Chapter Fifteen

• Jurisdiction: New York

Chapter Fifteen

Reinsurance

Larry P. Schiffer, Esq.*

* Stephen T. Brewi was one of the original authors of this chapter, and much of its structure and original background research is based on his work. Gordon Hwang, Melissa Battino, Riki King, Alexander Roberts, George Mustes, Daren Moreira, Devon Corneal, Kate Woodhall, James M. Hafner, Jr., Jamie Jackson, Stanford L. Moore and Kinal M. Patel assisted with earlier updates. The author would like to thank Lily C. Geyer and India Scarver for their assistance with the current update of this chapter.

I. Introduction

Reinsurance is a formerly quiet and largely unknown part of the insurance industry that in the last decade has made it to the front pages of the public press. So what is reinsurance? Some call reinsurance “the insurance of one insurer by another.”¹⁶⁵⁹ Reinsurance is merely an extension of the basic theory of insurance: the spreading of risk between multiple insureds to an insurance company. In reinsurance, however, risk of loss is spread from a single policy-issuing insurance company to other insurance companies. These other insurance companies—reinsurance companies—assume a portion of the risk from the original insurance company.

New York has been in the forefront of reinsurance law through its statutes and regulations, and through the significant number of reinsurance cases decided by its courts. New York’s federal and state courts probably have more experience resolving reinsurance disputes than courts in any other jurisdiction; in fact, many of the leading reinsurance cases in the United States were, and continue to be, decided in New York.

II. Reinsurance, Generally

A. Nature of Reinsurance

When an insurer wishes to mitigate some of the risk it has undertaken under a policy of insurance issued to an insured, it transfers or “cedes” all or a portion of that risk to another insurer.¹⁶⁶⁰ This is known as reinsurance.¹⁶⁶¹ More formally, reinsurance is a contract between one insurer (the reinsured or “ceding insurer”)¹⁶⁶² and another insurer (the reinsurer or assuming company) by which the reinsurer agrees to assume all or part of the risk underwritten by the ceding insurer.¹⁶⁶³ In exchange for assuming a portion of the risk, the reinsurer receives a portion of the premium obtained by the ceding insurer on the underlying insurance policy.¹⁶⁶⁴

There are some basic differences between primary insurance and reinsurance. Reinsurance is a contract of indemnity between the ceding insurer and the reinsurer, not one of liability.¹⁶⁶⁵ Thus, a reinsurer ordinarily is not required to reimburse a ceding insurer for a loss until the underlying claim is actually paid by the ceding insurer.¹⁶⁶⁶ Depending on the terms of the reinsurance contract, however, a ceding insurer may have a right of payment from the reinsurer for a loss, even if the ceding insurer has not yet paid the loss on the underlying claim.

The reinsurer’s obligation to indemnify runs directly and solely to the ceding insurer.¹⁶⁶⁷ There is no privity between the reinsurer and the original insured;¹⁶⁶⁸ and, absent a specific provision to the contrary, the reinsurer has no obligation to the original insured.¹⁶⁶⁹ In general, the reinsurer is not responsible for providing a defense of the underlying claim, investigating the claim, or attempting to control the claim to obtain an early settlement.¹⁶⁷⁰ Instead, the burden typically falls solely on the ceding insurer.¹⁶⁷¹ The reinsurer is bound, however, by the ceding insurer’s good faith settlement of the underlying claim.¹⁶⁷²

One purpose of reinsurance is to permit the ceding insurer to mitigate its risk by minimizing its exposure.¹⁶⁷³ Reinsurance also allows a ceding insurer to “reduce the amount of the legally required reserves held for the protection of policyholders and to increase [its] ability to underwrite other policies or make other investments.”¹⁶⁷⁴ A ceding insurer will use reinsurance to protect itself from catastrophic losses, individual losses, losses by certain policyholders or specific lines of insurance, or financial downturns in the economy.

Reinsurance may also facilitate insurance placement. An insurer that is not licensed to issue coverage in a jurisdiction may arrange with a licensed insurer to “front” coverage on its behalf. Having the unauthorized insurer reinsure 100 percent of the underlying liability creates the fronting arrangement. Fronting also is used when the credit rating of one insurer is not acceptable to the insured. Having the lower rated insurer reinsure 100 percent of the underlying policy creates the fronting relationship. Policyholders can also use reinsurance to reduce their insurance costs through the creation of a “captive” insurer owned by the policyholder.¹⁶⁷⁵ The captive insurer typically reinsures 100 percent of the policy liability.¹⁶⁷⁶

B. Types of Reinsurance

There are two basic types of reinsurance—treaty and facultative.¹⁶⁷⁷

1. Treaty Reinsurance

Treaty reinsurance contemplates an ongoing, long-term relationship between two insurers binding one in advance to cede and the other to assume “its risk under an entire line of business spanning multiple insurance policies” as defined under the terms of a written agreement.¹⁶⁷⁸ The agreement itself is called a treaty—hence the name “treaty reinsurance.”¹⁶⁷⁹

A treaty is a reinsurance contract that details in some length the agreement between the ceding insurer and the reinsurer. It usually contains provisions concerning the term of the agreement, the nature of the business reinsured, reporting requirements, commissions, arbitration and audit rights, and an insolvency clause. A treaty relationship generally is a long-term relationship “‘in which the reinsurer’s profitability is expected, but measured and adjusted over an extended period of time.’”¹⁶⁸⁰

Under a treaty, a reinsurer agrees to indemnify the ceding insurer on an entire portfolio or “book of business” that the ceding insurer underwrites.¹⁶⁸¹ For example, a treaty may reinsure all comprehensive general liability policies issued by the ceding insurer to a particular class of insured,¹⁶⁸² or all business written by the commercial accounts department of the ceding insurer. The obligation to reinsure attaches automatically under a treaty when the ceding insurer accepts a risk.¹⁶⁸³ The reinsurer does not have a right to decline a particular risk undertaken by the ceding insurer. The reinsurance is automatically effected, and a percentage of the risk is assigned to the reinsurer based on a schedule attached to the agreement.¹⁶⁸⁴ A treaty may permit the ceding insurer to submit for special acceptance business that is excluded from the automatic cession.

a. Quota Share Treaty

Treaties typically are written on a proportional or nonproportional basis. A “quota share” treaty is a proportional or pro rata reinsurance agreement by which the reinsurer agrees to share the risk proportionally with the ceding insurer.¹⁶⁸⁵ For example, a reinsurer may agree to accept 25 percent of all of the ceding insurer’s professional liability business written during a specified period of time. The reinsurer will receive 25 percent of the premiums written by the ceding insurer, less a “ceding” commission retained by the ceding insurer,¹⁶⁸⁶ and will be responsible to indemnify the ceding insurer for 25 percent of the losses incurred under those policies.

Generally, a quota share treaty has a number of reinsurers participating, each agreeing to a proportional share of the ceding insurer’s risks.¹⁶⁸⁷ A quota share treaty often is written on less than a 100 percent basis. For example, an 80 percent quota share treaty means that the reinsurers share proportionally in 80 percent of the premiums and losses and the ceding insurer retains 20 percent of the premiums and remains responsible for 20 percent of the losses. Each quota share reinsurer participates on a several, and not a joint, basis.¹⁶⁸⁸

b. Non-proportional/Excess-of-Loss Treaty

Nonproportional treaties are reinsurance agreements in which the reinsurers participate at a particular liability attachment level or on a set premium. Typically, these agreements are “excess-of-loss” treaties, in which the reinsurer’s liability does not attach until the loss exceeds the agreed-upon attachment point. For example, a reinsurer may agree to assume 50 percent of the ceding insurer’s liability for all professional liability policies where the loss exceeds $500,000. An excess reinsurer will receive a smaller share of the premium written by the ceding insurer because of the reinsurer’s more restrictive participation.

Another distinguishing factor between quota share and excess-of-loss reinsurance treaties is the requirement for loss reporting. Generally, losses are reported to a quota share reinsurer on a statement of account or “bordereau” basis where the details of individual losses are not disclosed. Excess-of-loss treaties generally require individual loss reporting and often notice of potential losses when the ceding insurer’s loss reserves exceed a threshold amount.

c. Other Treaties

There are many types of reinsurance treaties and other reinsurance arrangements beyond the typical quota share or excess-of-loss treaties. Property insurers reinsure their risks through an arrangement called a “surplus” treaty, which provides reinsurance for a ceding insurer’s property insurance policies over a certain threshold property value. Ceding insurers protect themselves from the dangers of earthquakes and floods by purchasing catastrophic reinsurance policies known as “cat covers.” Another form of protection is “clash cover” reinsurance. Clash cover protects a ceding insurer from multiple claims attributable to a single occurrence where it otherwise would have been limited by the occurrence limit of its quota share treaty.

d. Capital Markets Vehicles in Reinsurance

Third-party capital investment in reinsurance markets has become increasingly common in recent years. Capital markets investors view...