The tragedy of September 11 and other recent catastrophic events have pushed the traditionally unseen and unnoticed world of reinsurance to the forefront of the insurance and risk managing industries. This article serves as an overview of this evolving business discipline, as well as certain recent trends and debates.
Reinsurance is simply an agreement whereby a company ("reinsurer") agrees to indemnify an insurance company ("ceding company," "cedent," "cedant," or "reinsured") against all or a portion of the loss that the ceding company sustains under a standard insurance policy or a book of business. In other words, reinsurance is insurance for insurance companies.
Almost all ceding companies are reinsured. Locally, this would include such well-known ceding companies as Ace, American International Group (AIG), Travelers, PMA, CIGNA and Liberty Mutual Insurance Company. Professional reinsurers include American Re-Insurance Company, General Re, and Scor Re. Many of our domestic insurance companies have overseas reinsurers in London, Bermuda, or elsewhere.
Reinsurers are sometimes also reinsured themselves. This type of agreement is called a retrocessional agreement. The reinsurer of a reinsurer is called a retrocessionaire. Many reinsurers also function as retrocessionaires.
Purpose Of Reinsurance
Reinsurance provides capacity to ceding companies to write additional business. This is due to the fact that reinsurance agreements allow the ceding companies to spread all or a portion their risks of loss to other insurers (reinsurers). Reinsurance also helps smooth out the overall results for insurers in that a particularly bad claim is often shared with the company's reinsurers.
In many instances, reinsurers function as financial partners with ceding companies in their overall financial results. Most professional reinsurers have hundreds (if not thousands) of reinsurance agreements with a vast number of ceding companies. It should be noted that reinsurance agreements are contracts of indemnity, and not contracts of liability.
Different Types Of Reinsurance
Treaty Reinsurance. Treaty reinsurance reinsures an entire "book of business" for an insurer or ceding company. For example, a reinsurer like General Re may decide that it will reinsure all the workers compensation business that Ace will write in 2004.
Facultative Reinsurance. Sometimes, ceding companies need to reinsure a particular risk. Reinsurance of a specific risk or policy is called facultative reinsurance. For example, an insurance carrier may only want to cover the first $1 million on a risk, and will look to reinsure the loss above that amount.
Catastrophe (or Cat) Reinsurance. Catastrophe or "Cat" reinsurance involves reinsuring an insurance carrier's book of business against a particular type of risk; for example, natural (and some unnatural) events or calamities such as hurricanes, tornadoes, earthquakes or the September 11 tragedy.
Generally, reinsurers assume risk under these agreements either on a "quota share" or "excess of loss" basis. With "quota share" arrangements, reinsurers share a portion of the risk with ceding companies from the first dollar. With an "excess of loss" program, reinsurers generally indemnify the ceding company only when the loss exceeds a specified amount of the risk retained by the ceding company. Retentions and quota shares vary depending on the book of business, the nature of the risks, the size of the insurer and the insurer's appetite to retain risk.
Relationship Between Reinsurers And Ceding Companies
The relationship between the participants is very unique. Historically, despite the contractual and somewhat adversarial nature, it has been described as one involving uberrima fides, or "utmost good faith". Christiana Gen. Ins. Co. v. Great American Ins. Co., 979 F.2d 268 (2d Cir. 1992 ). This duty of utmost good faith is a reciprocal one. Compagnie De Reassurance D'Ile de France v. New England Reins. Corp., 57 F.3d 56 (1st Cir. 1995), cert. denied, 516 U.S. 1009 (1995); Mentor Ins. Co. v. Brannkasse, 996 F.2d 506 (2d Cir. 1993).
Courts remain divided, however, as to whether this creates a fiduciary relationship between the ceding company and reinsurer. The majority of courts have declined to find a broad fiduciary relationship between the ceding company and reinsurer, but the debate remains. These issues were reviewed as recently as last month in PXRE Reinsurance Co. v. Lumbermens Mutual Casualty Co., 2004 WL 1166631 (N.D. Ill., May 24, 2004).
One of the most basic tenets in reinsurance is the so-called "follow the fortunes" (or the related "follow the settlements") doctrine. Generally, reinsurers follow the fortunes of ceding companies, requiring reinsurers to reimburse ceding companies for good faith payments that are arguably within the terms of the original policy. See, e.g., Mentor Ins. Co. v. Brankasse, supra. Historically, the "follow the fortunes" doctrine severely restricted the ability of reinsurers to question a settlement made by the ceding company. In fact, the doctrine was so fundamental that it was sometimes read into reinsurance contracts, even when they did not contain the express provision. See, e.g., International Surplus Lines Ins. Co. v. Certain Underwriters at Lloyds, London, 868 F. Supp. 917 (S.D. Ohio 1994).
The recent case of North River Ins. Co. v. Ace American Reinsurance Co., 361 F.3d 134 (2d Cir. 2004) is very instructive on how the "follow the fortunes" doctrine plays out between ceding companies and reinsurers in a modern context. North River settled various non-products liability asbestos claims with Owens Corning Fiberglass (OCF) for $335 million without conceding liability coverage for the claims to OCF. As part of the release, North River insisted upon a full policy buy-back from OCF. As noted in the opinion of the Second Circuit, "Having paid $1 billion for products losses, and then $335 million to resolve the non-products losses, it never wanted to hear from Owens-Corning again."
After reaching settlement with OCF, North River billed its reinsurers, including Ace American ("Ace"). North River allocated 1% of the settlement to all of its policies to represent the buy-out portion of the settlement. It then allocated the remaining 99% on a "rising bathtub" approach, connecting the settlement to certain reinsurance agreements first; consistent with its past cessions to its reinsurers and the way it had paid OCF. Ace questioned the propriety of the allocations and cession, arguing that North River did not take into account (1) other potentially exposed/released policies; and (2) that its allocation to Ace did not closely match North River's pre-settlement analysis. The Federal District Court for the Southern District of New York granted summary judgment in favor of North River and its allocation among reinsurance agreements, and Ace appealed to the Second Circuit.
It should be noted that the reinsurance contracts between North River and its reinsurers contained "follow the fortunes" provisions. These provisions stated that "the liability of the Reinsurer shall follow that of the Company." The contracts also contained a "Loss Settlement" clause that stated, "all claims involving this reinsurance, when settled by the Company shall be binding on the Reinsurer." These provisions are found in many reinsurance agreements.
In reviewing the issues, the Second Circuit noted that the "follow the fortunes" doctrine binds reinsurers to the settlements made by ceding companies, unless the reinsurer can show fraud, bad faith, or that the payments were beyond the scope of coverage. The Court similarly noted, "the doctrine extends to a cedent's post-settlement allocation decisions, regardless of whether an inquiry would reveal an inconsistency between the allocation and the cedent's pre-settlement assessment of risk, as long as the allocation meets the typical follow-the-settlements requirements, i.e., is in good faith, reasonable, and within the applicable policies."
The Second Circuit held that "An insurer may engage in all manner of analyses to form its decision as to whether, and in what amount to settle, but those analyses are irrelevant to the contractual obligation of the reinsurer to indemnify." As a result, the Second Circuit upheld the decision of the District Court, finding in favor of North River and requiring reimbursement as requested from Ace and the other reinsurers.
Accordingly, based upon industry custom and practice, and existing case law, as long as the cedent acts in good faith, and the settlement is not a result of fraud or collusion, and the payment is not ex gratia or outside the scope of coverage, the settlement should be binding on reinsurers.
Current State Of The Relationships Between Ceding Companies And Reinsurers
In recent years, the relationship between the ceding companies and the reinsurers has deteriorated significantly. Much of this has to do with the cession of large and voluminous environmental, asbestos and other latent injury losses to the reinsurance community.
According to A. M. Best, the last 5 years have not been kind to the insurance industry as a whole. For the 5-year period ending in November 2003, downgrading of insurance and reinsurance companies has out-paced upgrading by a 2 to 1 margin. This downgrading has resulted in companies closing their doors, and in some instances, going insolvent. The downgrading of reinsurers far outpaces that of ceding companies. Some of the local ceding companies that have gone insolvent include Reliance and Legion. More recently, PMA Reinsurance Corporation closed its doors after being downgraded from an A rating.
As a result of the foregoing, the "follow the fortunes" doctrine has been under attack, and disputes have increased significantly. Old business partners are compelled to deal with each other in more of an "arms-length" manner, and payments from reinsurers have slowed down considerably (as closer scrutiny is paid to all transactions by the participants).
Knowledge of the "behind-the-scenes" world of reinsurance is beneficial to all insurance industry professionals, as well as corporate risk managers and counsel. Direct insurance claims are inevitably influenced to some degree by the underlying reinsurance arrangements in place, and a working knowledge of the topic will enhance insurance claims handling by all the participants to the process.
Timothy W. Stalker is a Partner who heads up the Reinsurance Practice in the Recovery Group at Nelson Levine de Luca & Horst, LLC. The firm, whose main office is in the Philadelphia area, focuses on the business of insurance and specializes in the defense of class action and other types of complex litigation. Please visit www.nldhlaw.com for additional information.