Reinsurance


A contract between two insurance companies (insurers) whereby one company (the “reinsurer”) agrees to protect the other (the “reinsured”) from a risk already assumed.  The contract binds the reinsurer to pay to the reinsured the whole loss sustained in respect to the subject of the insurance to the extent to which it is reinsured.

Reference Desk

North River Insurance Co. v. CIGNA Reinsurance Co., 52 F.3d 1194 (3d Cir. 1995):

Before we discuss the parties’ contentions, some background is useful. Primary insurers, excess insurers, and reinsurers play different roles in the insurance industry. Both primary and excess insurers provide coverage directly to the insured policy holder. Primary insurance policies describe what kinds of liability will be covered and specify dollar limits. Excess insurers typically track the coverage offered by the primary insurer and also specify dollar limits, but the excess insurer’s liability is not triggered until the primary insurer’s limit is exhausted. Reinsurers do not provide coverage directly to the insured but issue certificates of reinsurance 1199*1199 to the excess or primary insurer, also specifying dollar limits.

Reinsurance is purchased by insurance companies to insure their liability under policies written to their insureds. See Henry T. Kramer, The Nature of Reinsurance, in Reinsurance 1, 5 (R.W. Strain ed., 1980). Typically, an insurer who has provided coverage against a large loss will cede all or part of that risk to other insurance companies along with a portion of the premiums. Ceding risk increases the insurer’s capacity to insure other customers and decreases the likelihood that insurer insolvency will result from any large claim.[4]

There are two types of reinsurance contract: treaty and facultative. Under a reinsurance treaty, the reinsurer agrees to accept an entire block of business from the reinsured. William G. Clark, Facultative Reinsurance: Reinsuring Individual Policies, in Reinsurance, supra, at 117, 121. Once a treaty is written, a reinsurer is bound to accept all of the policies under the block of business, including those as yet unwritten. Because a treaty reinsurer accepts an entire block of business, it does not assess the individual risks being reinsured; rather, it evaluates the overall risk pool. Id.

Facultative reinsurance entails the ceding of a particular risk or policy. Unlike a treaty reinsurer who must accept all covered business, the facultative reinsurer assesses the unique characteristics of each policy to determine whether to reinsure the risk, and at what price. Thus, a facultative reinsurer “retains the faculty, or option, to accept or reject any risk.” Id.; see also Francis M. Gregory, Jr. & Nicholas T. Christakos, Primary, Excess and Reinsurance Problems in Large Loss Cases, 59 Def.Couns.J. 540, 543 (1992) (“[T]he distinguishing characteristic is always the reinsurer’s right of individual risk rejection.”).

The reinsurance relationship depends on the reinsurer and the reinsured observing high levels of good faith. See Unigard III, 4 F.3d at 1069. The reinsured must keep its interests aligned with those of the reinsurer, see id., and the reinsurer must “follow the fortunes” of the reinsured, see Kramer, supra, at 12-13.

Reinsurance certificates usually employ standard forms. A reinsurance certificate typically includes a “following forms” provision that expressly limits the reinsurance to the terms and conditions of the underlying policy and provides that the reinsurance certificate will cover only the kinds of liability covered in the original policy issued to the insured. The reinsurance certificate often, as here, also includes a “follow the fortunes” clause, which is somewhat broader than the “following forms” clause and obligates the reinsurer to indemnify the reinsured for any good faith payment of an insured loss.

“Follow the fortunes” clauses prevent reinsurers from second guessing good-faith settlements and obtaining de novo review of judgments of the reinsured’s liability to its insured. See International Surplus Lines Ins. Co. v. Certain Underwriters & Underwriting Syndicates at Lloyd’s of London, 868 F.Supp. 917, 921 (S.D. Ohio 1994) (“Were the Court to conduct a de novo review of [the reinsured’s] decision-making process, the foundation of the cedent-reinsurer relationship would be forever damaged.”). But while a “follow the fortunes” clause limits a reinsurer’s defenses, it does not make a reinsurer liable for risks beyond what was agreed upon in the reinsurance certificate. See Bellefonte Reinsurance Co. v. Aetna Casualty & Sur. Co., 903 F.2d 910, 914 (2d Cir.1990); see also Kramer, supra, at 13 (“[T]he concept of follow fortunes cannot create a reinsurance where none exists.”). In that regard, the reinsurer retains the right to question whether 1200*1200 the reinsured’s liability stems from an unreinsured loss. A loss would be unreinsured if it was not contemplated by the original insurance policy or if it was expressly excluded by terms of the certificate of reinsurance.

Unigard Security Insurance Co., Inc. v. North River Ins. Co., 4 F.3d 1049 (2d Cir. 1993):

A. THE BUSINESS OF REINSURANCE

Reinsurance occurs when one insurer (the “ceding insurer” or “reinsured”) “cedes” all or part of the risk it underwrites, pursuant to a policy or group of policies, to another insurer. See 13A John A. Appleman & Jean Appleman, Insurance Law and Practice § 7681, at 480 (1976); 19 George J. Couch, Cyclopedia of Insurance Law § 80:1, at 624 (2d ed. 1983). The reinsurer agrees to indemnify the ceding insurer on the risk transferred.

The purpose of reinsurance is to diversify the risk of loss, see Delta Holdings v. National Distillers, 945 F.2d 1226, 1229 (2d Cir.1991), and to reduce required capital reserves. See Colonial Am. Life Ins. Co. v. Comm’r, 491 U.S. 244, 246, 109 S.Ct. 2408, 2410, 105 L.Ed.2d 199 (1989). Spreading the risk prevents a catastrophic loss from falling upon one insurer. By reducing the legal reserve requirement, the ceding insurer then possesses more capital to invest or to use to insure more risks. See Bart C. Sullivan, Reinsurance in the Age of Crisis, 38 Fed’n Ins. & Corp. Couns. Q. 3, 4 (1987).

There are two basic types of reinsurance policies — facultative and treaty. See generally 1 Klaus Gerathewohl, Reinsurance Principles and Practice 64-128 (1980) (discussing 1054*1054 various types of reinsurance coverage). In facultative reinsurance, a ceding insurer purchases reinsurance for a part, or all, of a single insurance policy. Treaty reinsurance covers specified classes of a ceding insurer’s policies. As the district court explained, a “typical treaty reinsurance agreement might reinsure losses incurred on all policies issued by the ceding insurer to a particular insured, while facultative reinsurance would be limited to the insured’s losses under a policy or policies specifically identified in the reinsurance agreement.” Unigard, 762 F.Supp. at 572 n. 2.

The reinsurer is not directly liable to the original insured. See Unigard, 79 N.Y.2d at 582, 584 N.Y.S.2d 290, 594 N.E.2d 571. Reinsurance involves contracts of indemnity, not liability. Id. at 582-83, 584 N.Y.S.2d 290, 594 N.E.2d 571. Reinsurers do not examine risks, receive notice of loss from the original insured, or investigate claims. Id. at 583, 584 N.Y.S.2d 290, 594 N.E.2d 571. In practice, the reinsurer has no contact with the insured.

To enable them to set premiums and adequate reserves, see Delta Holdings, 945 F.2d at 1229, and to determine whether to “associate” in the defense of a claim, reinsurers are dependent on their ceding insurers for prompt and full disclosure of information concerning pertinent risks. The reinsurance relationship is often characterized as one of “utmost good faith.” This utmost good faith may be viewed as a legal rule but also as a tradition honored by ceding insurers and reinsurers in their ongoing commercial relationships. Historically, the reinsurance market has relied on a practice of the exercise of utmost good faith to decrease monitoring costs and ex ante contracting costs. Reinsurance works only if the sums of reinsurance premiums are less than the original insurance premium. Otherwise, the ceding insurers will not reinsure. For the reinsurance premiums to be less, reinsurers cannot duplicate the costly but necessary efforts of the primary insurer in evaluating risks and handling claims. Reinsurers may thus not have actuarial expertise, see Delta Holdings, 945 F.2d at 1241, or actively participate in defending ordinary claims. They are protected, however, by a large area of common interest with ceding insurers and by the tradition of utmost good faith, particularly in the sharing of information. Because repeat transactions are the norm, reputation is thus important to commercial success and the loss of repeat business is a penalty that usually outweighs the short-term gains of misrepresentations or stonewalling contractual obligations. The New York Court of Appeals thus recently commented: “This appeal calls upon us to resolve a question of reinsurance law — a field in which differences have often been settled by handshakes and umpires, and pertinent precedents of this court are few in number.” Sumitomo Marine & Fire Ins. Co. v. Cologne Reins. Co. of Am., 75 N.Y.2d 295, 298, 552 N.Y.S.2d 891, 552 N.E.2d 139 (1990).

However, in recent years, the reinsurance market has witnessed an increase in participants and a decline in profitability due to huge environmental losses. This has led some commentators to question the continued vitality of utmost good faith as a description of the current practices in the reinsurance market, see Eugene Jericho, Insurance and Reinsurance Disputes, 55 Def. Couns. J. 289, 289 (1988), and argue that the market is now one of caveat emptor. John Milligan-Whyte & Mary Cannon Veed, Bermudian, English and American Reinsurance Arbitration Law and Practice and Alternative Dispute Resolution Methods, 25 Tort & Ins. L.J. 120, 124 (1989). See also Unigard, 762 F.Supp. at 591 (noting that the customs and practices of reinsurance had changed due to the “overwhelming pressures” of huge environmental losses like asbestos); Steven W. Thomas, Note, Utmost Good Faith in Reinsurance: A Tradition in Need of Adjustment, 41 Duke L.J. 1548, 1558-61 (1992).

If these commentators are correct, the reinsurance industry may encounter severe difficulties. It involves a market that has relied upon informal understandings and practices that cause participants to act toward each other with the good faith expected of joint venturers. Whether the industry can thrive if these understandings and practices are eroded and replaced by litigation is an open question.