Reinsurance

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REINSURANCE

The contract made between an insurance company and a third party to protect the insurance company from losses. The contract provides for the third party to pay for the loss sustained by the insurance company when the company makes a payment on the original contract.

A reinsurance contract is a contract of indemnity, meaning that it becomes effective only when the insurance company has made a payment to the original policyholder. Reinsurance provides a way for the insurance company to protect itself from financial disaster and ruin by passing on the risk to other companies. Reinsurance redistributes or diversifies the risk or threat associated with the business of issuing policies by allowing the reinsured to show more assets by reducing its reserve requirements. The reinsurance industry became more popular during the late 1990s and early 2000s because natural disasters and mass tort litigation resulted in large payouts by insurance companies. Because of the large size of the payments, some insurance companies became insolvent.

The parties to the reinsurance contract are the reinsurer, the reinsured, and the original policyholder. The reinsurer is the third party or the company issuing the reinsurance policy. Typically, reinsurers engage solely in the business of issuing reinsurance policies; however, any company that meets the requirements and is authorized to issue insurance may issue such policies. The reinsured is the insurance company that issued the first policy and is applying for reinsurance. The original policyholder or original insured is the party who purchased the original policy. When the reinsurance contract is between just the two insurance companies (the reinsured and the reinsurer), the original policy-holder usually has no rights against the reinsurer.

The reinsurance policy covers the risk or liability associated with the original policy issued. The reinsurance policy must be for a specific insurable interest. The interest to be insured must exist at the time the reinsurance policy is issued; it cannot be created later. All or part of the liability of the original policy can be covered by the reinsurance, but nothing greater. The reinsurance policy cannot cover a period longer than the original policy. Generally, because the reinsurance is not a promise to pay the debt of another but to indemnify a potential liability, the statute of frauds does not require the agreement to be in writing. Most often in practice, however, reinsurance policies are written to avoid problems later.

The two basic types of reinsurance are facultative reinsurance and treaty reinsurance. Facultative reinsurance is issued on an individual analysis of the situation and facts of the underlying policy. It may cover all or part of the underlying policy. By deciding coverage case by case, the reinsurer can determine if it wants the risk associated with that particular policy. Facultative reinsurance is used by the reinsured to reduce the chance of loss or risk associated with a certain policy.

Treaty reinsurance, on the other hand, is written to cover a particular class of policies issued by the reinsured. Examples of classes covered by treaty reinsurance are all property insurance policies or all casualty insurance policies written by the reinsured. Treaty reinsurance automatically passes the risk to the reinsurer for all policies that are covered by the treaty, not just one particular policy. Treaty policies are more general than facultative policies because the reinsurance decision is based on general potential liability rather than on a specific enumerated risk.

In addition to the two types of reinsurance issued, there are two ways that coverage can be allotted between the parties: either proportionally or non-proportionally. In the case of proportional reinsurance, the reinsured obtains coverage for only a portion or percentage of the loss or risk from the reinsurer. The proportion of coverage is typically based on the percentage of premiums paid to the reinsurer. For example, if the reinsured pays 40 percent of the premiums to the reinsurer, then the reinsured recovers 40 percent of its losses when it pays the original policyholder according to the original policy terms. The reinsured can only recover a portion of its total loss, not the entire amount. The amount actually paid by the reinsurer is not figured into the reinsurance contract, only the percentage of loss the policy will cover.

In contrast, non-proportional reinsurance covers a set amount of loss. A base or deductible amount is set in the reinsurance policy, and any loss exceeding that amount is paid by the reinsurer. The amount being paid by the reinsurer has no relationship to the premiums received. The reinsured, in effect, is reimbursed for all payments made under the original policy that exceed the deductible amount. The deductible amount can be figured either by each event or in the aggregate. Either type of coverage can be used in either facultative or treaty insurance contracts. The terms of the policy depend on the situation and the relationship the reinsured and the reinsurer have had in the past. Reinsurance policy terms can be made to be flexible for the appropriate facts at the time.

Although the terms of the policies can be flexible, several doctrines help to define the nature of the reinsurer and reinsured relationship. These doctrines are the duty of utmost good faith and the doctrine of "follow the fortunes." The duty of utmost good faith has several facets, including the requirement that both parties to the reinsurance contract deal with each other with candor and honesty. The duty assumes that both parties are sophisticated and knowledgeable in the insurance industry. As a result, they should be aware of what is relevant and necessary for the other party to know. The reinsured must follow the duty by disclosing all material facts to the reinsurer that relate to or affect the original policy and its calculated risk. The reinsured must essentially put the reinsurer in the same position as it would be in when deciding about the risks and the possibility of coverage on the original policy.

In addition, the duty requires that the reinsured act with honesty in negotiating any settlement with the original policyholder. If the settlement is not handled by following the appropriate business procedures, the reinsurer may not be bound by its terms and then does not have to pay under the policy coverage.

Lastly, the duty of utmost good faith requires the reinsured to provide adequate notice of any claim or potential claim to the reinsurer. For notice to be adequate, it should be given as soon as the reinsured becomes aware of a potential claim. To be aware, the reinsured must investigate with diligence to discover these possible claims. Notice is required to make the reinsured aware of the possible need for available funds in case a claim is filed. Notice also allows the reinsured to participate, if desired, in the defense of the underlying claim. Practically, reinsurers may also use the notice of potential claims to determine renewal of, or change in, premiums under the reinsurance contract. The duty of utmost good faith that is part of reinsurance policies requires the reinsured and reinsurer to deal honestly with each.

Also implicit to reinsurance policies is the follow-the-fortunes doctrine. "Follow the fortunes" means the reinsurer should follow along with the reinsured's payment to the original policyholder. Provided the reinsured makes a good faith payment that reasonably falls within the terms of the original policy to the policyholder, the reinsurer is then required to make payment according to the terms of the reinsurance policy. The reinsurer should make the payment even if payment is not specifically mandated under the terms of the policy but is arguably within the meaning of its terms. The doctrine is meant to encourage coverage by reinsurers and discourage unnecessary litigation by the parties over interpretation of the policy.

The follow-the-fortunes doctrine does have limits to protect the reinsurer from excessive payments. The reinsurer is not obligated to cover payments made by the reinsured that are clearly outside of the policy language. Also, the reinsurer is not obligated to follow the business fortune of the reinsured, only the insurance-related fortune of the company. The reinsurer need only indemnify for the type of loss intended by the policy, not losses due to uncollectible premiums. Losses clearly related to the business decision and not the policy are not within the scope of the doctrine. The follow-the-fortunes doctrine implies a duty by the reinsurer to indemnify reasonable payments made by the reinsured under the underlying insurance policy.

Once the policy terms and the parties' relationship are defined, several defenses are available to the parties to avoid liability. Defenses that may be available include normal contract defenses, inadequate notice and failure to disclose, or misrepresentation. Usually any defense available to either party to a contract would be available to either the reinsurer or the reinsured. Those defenses can include impossibility of performance, an act outside the parties' authority, actions by a party that are inconsistent with the policy, actions by a party that unreasonably increase the risk, or misconduct by the parties. Any defense that would be an option for a party under the original insurance policy is available for the parties to the reinsurance policy.

The defense of inadequate notice is available to the reinsurer. If the reinsured has violated its duty to give prompt and reasonable notice to the reinsurer, the reinsurer may be able to reduce or refuse payment under the policy. Because of the relationship between the parties, the reinsured is required to comply fully with all the terms of the policy or the reinsurer is not necessarily obligated. However, the reinsurer must often show that it has been prejudiced or hurt by the lack of notice in order to avoid liability on the policy.

The most common defense available to the parties is the failure to disclose (also referred to as fraud, misrepresentation, or concealment). This defense is tied heavily to the duty of utmost good faith because both deal with the disclosure of material facts. For the reinsurer to assert the defense of failure to disclose, the reinsured must have concealed some relevant or important information. Relevant information would include facts such as a claim previously filed under the original policy or an unusually high risk related to the original policy. The failure to disclose need not be an intentional statement known to be false; it could be the reinsured's failure to investigate and determine the truth of a fact. When deciding if a fact or information is material or relevant, the courts ask if the misrepresented or withheld information, if disclosed, would have changed the reinsurer's decision to issue the policy. The false statement alone is not enough to avoid liability; the reinsurer must have acted upon that misrepresentation in such a way that it was prejudiced. If the reinsurer's decision or action would have been different regarding the risk, it may be relieved of liability.

Generally, the original policyholder has no rights against the reinsurer. Because the original policyholder has no contract with the reinsurer, they have no obligations to each other. This arrangement can be altered by inserting language into the reinsurance policy allowing the original policyholder to obtain payment directly from the reinsurer. Such language often is effective only when the reinsured becomes insolvent or unable to pay. These clauses are not often used because a reinsured can view such clauses as a lack of confidence in its ability to pay. The clause may be used in the case of a reassignment or sale of the policy to another insurance company to protect the original insured.

Without specific language in the policy, the original policyholder has few rights with the reinsured. If the reinsured becomes overly active in the claim process and defense, it could open itself to a direct claim. The original insured can bring an action against the reinsurer if the reinsurance policy requires the reinsurer to pay any claim directly to the original policyholder. The original policyholder is considered a third-party beneficiary and can sue either the reinsured or the reinsurer. The recovery obtained by the original policyholder cannot be more than the total loss.