Key Concepts for Captive Insurance Reinsurance Contracts

A key on top of wooden desk next to a ontract

March 25, 2024 |

A key on top of wooden desk next to a ontract

Captive insurance company owners and board members, have you thoroughly reviewed your reinsurance contracts? Do you understand all sections and the language employed? Are you aware of any differences in conditions between your reinsurance contracts and your own coverage documents? If you've answered no to these questions, who has conducted this review on your behalf, and have they identified any potential concerns that warrant your attention?

For those seeking a foundational understanding of the intricacies surrounding reinsurance, we recommend starting here. The aim of this article is to highlight key concepts regarding reinsurance contracts and what captive insurers should consider when entering into such agreements. It's important to note that this piece is not exhaustive, and it should not be regarded as the definitive authority on all reinsurance contract language. For comprehensive guidance, we advise consulting a reputable reinsurance broker and/or reinsurance attorney.

For the purpose of this discussion, we will focus on four key elements associated with reinsurance contracts as follows.

  • The doctrine of utmost good faith
  • Potential conflicts between underwriting submissions and reinsurance contract wording
  • The "follow the fortunes" concept
  • The "follow the settlements" concept

Additionally, most reinsurance contracts today include arbitration clauses, aimed at minimizing litigation costs in case of conflicts. As we've extensively covered these in a previous article, we won't include them in the current list. However, it's imperative for captive insurers to thoroughly grasp the operation and ground rules of their reinsurance arbitration clauses.

The Doctrine of Utmost Good Faith

The doctrine of utmost good faith has long been a standard of conduct in reinsurance transactions. This concept dictates the guidelines for the ceding party (in this case, the captive insurer) when dealing with the assuming company (the reinsurer). It stems from the notion that the party seeking coverage possesses the most comprehensive understanding of the risk being reinsured. Therefore, it is incumbent upon the captive insurer to disclose all relevant information to the reinsurer that may impact the risk being underwritten. Friction typically arises between the parties during the initial placement submission and when claims are filed.

When initiating the reinsurance application process or submitting a claim against an existing reinsurance contract, captive insurers should address two fundamental questions as follows.

  • Have we fully disclosed all material facts regarding the risk being underwritten or the claim being submitted?
  • If there is any undisclosed information, why are these facts not considered relevant to either the underwriting submission or the claim?

In both instances, particularly with claims, seeking a coverage opinion from an experienced reinsurance attorney can be invaluable. A skilled attorney will ensure that the captive insurer has adhered to all established procedures throughout the claims process.

Placement Submission and Reinsurance Contract Wording

As highlighted earlier, the doctrine of utmost good faith is particularly pertinent during the initial underwriting and issuance of a reinsurance contract. Captive insurers must scrutinize the reinsurance placement submissions sent to their current or prospective reinsurance partners.

In many cases, these submissions are developed by the captive insurer's reinsurance broker, often with input from the captive itself. Regardless of whether the broker seeks input, it is crucial for captive insurers to review and understand the reinsurance submission before it is presented to reinsurers on their behalf. Failure to disclose material facts can lead to the contract being voided by the reinsurer, even in cases of innocent misrepresentation by the captive. Therefore, thorough review by multiple parties, including the captive insurer, is essential.

An instance of innocent misrepresentation could involve lines of business covered in treaty reinsurance. For example, the captive may indicate in the submission that it does not intend to underwrite a certain line of business and thus is not seeking coverage for it. However, when the treaty is issued, the line of business is included in the coverage without anyone noticing the discrepancy. Several years later, the captive decides to add coverage for this line of business without notifying the reinsurer of the change. When a claim arises involving a reinsurance recovery, the reinsurer may face a dilemma: whether to pay the claim based on the treaty's coverage or deny it, citing the captive's initial indication that it did not write this type of coverage and failure to notify the reinsurer of the change.

Follow the Fortunes Concept

The "follow the fortunes" clause in reinsurance doctrine stipulates that the reinsurer's business fortunes will track those of the captive insurer it has agreed to reinsure. Captives commonly seek to include this language in their reinsurance contracts to ensure that reinsurers align with their business decisions and outcomes.

When a reinsurer consents to incorporating a "follow the fortunes" clause, it signifies a commitment to support the captive's business decisions and underwriting throughout normal operations for the business lines being reinsured. This commitment provides crucial protection to the ceding company, offering reassurance that the reinsurer will stand by them through both favorable and adverse results, particularly in the face of unexpected losses.

Yet, an equally significant aspect of this doctrine concerns the reinsurer's deference to the captive's claims-related decisions and payments. While captives often assume that the "follow the fortunes" clause suffices for securing coverage and payments on all settled claims under the contract, some courts have indicated otherwise. To ensure comprehensive protection, it is advisable for captives to include an additional "follow the settlements" clause in their contracts.

Follow the Settlements Concept

The "follow the settlements" clause mandates that a reinsurer must respect its cedents' claims-related business decisions, potentially obligating the reinsurer to honor the captive's objectively reasonable and good faith claims payments or settlement choices. This clause offers the captive extensive protections, including the requirement for immediate payment of any claim.

Given the unique relationship captive insurers share with their members and owners, incorporating a "follow the settlements" clause into their reinsurance contracts offer additional assurance that the reinsurer will be bound to fulfill claims presented by the captive. However, it's essential to recognize that even in this scenario, the principle of "utmost good faith" remains crucial. While the captive is vested in ensuring that all reasonable claims from its members are settled, it must also do so in a manner that upholds the requirement of good faith with its reinsurer.

By adhering to these doctrines and incorporating relevant clauses into your reinsurance contract, you can mitigate the chances of encountering disagreements with your reinsurance partners. Here's to smooth dealings ahead!

March 25, 2024