Reserves and communications between reinsurer and reinsured: a danger zone.

• Author: Brady, Michael J.

Difficult as it may be to do, attorneys should be involved in the process, so that documents and information may be protected from disclosure

ALTHOUGH the law on the discovery of reserve information and communications between the reinsurer and reinsured in the context of extracontractual litigation has not entirely escaped appellate review, higher court authority remains scant.

RESERVES

1. State Requirements

   States statutorily require reinsurers to set reserves. For example, Section 923.5 of the California Insurance Code provides:

   Each insurer transacting business in this state shall at all times maintain reserves in an amount estimated in the aggregate to provide for the payment of all losses and claims for which the insurer may be liable, and to provide for the expense of adjustment or settlement of losses and claims. The reserves shall be computed in accordance with regulations made from time to time by the commissioner.... The commissioner shall make the regulations upon reasonable consideration of the ascertained experience and the character of such kinds of business for the purpose of adequately protecting the insured and securing the solvency of the insurer. Although the setting of reserves can be required by law, a general misunderstanding as to how and why reserves are set seems to permeate an otherwise rational process. There is a mistaken belief that the reserve figure set by a reinsured on a particular claim reflects the value of that claim in terms of settlement potential and/ or jury verdict result.(1) It is generally accepted that loss reserves are not the same as settlement authority. A California court of appeal stated: "The main purpose of a loss reserve is to comply with statutory requirements and to reflect, as accurately as possible, the insured's potential liability. It does not automatically authorize a settlement at that figure."(2) Simply stated, reserves are funds set aside for the payment of future claims.(3)

   As a general proposition, it would appear that if reserves are required to be set by law so as to reflect a reinsured's "aggregate" exposure and not the value of a particular claim, their discoverability in a subsequent extracontractual action should be precluded on relevance grounds and, at the very least, inadmissible at trial. The probative value of using the reserve information as circumstantial evidence to show unreasonable conduct, malice, fraud or oppression, could not outweigh, as a matter of law, the prejudicial effect of tainting the jury with information that has no bearing on a particular claim at issue.

   Several courts, however, have disagreed with this proposition in the context of extracontractual discovery and have carved out exceptions to various relevance, prejudice and trade secret privileges asserted by a reinsured in objection to producing and disclosing this information. Several questions, therefore, exist as to how a reserve should be set. Should the reinsured review a claim globally in context with other similar claims or types of litigation? Should a reinsured set a reserve based on "reasonable value," without regard to the fear of reprisal if incorrect? Should a reinsured even set a reserve on a particular case, but instead set reserves globally on various lines of business?

   Although there are no clear or distinct answers to these questions, several courts have rendered decisions on how reserve information will be treated in the context of extracontractual litigation. These decisions provide a framework for developing an approach for handling these issues from a litigation and business perspective.

2. Value of Reserve Information

   In extracontractual litigation, plaintiffs, who could be policyholders, judgment creditors, or assignees following judgment and covenants not to sue, will try to discover the claims file and the reinsured's reserve information. There are, arguably, many reasons for this request. However, two reasons appear tantamount: (1) to impeach the reinsured's no-coverage position and (2) to attempt to inflame the jury's sensibilities at trial.(4)

   DISCOVERABILITY

1. Relevance

   In Lipton v. Superior Court (Lawyers' Mutual Insurance Co.), the California Court of Appeal stated: "We cannot conclude ... that loss reserve information has no discovery relevance.... The evaluation of a case made by an insurer, whether compelled by law or business prudence, is information which might well lead to discovery of evidence admissible on any number of issues which commonly are presented in bad faith actions."(5)

   In Lipton, the insured allegedly failed to handle a personal injury suit properly, which resulted in the filing of a legal malpractice action. The defense was tendered to the insurer and a question arose as to whether there were multiple or single claims over successive policy periods, potentially increasing the insurer's exposure. A pre-suit request was made for the claims file, which was provided with the reserve information redacted. After suit was instituted, a similar request was made, and a similar response was generated. The insured filed a motion to compel production of the reserve information.

   At the hearing on the motion to compel, the court-appointed referee sustained the insurer's objection to the production of reserve and reinsurance documentation, but the referee rejected the contention by the insurer that reserve information was "never discoverable," relying on a California Court of Appeal decision, Fireman's Fund Insurance Co. v. Superior Court,(6) which held it was an abuse of discretion to order production without an in camera inspection.

   On appeal, the Lipton court first noted that the rules of discovery under California law (Section 2017(a) of the Code of Civil Procedure) allow production of "any" matter, not privileged, that is relevant to the subject matter of the litigation. Rule 26 of the Federal Rules of Civil Procedure has a similar provision.

   Although the court recognized that reserves are "statutorily compelled estimates and are likely to be frequently adjusted during the course of the litigation" and that a "particular reserve amount may be substantially more or less than the amount ultimately paid on a particular claim," the court stated:

   Thus, such evidence may or may not be relevant in a subsequent bad faith action, depending on the issues presented. Thus, in a case where the insurer has denied coverage and refused a defense, the fact that a reserve had been set by the insurer might well be relevant to show that the insurer must have had some knowledge that a potential for coverage existed.... In addition, an argument can be made for the proposition that loss reserve information might have some relevance to the question of whether a reasonable likelihood of an excess verdict existed or the insurer had conducted a proper investigation or given reasonable consideration to all of the factors involved in a specific case which might expose its insured to an excess verdict. On the other hand, depending on the circumstances of a particular case, there may be no relevance whatever. However, these are all questions of relevancy which are related to the trial and the admissibility of evidence.(7) Although it was rejected by the court, the insurer contended that "insurers would be faced with a Hobson's choice: To avoid or minimize any potential `admissions' of liability, reserves would have to be set for amounts that were unrealistically low. To avoid later contentions of `bad faith' reserves would have to be set at maximum levels irrespective of available defenses to the claims asserted--and would be `evidence' of bad faith if not offered before trial."

   A rationale similar to that in Lipton was adopted by the U.S. District Court for the Eastern District of Louisiana in American Medical Systems Inc. v. National Union Fire Insurance Co.(8) A district court magistrate allowed disclosure, stating "reserve information could show how National Union's evaluation of its case impacted its decision to deny coverage," and citing North River Insurance Co. v. Greater New York Mutual Insurance Co.(9)

   As a result, some courts have deemed reserves information relevant when reviewing discovery requests on the ground that the information could be used to show the insurers' knowledge that the potential for coverage existed where a claim was denied,(10) The reserve information...