Key Concepts for Captive Insurance Reinsurance Contracts

We start by asking an open question of all the captive owners and board members who read Captive Wire. Have you read your reinsurance contracts in their entirety? Do you understand all of the sections and language used? Do you know whether there are any differences in conditions that exist between your reinsurance contracts and your own coverage documents? If you answered no to our question, who has read them on your behalf, and have they reported any issues you should be concerned about? Having just been part of a rather lengthy case involving a reinsurance dispute, this editor thinks an article on key concepts for reinsurance contracts is warranted.

International Risk Management Institute, Inc. (IRMI), publisher of Captive.com and Captive Wire, offers a series of Expert Commentary articles on reinsurance. For those seeking a basic understanding of the complexities associated with reinsurance, we suggest this is an excellent starting point. The purpose of this article is to focus on some of the key concepts concerning reinsurance contracts and what captive insurers should be cognizant of when entering into a contract. This piece is not intended to be all-inclusive, nor should you rely on it as the final authority of any reinsurance contract wording. For that, we would recommend the use of a good reinsurance broker and/or reinsurance attorney.

For purposes of this discussion, we are going to focus on four key elements associated with a reinsurance contract, as follows.

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

Most of today's reinsurance contracts also contain arbitration clauses, which purportedly are intended to reduce the costs of litigation when conflicts do arise. Since we covered these in detail in a previous article, we won't add them to our list above. Suffice it to say, captive insurers need to make sure they truly understand how their reinsurance arbitration clause operates and under what ground rules.

The Doctrine of Utmost Good Faith

The doctrine of utmost good faith has been applied as a standard of conduct for reinsurance transactions for a long time. The concept, as it applies, is intended to establish the guidelines the ceding party (i.e., the entity seeking coverage), in this case the captive insurer, must follow when placing business with the assuming company, in this case the reinsurer. It flows from the idea that the party seeking coverage has the best understanding of the risk being reinsured. Therefore, the burden rests on the captive insurer to provide all information that may have a bearing on the risk being underwritten to the reinsurer. The two areas where this doctrine typically causes friction between the parties is the initial placement submission and when claims are filed.

In beginning the application process for reinsurance or when submitting a claim against an existing reinsurance contract, a captive insurer should seek to answer two basic questions, as follows.

• Have we truthfully disclosed all material facts concerning the risk being underwritten or the claim being submitted?
• And, if there is any information we haven't disclosed, why are these facts not deemed relevant to either the underwriting submission or the claim?

In both cases, but especially with claims, this is where a coverage opinion provided by an experienced reinsurance attorney can be invaluable. A good attorney will look to ensure the captive has followed all the established procedures when handling the claim as part of the process.

Placement Submission and Reinsurance Contract Wording

As we noted above, one area where the doctrine of utmost good faith comes into play is in the initial underwriting and issuance of a reinsurance contract. Captive insurers should play close attention to the reinsurance placement submissions that are sent to their current or potential reinsurance partners.

In many instances, the captive's reinsurance broker develops these reinsurance submissions, typically with input from the captive. Regardless of whether the broker asks for input from you, it is imperative that you see and read the reinsurance submission before it is submitted on your behalf to reinsurers. The penalty for failure to disclose any material facts can be the voidance of the contract by the reinsurer. Reinsurers can seek this remedy even in instances where the captive innocently misrepresented a material fact. Therefore, the more eyes that review the submission, particularly from the captive, the better.

An example of innocent misrepresentation concerns lines of business covered in treaty reinsurance. In a submission to the reinsurer, the captive indicates it does not currently intend to underwrite a line of business and therefore is not seeking coverage. However, when the treaty is issued, the line of business in question is included in the coverage. No one catches the discrepancy. Several years go by with the treaty being renewed with no changes. For some reason, most often driven by a policyholder, the captive decides to add coverage for the line of business it did not offer. In checking the treaty, the business line shows as covered and therefore no additional disclosure is made to the reinsurer. Then a claim arises that involves a reinsurance recovery. Does the reinsurer pay the claim since the treaty includes coverage, or does it deny the claim under the context that the captive indicated in its submission it did not write this type of coverage and never notified the reinsurer when the change was made?

Follow the Fortunes Concept

The "follow the fortunes" clause is a reinsurance doctrine that states the business fortunes of the reinsurer will follow the fortunes of the captive the company has agreed to reinsure. Typically, captives will look to have "follow the fortunes" language inserted into their reinsurance contract as a condition of the reinsurance. In doing so, the clause is intended to assure the reinsurers will follow the business decisions and fortunes of the captive as they arise in the normal course of business.

Where the reinsurer agrees to the insertion of a "follow the fortunes" clause in the contract, it is widely understood within the industry that the clause provides protection to the ceding company, in this case the captive. This protection amounts to the reinsurer agreeing to be party to the captive's underwriting and management of the business lines being reinsured through both good and bad results. Obviously, the captive and the reinsurer are mostly concerned with poor results due to unexpected or adverse loss developments.

However, an equally important corollary doctrine has evolved concerning the reinsurer's deference to the captive's claims-related business decisions and payments. Captives typically assume that the inclusion of the "follow the fortunes" clause is sufficient to ensure the reinsurer will provide coverage and payments on all claims the captive settles covered under the contract. While some courts have agreed with this interpretation, a better alternative for the captive is to include the additional "follow the settlements" clause.

Follow the Settlements Concept

The "follow the settlements" clause requires a reinsurer to afford its cedents' claims-related business decisions deference and may bind the reinsurer to the captive's objectively reasonable and good faith claims payments or settlement decisions. A follow the settlements clause can provide the captive with a wide degree of protections, including requiring immediate payment of any claim.

Given the unique relationship captive insurers have with their members and owners, a follow the settlements clause in their reinsurance contract provides additional protection that the reinsurer will be obligated to pay claims presented by the captive. It is important to note though that even here, the first concept we talked about, "utmost good faith," comes into play. While the captive has a vested interest in making sure all reasonable claims presented by its members are paid, it also must do so in a way that maintains this good faith requirement with its reinsurer.

Hopefully, all of your dealings with your reinsurance partners will be free from any disagreements. But by following these doctrines and having these clauses within your reinsurance contract, you can lessen the likelihood of these disagreements materializing.