. 2011). 15. Id. at 371 (citing Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d Cir. 1928)). 16. Id. at Id. at No /08, 2011 WL (N.Y. Sup. Ct. May 26, 2011). 19. Id. at *1.

5 Excess, Surplus Lines, and Reinsurance Law 189 allocating the amounts to specific policies. A higher-layer excess carrier moved to dismiss JPMorgan s complaint on the basis that the policyholder did not comply with the express conditions precedent in its policy 20 specifically, that the insurer be required to pay losses only after each insurance carrier beneath [it] in the insurance tower ha[d] both admitted liability for the losses under its policy and paid the full amount of its liability under its respective policy. 21 Finding the policy language to be clear and unambiguous, 22 the court granted the motion to dismiss and held that the settlement, which lacked an allocation among the underlying policies, failed to satisfy the higher-layer excess carrier s clear policy conditions. 23 B. Annualization of Limits In Union Carbide Corp. v. Affiliated FM Insurance Co., the New York Court of Appeals ruled that aggregate limits in an excess liability policy with a three-year policy period were annualized even though the policy did not expressly so provide. 24 The case involved two of six carriers participating in the fifth excess layer, which provided $30 million worth of coverage divided equally between the six, with a policy period of three years. 25 The excess policy contained a follow-the-form clause. 26 The primary coverage, which also had a duration of three years, specifically provided for annualized limits. That policy referred to an annual aggregate and contained a condition stating that the total limit of liability was for ultimate net loss... during each consecutive twelve months of the policy period. 27 The carriers argued that the follow-the-form clause was subject to the declarations in the excess policy, which provided an aggregate, not an annual aggregate, limit. 28 The court determined that the limits were annualized based on the follow-the-form clause, finding it implausible that an insured with as large and complicated an insurance program as UCC would have bargained for policies that differed, as between primary and excess layers, in the time over which policy limits were spread Id. at * Id. at *5 (emphasis omitted). 22. Id. at * Id. at *10. Although the other excess carriers policies contained slightly different language than the Twin City policy, the JPMorgan court also granted those carriers motions for summary judgment on the same basis as the Twin City motion. Id. at *13, N.E.2d 111 (N.Y. 2011). 25. Id. at Id. 27. Id. (quoting the policy). 28. Id. at Id. The court did not decide whether the policy was ambiguous in order to consider extrinsic evidence but noted that the extrinsic evidence all of which was submitted by UCC favored UCC s interpretation. Id. at 114.

6 190 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) C. Insolvent Insurers The U.S. District Court for the District of Minnesota applied Minnesota law to allocate loss for claims that would have been covered by insurers who had become insolvent. 30 The insured, facing claims for injury caused by exposure to its asbestos-containing products, purchased coverage for the period between 1976 and 1985, at which point the insured claimed asbestos insurance coverage was no longer available. 31 The insurer-defendants issued umbrella or second layer policies between 1976 and The insured purchased coverage for the period from 1980 to 1984 from insurers that have since become insolvent. 33 The insured asked the court to determine that no liability be allocated to it for the period from 1980 through 1984 and for a threshold declaration that allocation of funding for settlements or judgments relating to asbestos claims against it should exclude the insolvent insurers coverage periods. 34 While Minnesota law permitted allocation to an insured if insurance coverage is available during a particular period, and an insured voluntarily self-insures, the rule did not contemplate a situation involving insolvent insurers. 35 The court looked to other jurisdictions where courts considering the issue had placed the burden on the insured for uninsured periods caused by insurer insolvency. 36 The court compared making the insurers cover the insolvent insurers liability to requiring drop down coverage. 37 Noting that the insurers did not agree to provide coverage during the relevant time period, the court found that insurance was available to the insured and allocated liability for the time period covered by the insolvent insurers to the insured. 38 ii. surplus lines insurance: the implementation of the nonadmitted and reinsurance reform act During the last year, the surplus lines industry continued to implement the significant changes mandated by the Nonadmitted and Reinsurance 30. H.B. Fuller Co. v. U.S. Fire Ins. Co., Civ. No ( JRT/JJG), 2011 WL (D. Minn. July 18, 2011). 31. Id. at * Id. at * Id. at * Id. at * Id. at *5 (discussing Wooddale Builders, Inc. v. Maryland Cas. Co., 722 N.W.2d 283 (Minn. 2006)). 36. Id. at * Id. at * Id. at *8. Despite the lack of controlling state law directly on point, the court declined to certify the question to the Minnesota Supreme Court on the ground that principles enumerated by that court, along with precedent in other jurisdictions and public policy considerations, allowed the court to determine the issue without certification. Id. at *9.

7 Excess, Surplus Lines, and Reinsurance Law 191 Reform Act (NRRA), 39 which was enacted into law in July 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). 40 The NRRA reformed the regulation of surplus lines insurance by limiting regulatory authority over surplus lines transactions to the home state of the insured, and by setting federal standards for the collection of surplus lines premium taxes, insurer eligibility, and commercial purchaser exemptions. 41 Most of the provisions of the NRRA went into effect on July 21, In anticipation of that deadline, many states revised their laws and regulations to conform to the new law. With minor exceptions, the new state laws focus on surplus lines premium taxation, which is the most challenging compliance issue for both insurance brokers and state regulators. In addition to the tax issue, most of the states have attempted to conform their laws to the other areas addressed by the NRRA, including the commercial purchaser exemption and surplus lines insurer eligibility standards. A number of state legislatures adjourned without taking any action to conform their laws and rules to the NRRA, and therefore their laws do not necessarily match the federal standards. Whether or not a state has taken action, however, the NRRA standards apply, and any countervailing state law is preempted. Therefore, surplus lines brokers must look to both the NRRA and the laws of the home state of the insured to determine what they need to do to comply with all applicable rules. A. Regulation by the Home State of the Insured The NRRA establishes a single-state compliance regime for surplus lines insurance transactions. Only the home state of the insured is permitted to require the payment of surplus lines premium tax and to otherwise regulate the placement of a surplus lines policy placed on or after July 21, This means that a broker must only comply with the regulatory requirements of the home state of the insured relating to diligent search, disclosure language, eligibility requirements, filings, broker licensing requirements, and premium tax requirements. Correctly identifying the home state of the insured for a particular surplus lines placement is necessary for proper compliance with the regulatory requirements that apply to the transaction. 43 The home state of the insured will have to be determined on a transaction-by-transaction basis 39. Nonadmitted and Reinsurance Reform Act, Pub. L. No , , 124 Stat (2010) (codified at 15 U.S.C ). 40. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010) U.S.C U.S.C The NRRA defines the home state of the insured as (i) the State in which an insured maintains its principal place of business or, in the case of an individual, the individual s principal

8 192 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) by the broker placing the surplus lines coverage. Although identifying the home state likely will be straightforward in most cases, there may be times when the determination is not clear-cut, or when more than one state could claim to be the home state of an insured with respect to a particular transaction. For this reason, when determining an insured s home state, it is particularly important to pay close attention to the relevant definitions in state law, as well as those under NIMA (the Nonadmitted Insurance Multi-State Agreement) and SLIMPACT (the Surplus Lines Insurance Multi-State Compliance Compact). NIMA and SLIMPACT are the two principal multistate frameworks the states are using to implement the NRRA. NIMA and SLIMPACT incorporate the NRRA definition of home state, including the affiliated group clarification. Both NIMA and SLIMPACT, however, also define additional terms to address gaps in the NRRA s home state definition. NIMA adds definitions for principal place of business, principal residence, and group insurance. 44 SLIMPACT adds a definition for purchasing group. 45 B. Treatment of Surplus Lines Premium Tax Under the NRRA, the home state of the insured has sole regulatory authority over the collection and allocation of surplus lines premium taxes. The federal law prohibits any state other than the home state of the insured from requiring any premium tax payment for surplus lines insurance. 46 Thus, for surplus lines policies placed on or after July 21, 2011, only the laws of the home state of the insured govern with respect to the amount of premium tax owed on a surplus lines transaction, and for any other regulatory requirements the state may impose in connection with the payment of the premium tax, such as the timing of tax payments and whether the state requires the submission of risk allocation information for multistate residence; or (ii) if 100 percent of the insured risk is located out of the State referred to in clause (i), the State to which the greatest percentage of the insured s taxable premium for that insurance contract is allocated. 15 U.S.C. 8206(6)(a). The definition goes on to clarify that, with respect to affiliated groups, [i]f more than 1 insured from an affiliated group are named insureds on a single nonadmitted insurance contract, the term home State means the home State, as determined pursuant to [clauses (i) and (ii) above], of the member of the affiliated group that has the largest percentage of premium attributed to it under such insurance contract. 15 U.S.C. 8206(6)(B). 44. Model Nonadmitted Insurance Multi-State Agreement 5 (Nat l Ass n of Ins. Comm rs 2011), available at execution_copy.pdf (last visited Oct. 30, 2011) [hereinafter NIMA]. 45. Model Surplus Lines Multi-State Compliance Compact, art. II, 25 (Council on State Gov t, 2009), available at SLIMPACTFinal91409.pdf (last visited Oct. 30, 2011). [hereinafter SLIMPACT] U.S.C

9 Excess, Surplus Lines, and Reinsurance Law 193 transactions. Also as of July 21, 2011, surplus lines brokers are required to submit the premium tax payment on a surplus lines transaction only to the insured s home state. 47 Brokers no longer have to make separate payments to each state in which a covered risk is located for multistate placements entered into on or after July 21, Note that both NIMA and SLIM- PACT contemplate payment of surplus lines premium taxes to central clearinghouses, which will accept the payments on behalf of their member states. As of this writing, however, neither NIMA nor SLIMPACT has created such a clearinghouse. 1. Policy Endorsements Premium taxes on policies with new or renewal effective dates prior to July 21, 2011, including associated premium-bearing endorsements to such policies entered into subsequent to July 21, 2011, will continue to be payable in accordance with the applicable tax law at the time of the policy placement or renewal, not the date of the endorsement. Taxes on policies with new or renewal effective dates on or after July 21, 2011, including associated premium-bearing endorsements, will be payable solely to the home state of the insured Allocation Many states will continue to require brokers to submit documentation regarding allocation by state of the risks covered by a surplus lines transaction. If the home state of the insured is a state that has joined NIMA, the broker will be required to use the NIMA risk allocation formula. If the home state is a state that has joined SLIMPACT, the broker will be required to use the SLIMPACT risk allocation formula. To the extent other states require submission of allocation information, the allocation requirement will be determined in accordance with state laws and regulations. 3. Categorizing the States The states can be categorized as follows for surplus lines premium tax purposes: a. Pro-Rata States A number of states have not changed their premium tax laws to conform to the NRRA. 49 Nonetheless, they still must comply with the NRRA s requirement that only the home state of the insured may require surplus line premium tax payments. Most, if not all, of these states currently impose tax only on the portion of the risk located in the 47. Id. 48. Id. 49. Colorado, Iowa, and South Carolina.

10 194 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) state. This means that, for transactions on or after July 21, 2011, if one of these pro-rata states is the home state of the insured, the broker will be required to pay tax only on the portion of the risk located in the insured s home state. b. 100% Retention States As of July 21, 2011, a number of states tax 100% of the premium on surplus lines policies and do not allocate the taxes to other states where covered risks are located. 50 This means that, for transactions on or after July 21, 2011, if one of these 100% retention states is the home state of the insured, the broker will be required to pay tax to the home state of the insured on the entire amount of the premium, most likely at the home state s tax rate. It is unlikely that these states will require brokers to file risk allocation reports because there will be no allocation of the tax proceeds among the states. Nonetheless, brokers should review the laws and regulations of the home state of the insured to confirm tax payment and reporting requirements. c. NIMA States When NIMA s clearinghouse is operational, if a NIMA state is the home state of the insured, the broker will be required to pay tax and submit allocation and report information to the NIMA clearinghouse on a quarterly basis (February 15 for the quarter ending the preceding December 31; May 15 for the quarter ending the preceding March 31; August 15 for the quarter ending the preceding June 30; and November 15 for the quarter ending the preceding September 30). 51 d. SLIMPACT States When SLIMPACT s clearinghouse is operational (which will not be until at least January 2013), if a SLIMPACT State is the home state of the insured, the broker will be required to pay tax and submit allocation and report information to the SLIMPACT clearinghouse in accordance with the rules and timeframes mandated by the SLIMPACT Commission. 52 Note, however, that SLIMPACT is not yet effective. SLIMPACT will become effective for purposes of adopting rules and creating a clearinghouse when ten states, or states representing forty percent of all surplus lines premium volume, enter into the compact. 53 As 50. California, Idaho, Illinois, Minnesota, Missouri, New York, Pennsylvania, Virginia, and Washington have not authorized a multistate allocation agreement and will remain 100% retention states. Several other states have authorized an allocation agreement but will remain 100% retention states until an agreement is formally adopted and operational. 51. NIMA, supra note 44, 20. The states that have adopted NIMA are Alaska, Connecticut, Florida, Hawaii, Louisiana, Mississippi, Nebraska, Nevada, South Dakota, Utah, and Wyoming (and Puerto Rico). 52. SLIMPACT, supra note 45, art. XVI. 53. Id., art. XIV.

11 Excess, Surplus Lines, and Reinsurance Law 195 of this writing, only nine states 54 have enacted SLIMPACT; the aggregate premium in those states does not reach the forty percent threshold. 55 A number of states are authorized to enter into a multistate allocation agreement but have not yet done so, pending studies or determinations by state officials. 56 Until such time as a state has entered into a multistate allocation agreement, the current laws of the state govern. For example, Arkansas requires payment of 100% of the premium tax to the state at the state s surplus lines premium tax rate of four percent unless the insurance commissioner enters into NIMA. If the insurance commissioner enters into NIMA, taxes then will be paid in accordance with the agreement. C. Surplus Lines Insurer Eligibility Standards Most states require that a surplus lines insurer be deemed eligible by meeting certain financial criteria or by having been designated as eligible on a state-maintained list. Prior to the enactment of the NRRA, state eligibility standards varied widely from state to state. As of July 21, 2011, a surplus lines transaction is only subject to the eligibility requirements of the insured s home state. If the insured s home state does not have insurer eligibility requirements, no such requirements apply; if, however, the home state does have insurer eligibility requirements, they must comply with NRRA. 57 Eligibility requirements themselves are made uniform across the country (in those states that have them) because the NRRA prohibits states from imposing eligibility requirements on surplus lines insurers except for (i) standards that conform with the NAIC s Non-Admitted Insurance Model Act or (ii) nationwide uniform requirements, forms, and procedures enacted pursuant to a compact or other agreement among the states. 58 At this time, SLIMPACT is the only interstate compact or agreement under consideration by the states that has the potential to establish nationwide, uniform insurer eligibility standards. Unless and until SLIMPACT establishes eligibility rules that become the standard in every 54. The states are Alabama, Indiana, Kansas, Kentucky, New Mexico, North Dakota, Rhode Island, Tennessee, and Vermont. 55. Despite the fact that SLIMPACT is not yet effective, the states that have enacted SLIMPACT into law have begun the process of drafting SLIMPACT s allocation formula and bylaws, as well as rules to adopt, amend, and repeal Commission rules. The bylaws and rules are based on the Interstate Insurance Product Regulation Commission (IIPRC) Uniform Standards and Operating Procedures governing life insurance products, available at (last visited Oct. 30, 2011). It is not clear when these documents and the allocation formula will be adopted. 56. Arizona, Arkansas, Delaware, Georgia, Maine, Maryland, Massachusetts, Montana, North Carolina, New Hampshire, New Jersey, Ohio, Oklahoma, Oregon, Texas, and West Virginia U.S.C Id.

12 196 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) state, however, the insurer eligibility rules in all states, including SLIM- PACT states, will need to comply with the standards set in the NAIC s Non-Admitted Insurance Model Act. The NAIC Model Act requires an unauthorized insurer to (i) be authorized in its domiciliary state to write the type of insurance that it writes as surplus lines coverage; and (ii) have capital and surplus, or its equivalent under the laws of its domiciliary jurisdiction, equaling the greater of (1) the minimum capital and surplus requirements under the law of the home state of the insured, or (2) $15 million. 59 Under the NAIC Model Act, the insured s home state commissioner may reduce or waive the capital and surplus requirements (down to a minimum of $4.5 million) after the commissioner makes a finding of eligibility based on several factors. 60 In addition to eligibility requirements for U.S.-domiciled insurers, the NRRA requires the states to permit the placement of surplus lines coverage with nonadmitted insurers domiciled outside the United States (alien insurers) that are listed on the NAIC s Quarterly Listing of Alien Insurers. 61 This means that all states must permit NAIC-listed alien insurers to place surplus lines coverage. A state may allow placement of coverage with alien insurers not on the NAIC list (and have a separate set of requirements for those nonlisted insurers), but the states cannot refuse to allow placement with listed alien insurers. D. Commercial Purchaser Exemption The NRRA establishes a single exempt commercial purchaser definition and exemption standard 62 that is applicable in every state. 63 As of July 21, 2011, no diligent search in the admitted market is required (and, therefore, 59. Model Nonadmitted Insurance Act 5(C)(2) (Nat l Assoc. of Ins. Comm rs, 1997), available at (last visited Oct. 30, 2011). 60. Id U.S.C An exempt commercial purchaser is a purchaser of commercial insurance that (1) employs or retains a qualified risk manager to negotiate insurance coverage; (2) has paid aggregate nationwide commercial property and casualty insurance premiums in excess of $100,000 in the immediately preceding 12 months; and (3) meets at least one of the following criteria: (i) possesses a net worth in excess of $20 million (as adjusted for inflation); (ii) generates annual revenues in excess of $50 million (as adjusted for inflation); (iii) employs more than 500 full-time or full-time-equivalent employees per individual insured or is a member of an affiliated group employing more than 1,000 employees in the aggregate; (iv) is a not-for-profit organization or public entity generating annual budgeted expenditures of at least $30 million (as adjusted for inflation); or (v) is a municipality with a population of more than 50, U.S.C. 8206(5). The term qualified risk manager is also defined at 15 U.S.C. 8206(13) U.S.C

13 Excess, Surplus Lines, and Reinsurance Law 197 a broker can go directly to the surplus lines market) to place a policy for an exempt commercial purchaser if (i) the broker has disclosed to the exempt commercial purchaser that coverage may be available from the admitted market, which may provide greater protection with more regulatory oversight, and (ii) the exempt commercial purchaser has requested in writing that the broker procure/place such coverage with a surplus lines insurer. 64 A number of states currently have exemptions for commercial purchasers (called industrial insureds in many states). Those exemptions are not preempted by the NRRA. Thus, in those states, if the industrial insured exemption is retained, there could be two classes of exemptions: one for entities that meet the NRRA exempt commercial purchaser requirements and one for entities that meet the state s industrial insured exemption. Before taking advantage of the exemption, brokers should check the law of the home state of the insured as well as the NRRA definition to ensure that the exemption is used correctly. E. Surplus Lines Broker Licensing The federal law prohibits any state except the home state of the insured from requiring that a surplus lines broker be licensed in order to sell, solicit, or negotiate surplus lines insurance with respect to the insured. 65 Accordingly, as of July 21, 2011, a broker needs only one surplus lines producer license to place a surplus lines policy a license (resident or nonresident) in the insured s home state. In wholesale transactions, the wholesale broker on each such account must have the appropriate license in the home state of the insured for each state where placements are made. On a related issue, NRRA prohibits a state from collecting fees relating to the licensing of a surplus lines broker or business entity unless the state participates in the NAIC s national insurance producer database for surplus lines producer licensure by July 21, Effectively, this provides a strong incentive to the states to utilize the NAIC s uniform producer licensing applications for surplus lines producers and to license surplus lines brokers electronically through the National Insurance Producer Registry. iii. reinsurance A. Regulatory Developments The passage of Dodd-Frank and the NRRA in 2010 set the stage for state legislative and regulatory efforts to reduce collateral requirements for overseas reinsurers. For more than twenty years, U.S. state regulators have 64. Id. 65. Id Id

14 198 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) required all nonaccredited reinsurers to post collateral equal to 100% of expected losses on reinsurance placed in the United States. Nonaccredited reinsurers by definition fall outside the reach of state supervision, but regulators have been able to require collateral through accounting rules applicable to domiciliary ceding insurers. Those rules simply required that in order for ceding insurers to receive reserve credit for reinsurance, the reinsurer had to post 100% collateral. In 2008, the NAIC adopted the Reinsurance Regulatory Modernization Framework, which included a proposal to reduce collateral requirements through a port-of-entry system for overseas reinsurers. 67 Under the proposed system, a nonaccredited reinsurer could apply for certification by a single U.S. state, which would give it permission to write reinsurance (without collateral requirements) in any other U.S. state as well. The NAIC lobbied unsuccessfully to have the framework enacted as part of Dodd-Frank and the NRRA. Rather than take up the issue directly, Congress included in the NRRA provisions that strengthened the authority of the domiciliary state of the ceding insurer (and only the domiciliary state) to determine credit for reinsurance. Specifically, if the domiciliary state of a ceding insurer is an NAIC-accredited state or a state that has financial solvency requirements substantially similar to the requirements necessary for NAIC accreditation, and recognizes credit for reinsurance for the insurer s ceded risk, then no other State may deny such credit for reinsurance. 68 Moreover, any laws or regulations of states other than the ceding insurer s domiciliary state that purport to limit credit for reinsurance are specifically preempted by Dodd-Frank and the NRRA. 69 This clear grant of authority to the ceding insurer s state of domicile and the absence of substantive federal rules have once again placed the issue squarely with the individual states and the NAIC, and there have been significant developments on both fronts. The NAIC s 2008 modernization framework included a set of guidelines that port-of-entry states would use to consider whether a nonaccredited reinsurer should be allowed to reduce its posted collateral. Now several states have adopted similar guidelines on their own. In response to ongoing reinsurance capacity problems, Florida was the first state to move on its own to reduce collateral requirements for nonaccredited reinsurers, passing legislation in 2007 directing its insurance department to reduce reinsurance collateral requirements. 70 The Florida department promulgated regulations under the new law in and 67. See NAIC Memo re Reinsurance (E) Committee Task Force Activities (Sept. 12, 2008). 68. Nonadmitted and Reinsurance Reform Act, Pub. L. No , 532, 124 Stat. 1589, 1595 (Credit for Reinsurance) U.S.C Fla. Stat (3)( e) (2007). 71. Fla. Admin. Code Ann. r. 69O (2008).

15 Excess, Surplus Lines, and Reinsurance Law 199 approved its first reinsurer for reduced collateral treatment in early More recently, New York amended its credit for reinsurance rules to allow for reduced collateral on January 1, 2011, 72 and it has begun approving companies for reduced collateral treatment. Finally, Indiana and New Jersey have adopted similar reduced collateral rules as well. 73 All of these states have set up procedures for approval of reduced collateral treatment similar to the guidelines in the NAIC framework. Those procedures require the insurance department to place each nonaccredited reinsurer applying for reduced collateral treatment into one of five rating categories: Insurance Department Rating Collateral Required for Full Reinsurance Reserve Credit Secure-1 0% Secure-2 10% Secure-3 20% Secure-4 75% Vulnerable-5 100% Each state s analysis begins with the reinsurer s published credit rating, and in order to be considered for collateral reduction the reinsurer must maintain two stand-alone (separate from any corporate parent or subsidiary) ratings. The insurance department then determines a base regulatory rating that corresponds to the credit ratings based on the following chart. 74 New York Insurance Department Rating Best S&P Moody s Fitch Secure-1 A++ AAA Aaa AAA Secure-2 A+ AA+, AA, AA Aa1, Aa2, Aa3 AA+, AA, AA Secure-3 A, A A+, A, A A1, A2, A3 A+, A, A Secure-4 B++, B+ BBB+, BBB, BBB Vulnerable-5 B, B, C++, C+, C, C, D, E, F BB+, BB, BB, B+, B, B, CCC, CC, C, D, R, NR Baa1, Baa2, Baa3 Ba1, Ba2, Ba3, B1, B2, B3, Caa, Ca, C BBB+, BBB, BBB BB+, BB, BB, B+, B, B, CCC+, CCC, CCC, DD 72. See New York State Ins. Dep t Tenth Amendment to Regulations 17, 20, and 20-A ( N.Y. Comp. Codes R. & Regs. tit. 11, 125 (2011)), available at insurance/r_finala/2011/rf17&20t.pdf (last visited Oct. 30, 2011) Ind. Legis. Serv. 11 (West); 2011 N.J. Sess. Law. Serv. 39 (West). 74. See N.Y. Comp. Codes R. & Regs. tit. 11, 125.4(h).

16 200 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) The insurance department rating cannot be higher than the corresponding lowest credit rating on the company. Thus, if the reinsurer maintains an A rating from Fitch and a BBB+ from S&P, the highest insurance department rating a company could receive would be Secure-4. Once this baseline is established, the state insurance department then considers a number of other factors including the reinsurer s history of claims payment, the reinsurer s overall financial condition, and regulatory actions against the reinsurer. After all of these factors are taken into account, a certification and regulatory rating are issued, and the reinsurer may begin writing business with reduced collateral in that jurisdiction. Both the Florida and New York insurance departments have begun reviewing and approving nonaccredited reinsurers for reduced collateral treatment. Meanwhile, the NAIC has moved forward along similar lines, finally adopting a new Credit for Reinsurance Model Law and Credit for Reinsurance Model Regulation on November 6, The models closely track the rules in Florida and New York and were approved by the NAIC s Reinsurance Modernization Task Force and the Financial Condition (E) Committee this summer. It is now up to the individual states to adopt the new rules by statute and /or regulation in the coming years. Under the model law and regulation, states can defer to certification and rating decisions of sister states, but deferral is not required. 76 Therefore, it is possible that the same reinsurer will be required to post different levels of collateral in different states. Under the new NAIC model, the NAIC will publish a list of non-u.s. jurisdictions qualified for reduced collateral treatment. A state commissioner that approves a reinsurer for reduced collateral from a jurisdiction not on the list will have to document the reasons for approval. 77 Although the new rules in New York, Florida, New Jersey, and Indiana and the changes to the NAIC model rules go a long way toward reducing reinsurance collateral requirements for overseas reinsurers, in the absence of federal regulation, the process will continue to be a slow evolution as the individual states make their own determinations about whether to adopt the new model rules and begin evaluating individual reinsurers. B. Case Law Developments Significant case law developments impacting the reinsurance industry addressed a variety of issues, including the effect of an honorable en- 75. See Press Release, NAIC, NAIC Adopts Revisions to Reinsurance Models (Nov. 7, 2011), available at surance_models.htm. 76. See Revision to NAIC Reinsurance Models (Nov. 6, 2011), available at naic.org/documents/committees_e_reinsurance_related_docs_preface_adopted_ex_ plenary_ pdf. 77. See id.

17 Excess, Surplus Lines, and Reinsurance Law 201 gagement clause, duties involving reinsurance intermediaries, the followthe-fortunes doctrine, various contract provisions, discovery matters, and developments in arbitration. Key decisions are discussed below. 1. The Honorable Engagement Clause A pair of recent cases addressed the effect of an honorable engagement clause with differing results. In the first case, the U.S. Court of Appeals for the Third Circuit held that a reinsurance contract s honorable engagement clause did not grant the arbitrator authority to rewrite the terms of the reinsurance contract in PMA Capital Insurance Co. v. Platinum Underwriters Bermuda, Ltd. 78 The parties had arbitrated a dispute concerning the reinsurance contract s deficit carry forward provision, and whether the provision entitled Platinum Underwriters to reimbursement for reinsurance losses that carried from one year to the next. 79 The arbitrator issued an award requiring PMA Capital to pay $6 million in reimbursement to Platinum Underwriters, but also prospectively eliminated the deficit carryforward provision of the reinsurance contract. PMA Capital petitioned to vacate or modify the arbitration award, asserting that the arbitrator exceeded its authority under the Federal Arbitration Act, 9 U.S.C. 10(a)(4) (2006). The U.S. District Court for the Eastern District of Pennsylvania granted the petition, and the Third Circuit affirmed. 80 The Third Circuit held that the honorable engagement clause permitted the arbitrators to stray from judicial formalities but did not give them authority to reinvent the contract before them, or to order relief no one requested. 81 By contrast, a federal district court in New York confirmed an arbitration award that effectively ordered the equivalent of a new prepayment provision to a reinsurance treaty under the honorable engagement clause at issue in Harper Insurance Ltd. v. Century Indemnity Co. 82 Century Indemnity initiated arbitration after an influx of asbestos claims under a reinsurance treaty led to a backlog of claims processing, as certain London Market Reinsurers imposed additional documentation requirements before indemnifying claims under the treaty. 83 One arbitration panel handling the F. App x 654 (3d Cir. 2010). The honorable engagement clause required arbitrators to interpret this Agreement as an honorable engagement and not merely a legal obligation. They are relieved of all judicial formalities and may abstain from following the strict rules of law. They will make their award with a view to effecting the general purpose of the Agreement in a reasonable manner rather than in accordance with the literal interpretation of the language. Id. at Id. at Id. at Id. 82. No. 10 Civ (NRB) 2011 WL (S.D.N.Y. July 28, 2011). 83. Id. at *1.

18 202 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) dispute granted Century Indemnity s request for declaratory relief in 2006, by ordering that the reinsurers had to pay the entire amount billed or the undisputed portion plus 75 percent of the disputed portion within 106 days of invoicing. 84 The panel retained jurisdiction to resolve future billing disputes, but neither party raised further issues with the panel until 2010, when the panel sought to close out its jurisdiction. The reinsurers then argued for elimination of the prepayment requirement for disputed claims prior to the panel s finalizing the award and ending its jurisdiction. Century Indemnity objected, and the panel denied the reinsurers requested relief. The reinsurers petitioned the district court to vacate the prepayment provision from the arbitration award under 9 U.S.C. 10(a)(4), arguing that the arbitrators exceeded their powers in crafting the remedy and ordered relief that neither party requested. 85 The court rejected the reinsurers arguments. First, the court reasoned that the reinsurers did not argue that the issue of how and when the reinsurers were required to indemnify Century Indemnity was raised before the arbitration panel, and no law requires that the remedy for an issue properly before an arbitration panel must be one proposed by the parties. 86 Second, the court held that the panel did not impermissibly rewrite the reinsurance contract because the contract s honorable engagement provision instructed the arbitrators to effect the general purpose of the contract in a reasonable manner. 87 The court distinguished from the Third Circuit s opinion in PMA Capital because, in the instant case, the additional terms for prepayment of disputed bills did not violate any explicit provision of the contract itself and were a legitimate interpretation of the contract s implied expectation that claims would be paid promptly Broker Duties In a key decision involving the duties of intermediaries, a California court of appeal was called upon to examine the legal nature of the duty owed by a reinsurance broker to a cedent company. In Workmen s Auto Insurance Co. v. Guy Carpenter & Co., 89 the court addressed a cedent s claim against 84. Id. at * Id. at *3 4. The court also noted that the parties disputed choice of law and whether New York law or the Federal Arbitration Act governed the proceeding. The issue was dispositive because if New York law applied, then the reinsurers petition to vacate was likely untimely as it was filed ninety-one days after the ninety-day requirement under New York s Civil Practice Law. Id. at *3. The court did not reach the issue, however, holding that regardless of the choice of law and timeliness issues, the reinsurers petition failed on its merits. 86. Id. at * Id. at * Id. at * Cal. Rptr. 3d 279, 286 (Cal. Ct. App. 2011). The court also addressed various California procedural issues and the propriety of the lower court s ruling on a discovery issue, neither of which are of particular import to reinsurance practitioners. Id. at ,

19 Excess, Surplus Lines, and Reinsurance Law 203 its broker for breach of fiduciary duty, among other claims. 90 Specifically, the cedent had alleged that its broker had breached its fiduciary duties by failing to secure timely payments from [the reinsurer], failing to secure the best available terms of reinsurance, and acting with the intent to injure the company by incurring inflated commissions. 91 The problem before the court of appeal lay in a conflict between California insurance law, which imposed a negligence standard on reinsurance brokers, and California agency law, which imposed a fiduciary duty standard. 92 The court concluded it should follow insurance law because of both stare decisis and public policy. 93 The court reasoned: [W]e are compelled to preserve the status quo rather than expand the duties of brokers. If we imposed new duties on brokers, our opinions would conflict with decades of case law regarding the duty of brokers to make disclosures, offer advice, etc. The profession would be thrown into limbo because the exact scope of a broker s duties would have to be defined through years of litigation.... Decades of cases have drawn a policy line between what brokers must do and need not do. Because that line has been drawn, we decline to revisit the issue. 94 Thus, the broker prevailed on appeal, and a negligence standard, not a fiduciary duty standard, governs broker relationships under California law. 3. The Follow-the-Fortunes Doctrine Of the cases over the last year that addressed the follow-the-fortunes doctrine, the decision rendered by the U.S. District Court for the District of Massachusetts in Trenwick America Reinsurance Corp. v. IRC, Inc. 95 was particularly significant. 96 At its most basic level, the case addressed whether a defendant retrocessionaire breached a reinsurance agreement for retrocessional cover on an employers liability insurance program, where no 90. Id. at Workmen s also raised negligence and breach of contract claims. The jury decided those claims in favor of Guy Carpenter, and its conclusions were not disturbed on appeal. Id. at Id. at Id. at Id. at 289. The court also noted: The agency of a broker must be viewed only through the lens of insurance law because it is a constellation of rules and policies all its own. Id. at Id. at F. Supp. 2d 274 (D. Mass. 2011). 96. Other courts also interpreted the follow-the-fortunes doctrine over the last year. In Arrowood Surplus Lines Insurance Co. v. Westport Insurance Co., 395 F. App x 778, 780 (2d Cir. 2010), the Second Circuit reiterated the well-established precedent that a follow-the fortunes provision cannot expand the express limits of coverage imposed by a reinsurance agreement. In Employers Reinsurance Co. v. Massachusetts Mutual Life Insurance Co., 654 F.3d 782 (8th Cir. 2011), the Eighth Circuit interpreted a treaty to include a follow-the-settlements provision and emphasized the limited ability of a reinsurer to challenge a cedent s settlements.

20 204 Tort Trial & Insurance Practice Law Journal, Fall 2011 (47:1) copy of the agreement could be located. 97 After a two-week bench trial, the court found in favor of the plaintiffs (the retrocedent and a fronting company) for approximately $4.1 million and entered judgment far in excess of that amount after application of penalties, interest, and other fees. 98 The underlying dispute arose when the retrocedent s intermediary attempted to collect outstanding balances on the retrocessional agreement related to claims resolved during an arbitration proceeding between the retrocedent and the direct insurer. 99 After a series of communications that appeared to relate to the amount in dispute only, the defendant retrocessionaire abruptly changed positions to contest the existence of the retrocessional agreement. 100 The court concluded that such a contract did in fact exist and that, despite the lack of a written agreement between the parties, the Massachusetts Statute of Frauds was not a bar to enforcing it. 101 The defendants argued that, even if an agreement existed, they were not liable because they had no obligation to follow the fortunes in the absence of an express contractual provision. 102 The plaintiff retrocedent argued that the follow-the-fortunes doctrine is inherent in every reinsurance relationship, even when the parties have not formally expressed it in their agreement, and therefore should be implied in its agreement with defendants. 103 The court noted that the law in Massachusetts is unresolved. 104 It held, however, that the follow-the-fortunes doctrine might be implied in the absence of an explicit clause, but only when supported by expert testimony on industry custom and practice. 105 Accordingly, the court permitted expert testimony on custom and practice in the reinsurance industry, and after both parties experts testified that the follow-the-fortunes doctrine was a core tenet of the reinsurance business, the court held that the doctrine was implied in the particular agreement at issue, even in the absence of an express contract. 106 Finally, the court concluded that defendants were liable under Chapter 93A of the Massachusetts General Laws, which prohibits unfair competition and unfair or deceptive acts or practices. 107 The court reasoned that 97. Arrowood Surplus Lines Ins. Co., 764 F. Supp. 2d at Id. at Id. at , Id. at Id. at The Statute of Frauds was satisfied by correspondence between the parties describing the essential terms of the agreement, including at least one piece of correspondence that was signed by all parties Id. at Id. at 296 (internal quotation marks omitted) Id Id. at Id. at Id. at