By Randall Kleinman, JD, CPCU, CLU, ARe
(Agents' Legal Issues provides a brief general overview of a complex area of law, and neither the author nor Rough Notes intends it to be taken as legal advice for any specific legal problem. For a specific problem, consult legal counsel that understands the law of insurance and insurance agencies and provide all the details.)
Reinsurers affect agents' lives tremendously. A lot of their power comes from their invisibility. One or more reinsurers may be wielding a ton of influence over your agency, and you don't even know it!
This article will take a look at reinsurers, their influence over agents, and how the laws of reinsurance shape the world of insurance and insurance agencies.
The secret power of reinsurers
Let's say you're an agent with a hot new prospective client. This client is a large bike shop, very successful in town, expanding with a second shop in a neighboring town, and doing a terrific business in a health-conscious society, getting good local publicity with its recreational bike trips and friendly races for the townspeople. You bring the application for $2 million in liability coverage to an underwriter (or, more likely these days, e-mail or fax the information to the underwriter) and are told that this one may take a while, even in these days of supposed quick turnaround.
A week later, you are told "Sorry, we can't do this one. We'd really like to, but we just can't." After you press for a more detailed response, the underwriter grudgingly admits, "Well, our excess-of-loss contract won't permit it, and we couldn't get a fac deal set up on it." Although pressed for more information, the underwriter will say no more.
What in the world of insurance is going on here?
Who invited these guys, anyway?
Reinsurers have an impact on the large majority of insurance policies written. Their influence can make or break a carrier, and so the carriers pay attention to the reinsurers. Who invited these guys? Let's see the various reasons why a reinsurer might be invited to participate in a book of business.
In the early days of insurance, insurers often went broke because they took on more than they could handle. Nothing prevented an early insurer from issuing a policy with a $50,000 limit even if it only had $50,000 total in surplus. Eventually, laws were passed to prevent an insurer from issuing a policy with a limit more than 5% or 10% (depending on the state, and sometimes on the type of policy) of a carrier's surplus. Laws were also passed preventing the carrier from writing a total amount of premium in excess (typically) of three times its surplus. These limitations on a carrier, although wise and sensible, caused business to be lost. So carriers began to turn to reinsurers as a way of dealing with these limitations and others:
* Insurance regulators may allow reinsurance with an acceptable reinsurer as a way of circumventing the limitations mentioned above.
* A carrier, even though not limited by insurance laws and regulators, may well choose to deal with a reinsurer to minimize its risk in a book of business about which it is uncertain, or in which it wishes to have less total exposure.
* Some carriers see themselves more as sales organizations than risk takers, preferring to emphasize production of business, and to leave most of the actual risk of loss to a reinsurer.
* Publicly-held insurers may wish to minimize the uncertainties of particular hazards, such as hurricanes, by "reinsuring out" catastrophic and volatile potential losses. That way, the stockholders aren't unduly upset by wild swings in the publicly-held insurer's results from year to year.
* A carrier that wants to diminish or totally drop a book of business can get that business reinsured.
A typical deal between a carrier and a reinsurer will involve hundreds, or even thousands or policies. Such a deal is called a "treaty." If it involves a sharing of premiums and losses (50/50 or even 90/10), it's called proportional reinsurance, with the most common type being "quota share." If it involves just covering the losses above a certain loss amount (for example, any loss above $100,000), it's called excess-of-loss reinsurance.
The Second Circuit Federal Court of Appeals recently had this to say about reinsurance:
"Reinsurance is not new....It dates back to the time the first bookie, fearful that he could not cover all his bets in the event he were to lose, decided to spread his risk by 'laying-off' some of the risks by getting other bookies to share his exposure..." Continental Casualty Co. -v- Stronghold Ins. Co. (1996) 77 F.2d 16.
The bike shop declination revealed
In the case of the bike shop, the underwriter recognized a general liability and products liability risk that was out of the ordinary. It was both a large risk, needing higher limits, and a risk that involved recreational liability and racing. When the underwriter contacted his company's people who handle "cessions" of reinsurance, he was told that the carrier "retains" only $25,000 of risk on any one policy, while reinsuring out all losses from $25,000 up on an "excess of loss" basis. The bike shop wanted $2 million in limits, but the reinsurance only covered a maximum of $975,000 above the $25,000. Furthermore, the reinsurance "contract" contained exclusions for recreational risks and racing, restricting its coverage to Main-Street-type businesses. The people who handle cessions asked about a single-policyholder reinsurance contract, called a "facultative contract," or "fac" for short, but the premium involved for this bike shop was not so large that the reinsurer was interested in constructing a contract for this one client alone, especially since this reinsurer didn't specialize in reinsuring recreational and racing risks.
If the carrier had been willing to issue a policy with $1 million in limits you could have sought excess insurance (as distinguished from "excess-of-loss" insurance) from another carrier. That excess insurance would kick in if the underlying policy was exhausted. However, excess insurance is not considered reinsurance, since it is issued to the policyholder.
Reinsurers--are they even in the business of insurance?
One can be excused for wondering if reinsurers are even in the business of insurance. Some reinsurers never meet insureds or agents, do not issue insurance policies, and may not even have claims departments. If you have acquaintances who work exclusively in reinsurance, you may have noticed that some of them are quite different from people who work as agents or underwriters: the historical image of the reinsurance professional has been the person who is one of "the elite," at home with huge amounts of premium per reinsurance contract, sophisticated in the analysis of overall books of business, dealing with "contracts" rather than policies, and whose hands aren't sullied by day-to-day contact with individual agents and policyholders. This author remembers asking one reinsurance underwriter about his mid-sized company's claims department and was told that since they typically had only one or two claims per year, they didn't have a claim department per se. Of course, the one claim they'd received the previous year was for $100 million, so it wasn't as though they never had any losses.
For the person who finds even reinsurance too mundane, there is also the business of "retrocessions," which is where reinsurers choose to reinsure out part of the risk they've taken on. The companies that accept retrocessions, called "retrocessionaires," must be extremely careful in their activity, since they find themselves far in the chain of relationships from the policyholder and the risk.
The mechanics of reinsurance
The process of reinsurance usually starts before a policy is written by the carrier (called the "primary insurer" by reinsurers). The carrier wants to make sure it has a reinsurance program in place to protect it for the reasons mentioned above, so it looks for a reinsurer with whom to enter into a reinsurance contract. Some carriers use "reinsurance intermediaries" (sometimes called "reinsurance brokers") to handle the negotiations. Some intermediaries may also have arrangements with reinsurers where they act as managing general agents or managing underwriters, of a sort, for the reinsurers. Other carriers deal directly with reinsurers. Reinsurers fall into two categories, those that do only reinsurance, and those that do both primary insurance and reinsurance.
Big reinsurers in the United States include General Re and Employers Re, but much reinsurance has always gone out of the country to big European reinsurers such as Lloyd's, Munich Re, Swiss Re, and others. You may think you're "selling American" when you use a locally owned carrier to compete against an agent that represents a carrier owned by a foreign corporation, but many carriers that are locally owned are actually sending much of the premium money overseas!
Once the agreement has been reached, it is described fairly briefly in a short document. Various documents may be involved (the "slip," the "cover note," or the "interest and liabilties agreement"), and each has a different legal meaning.The important thing for an agent to note is that the actual reinsurance contract may not be issued for many months, while the carrier and reinsurer rely on a few short documents to describe what they have arranged. The eventual detailed document is called a "contract" rather than a policy because the legal relationship between the carrier and the reinsurer is much different than the relationship between a policyholder and a carrier.
Historically, reinsurance was a very "genteel" business. In the old days, carriers usually didn't lose money, what with loss ratios under 100 year after year, and so reinsurers didn't lose money either. The result was that reinsurance, seen as a structuring mechanism for the various reasons noted above, involved long-term relationships where both sides could be gracious and overlook small mistakes on the other side's part. That situation has changed greatly, but some remnants of that historical relationship still exist.
Important legal consequences of reinsurance contracts
From the point of view of an agent, the most important consequence of reinsurance is that carriers will usually not take on a risk that isn't covered by their reinsurance. They may be violating state law by taking on a risk that is too large; but even if there is no legal violation of state law, they would be ignoring a carefully constructed plan to control their own risk. But this one consequence is by no means the only important consequence.
Insolvency. It is typical that reinsurers are obligated in reinsurance contracts to continue to pay claims if the primary carrier becomes insolvent. If your carrier goes insolvent, you as an agent will probably be extremely upset (some E&O policies do not cover policyholder claims made against you because a carrier went insolvent). But the reinsurer behind the carrier may yet save the day, at least in part.
Arbitration. Unlike the situation between policyholders and carriers where disputes are hardly ever settled by binding arbitration, most reinsurance contracts require arbitration between a carrier and a reinsurer. The parties to a reinsurance contract have always felt that their arrangements are so technical and specific that a typical judge or jury could not hope to understand. Since reinsurance contracts are different than insurance policies, the way arbitration looks is also much different than court cases involving insurance policies. The amount in dispute may be hundreds of millions, and the arbitration is almost always adjudicated in a conference room by experienced reinsurance professionals. Reinsurance contracts sometimes require that such adjudicators be current or former officers of insurance companies having substantial reinsurance experience. Since current officers often can't spare the time to adjudicate a big dispute (or may even have a conflict of interest, if one party is a competitor), the adjudicators are frequently retired reinsurance professionals, or reinsurance consultants who formerly worked in reinsurance companies.
Oddly enough, unlike in other types of disputes, a carrier and a reinsurer may have a dispute and still remain friends. Since their treaty may involve several years' worth of policies, they may need to remain on good terms with one another during and after the dispute. The genteel nature of the relationship and of the arbitration come into play here, as a result.
As was stated in the Continental Casualty case:
"Although it has been said that the relationship between a reinsured and its reinsurer is not technically a fiduciary one...centuries of history have treated both as allies, rather than adversaries...Because custom and usage have established a gentility and unity of interest between the reinsured and its reinsurer...(reinsurance is 'a field in which differences have often been settled by handshakes and umpires'), a generation ago, we doubt that the defendants would even have considered asserting a statute of limitations defense."
Reinsurance disputes can often be extremely complex. Many "layers" of reinsurance may exist, and lots of insurance and reinsurance companies may have a role. For example, here is an appellate court's description of a reinsurance treaty arrangement that erupted into arbitration and litigation:
"The London reinsurers participated only in so-called 'second layer treaties' involving a layer of $4 million of coverage in excess of a $1 million per occurrence. They agreed to an aggregate endorsement that gave North River certain options to combine products liability claims and submit them to the London reinsurers for coverage under various formulae. The aggregate endorsement was not included in the treaties to which the U.S. reinsurers subscribed.
"North River, having paid GAF under its primary policies, presented claims to the reinsurers. While the seven other reinsurers paid North River, the U.S. and London reinsurers declined to pay claims, in whole or in part, contending that the asbestos claims arose from 'multiple occurrences,' while North River contended that only one occurrence was involved. Calculations in respect of the London reinsurers were further complicated by the effect of the aggregate endorsement.
"In December 1988, North River commenced arbitration proceedings against the U.S. reinsurers, and on October 3, 1989, served a separate notice of intention to arbitrate against the London reinsurers. The London reinsurers and the U.S. reinsurers chose the same arbitrator, and North River appointed the same arbitrator in both proceedings, but the two arbitrators were unable to choose a third. It was at that point, October 30, 1989, that North River commenced this independent proceeding pursuant to the Federal Arbitration Act... " North River Insurance Company -v- Philadelphia Reins. Corp. (1995)63 F.3d 160, cert. den. 116 S.C. 1289.
Offset. The offset clause has been involved in some high-publicity disputes in the last several years. Typically, the reinsurer (or the carrier, called the "ceding company") is entitled to "offset" amounts owed, such as, for example, reinsurance premiums that are still owed, in considering payment of claims. However, in the case of insolvency, the insurance regulators, acting as liquidators, try to hold onto every last possible penny for the benefit of policyholders, and so the fine print of offset clauses can get called into issue.
Errors and Omissions Clause. Another example of the genteel approach in reinsurance, the errors and omissions clause, covers up for mistakes made because of the large number of policies that may be involved in a treaty. The clause generally states that even because of an error in including or failing to include a particular policy for coverage under the contract, if the mistake is fixed promptly, the mistaken party won't be penalized.
Follow the Fortunes. Many agents, if they know nothing else about reinsurance, have heard that reinsurers have a legal obligation to "follow the fortunes" of the carrier; in other words, that whatever the primary insurer has an obligation to do, the reinsurer must do for its part of the liability. This phrase, while it still appears in many contracts, has been the subject of a number of disputes, with the result that its interpretation has now been somewhat weakened. Whether a reinsurer must strictly "follow the fortunes" of the primary company depends on other language in the reinsurance contract, and depends on prior decisions interpreting that phrase.
Utmost Good Faith. A body of law has grown up around the relationship between a policyholder and his/her carrier, requiring the carrier to play fair with the policyholder, due to the carrier's much greater resources. Such a body of law does not exist for relationships between carriers and their reinsurers. Even though one could say that a small carrier may be disadvantaged vis-a-vis a big reinsurer upon whom it relies for payment of reinsurance claims, the law has seen the carrier as being in an advantaged position because it deals directly with the policyholder, deals directly with claimants, does investigations, chooses which submissions it will underwrite and thus have reinsured under a treaty, etc. As a result, the carrier bears the bulk of the responsibility to act "in utmost good faith" under the reinsurance contract.
Right to Defend. A reinsurance contract will usually give the reinsurer the right (but not the duty) to defend any case where the reinsurer may have some eventual liability. This right is especially important in the case of large claims, or near-insolvent primary carriers. However, in the modern world, involvement in claims by the reinsurer involves the risk of being sued for bad faith, not to mention the expense of legal fees; so unless the reinsurer really has a strong interest, it will generally refuse to get involved directly in the handling of any one particular claim.
Getting up to speed on reinsurance
Want to learn more about reinsurance? It used to be that you had to learn reinsurance on the job, because there was no other way to learn. Now, however, one can take courses. For example, in 1990, the American Institute for Property and Liability Underwriters introduced the Associate in Reinsurance designation, (called "ARe" for short). Many reinsurance professionals scurried to take the exams and receive the designation so that their expertise would be confirmed. This author became one of the first class of ARe designees and suggests the ARe series of courses for anyone who wants to learn more about the "secret" world of reinsurance. *
The author
Randall Kleinman, JD, CPCU, CLU, ARe, graduated from Stanford Law School in 1977 and has been involved in insurance since 1979. He is the editor of Insurance Magic, a publication that spots hidden trends, issues, and opportunities in the insurance industry, and also is Of Counsel for Selected Matters to the law firm of Sachs & Drake, of Morton Grove, Illinois.
©COPYRIGHT: The Rough Notes Magazine, 1998