Reinsurance

1.  Introduction

Reinsurance is insurance taken out by insurers to protect themselves against exposure to a massive claims liability and to allow them to participate in risks which would otherwise be beyond their resources. By spreading risks between insurers worldwide, it becomes possible to issue cover for major and often international risks which would otherwise be uninsurable and to support national insurance markets which are too small in capacity to cover domestic risks. In practice many reinsurance contracts written on the London market cover 100% of the underlying risk in respect of policies written by overseas insurers who themselves lack the sophistication or resources to underwrite the business, a practice known as ‘fronting’. Reinsurance also enables insurers to protect their own solvency, and indeed, the rules made by the Financial Services Authority under the Financial Services and Markets Act 2000 requires insurers to have adequate reinsurance in place as a guarantee of their solvency margin. Reinsurance is written by Lloyd’s syndicates, ordinary insurance companies and specialist reinsurers, and all are now regulated throughout the European Union in much the same way as direct insurers following the implementation of the Reinsurance Directive.²

Having struggled through the definition of an insurance contract, the reader will not find it too surprising to learn that it is rather difficult to arrive at an all-embracing definition of a reinsurance policy. There is no statutory definition of reinsurance, although there are statutory references to the activity, and there is no exhaustive judicial definition because of the sheer variety of different types of reinsurance. According to Lord Lowry, ‘Reinsurance is prima facie a contract of indemnity … under which the reinsurer indemnifies the original insurer against the whole or against a specified amount or proportion … of the risk which the latter has himself insured.’³ More simply, Viscount Cave LC said that, ‘by a contract of reinsurance the reinsuring party insures the original insuring party against the original loss’.⁴

Reinsurance is to be distinguished from co-insurance, insurance arranged in layers and double insurance, in each of which cases the assured has a separate contract of insurance with each underwriter. Reinsurance is also not an assignment of the direct policy by the reinsured to the reinsurers,⁵ neither is it a partnership between the reinsured and the reinsurers.⁶ There is no privity of contract between the assured and the reinsurers so that the assured’s only action is against his own insurers,⁷ although some reinsurance agreements contain cut-through clauses under which the assured is given a direct action against the reinsurers in the event of the reinsured’s insolvency and in principle it is perfectly possible for reinsurers to agree to accept direct liability to the assured.⁸ A cut-through clause is potentially enforceable by the assured under the Contracts (Third Parties) Act 1999, although there is some doubt as to whether a cut-through clause is valid under the English insolvency rule of equal treatment of unsecured creditors.⁹

There has long been a debate as to whether reinsurance is a further policy on the direct subject-matter or something akin to a liability policy under which the reinsured obtains indemnity when it faces liability to the direct assured. For regulatory purposes under the 2000 Act, reinsurance is deemed to be of the class of direct insurance to which the contract relates.¹⁰ However, regulatory issues aside, it is clear that reinsurance shares many of the characteristics of a liability policy, not the least that the reinsurers’ liability is triggered by the reinsured establishing and quantifying its loss in exactly the same way as an assured under a liability policy.¹¹ The authorities are inconsistent.¹² The matter was given consideration by the House of Lords in Wasa International Insurance Co v Lexington Insurance Co,¹³ where the argument for the reinsured was that the reinsurers were required to provide an indemnity whenever the reinsured faced liability under the direct policy. The House of Lords ruled that a reinsurance contract is generally to be construed as further insurance on the underlying subject-matter so that the reinsurers had the right to assert that the direct loss did not fall within the coverage of the reinsurance, although their Lordships all recognised that it is perfectly possible to frame a reinsurance agreement as a liability cover. In Feasey v Sun Life of Canada,¹⁴ for instance, a reinsurance agreement covering personal accident claims was originally drafted in liability terms, but the wording was subsequently altered so that the agreement was expressed as one which responded to accidents rather than the reinsured’s liability to make payment for accidents. The reinsurance was held to be a life policy and thus subject to the rules on insurable interest in the Life Assurance Act 1774.¹⁵

For the most part the same principles apply to reinsurance policies as to insurance policies in general, and therefore in this chapter only the features which are peculiar to reinsurance will be examined.

2.  Types of reinsurance contracts

Reinsurance agreements¹⁶ may be proportional or non-proportional. Under a proportional agreement, the reinsured retains a proportion of the risk and cedes the balance to reinsurers. The premium paid to the reinsured is (minus brokerage and ceding commission) payable to the reinsurers to reflect the parties proportions. Under a non-proportional agreement, the reinsured retains a given sum (referred to as the ‘deductible’, and much the same as an excess clause in a direct policy) and the reinsurers accept liability for an amount in excess of that sum up to a given maximum sum. The premium under a non-proportional agreement is not necessarily based on the direct premium. The reinsured may on occasion be required by a reinsurance of either type to retain the deductible for its own account, thereby giving the reinsurers some guarantee that the business accepted by the reinsured is of the appropriate quality, although in most cases there is no such provision and the reinsured is free to reinsure the amount of its deductible elsewhere.¹⁷ A deductible is normally to be construed as applying to the amount of the reinsured’s liability for a claim and not to the totality of the claim itself.¹⁸

The simplest form of reinsurance is facultative, which is the reinsurance of a single risk. By way of example, A insures a ship with B and B enters into facultative reinsurance with C to cover the liability undertaken in the first agreement. This type of reinsurance is nearly always proportional, and is written in the London market by a short form¹⁹ which has appended to it the terms of the direct policy. This document is a short one and its most important provision is the ‘full reinsurance’ clause, of which the following is typical: ‘being a reinsurance of and warranted same terms and conditions as original, and to follow the settlements’. These days it is commonly abbreviated to ‘as original’. There may be other terms, including claims provisions.

Treaty reinsurance is appropriate where the reinsured wishes to obtain cover for a portfolio of risks. The reinsurance may extend to the reinsured’s entire business (‘whole account’ reinsurance) or it may be confined to a part of that business (eg the marine account). A treaty is a framework arrangement under which the parties agree that all risks of the type described are to fall within the scope of the treaty. Treaties may be obligatory or non-obligatory. Under the former, any risks accepted by the reinsured are automatically ceded to the reinsurance without either party having any discretion in the matter: there may be an obligation on the reinsured to inform the reinsurers on a regular basis²⁰ of risks accepted, but failure to notify the reinsurers will not prevent the risk from attaching even if notification is not made until after the loss has occurred.²¹ If the contract is non-obligatory, the reinsured has the right to decide whether to proffer a risk for acceptance, and the reinsurers have the right to refuse any particular risk. The treaty here is less a binding obligation and more of an agreed machinery for the presentation of proposals by the reinsured. A hybrid is a facultative-obligatory contract under which the reinsured has the right to decide which risks to cede but the reinsurers have no right to reject what is presented to them. This arrangement is unfavourable to reinsurers as they are more or less at the mercy of the reinsured who may decide to offload poor business on the reinsurers,²² and a ‘fac-oblig’ contract imposes an obligation on the reinsured to inform the reinsurers of risks which have been ceded, as in the absence of a declaration the reinsured cannot be seen to have exercised the option to cede.²³

Treaties come in various proportional and non-proportional forms. Quota share and surplus treaties are both proportional, the reinsured retaining an agreed proportion of each risk and the reinsurers taking the remainder. The most important form of non-proportional treaty is excess of loss, under which the reinsurers accept liability for sums in excess of the reinsured’s ‘ultimate net loss,’ a figure defined as the total aggregate of liabilities, excluding fixed costs, arising out of an event or occurrence. Stop loss reinsurance is a guarantee of solvency, and comes into play when the reinsured’s loss reach an agreed figure. Lloyd’s operates reinsurance to close which enables syndicates of members to place limits on their liabilities. A syndicate’s accounts for each year remain open for three years for the receipt of premiums and the payment of claims, the account is then closed and future liabilities reinsured by another Lloyd’s syndicate.²⁴

Where the amounts at stake are large, a combination of the various forms of reinsurance may be used. In particular there may be a number of different excess layers of reinsurance.²⁵ Reinsurers may themselves take out cover, known as retrocession, and there may often be a large number of contracts at different levels. The London market in the 1980s and 1990s operated the London Market Excess (LMX) Spiral, which consisted of a chain of excess of loss treaties, sometimes involving many thousands of contracts.²⁶

There has been some discussion as to whether all reinsurance treaties are insurance contracts. If the reinsurers are obliged to accept risks ceded to them, then there seems no difficulty in seeing this as a contract of insurance.²⁷ But where there is no such obligation, then this is not reinsurance, rather it is, as Gatehouse J expressed it, ‘simply a procedural mechanism which, if operated as both parties no doubt hoped and expected, would secure considerable commercial benefit to both sides’.²⁸

Reinsurance treaties are generally long-term contracts which last for more than the one year traditional for direct policies. Three year agreements are common. Provision is made in such agreements for annual review of the contract, so that if the reinsured’s losses are unusually high the reinsurers may have the right either to cancel the agreement on its anniversary date or at the very least give notice of a premium increase.²⁹

3.  Formation of the contract

Reinsurance is subject to all the rules applied to other insurance contracts, including the particular requirements of a marine or life policy, where appropriate. As noted above, the reinsureds’ insurable interest is either the risk under the primary policy or the risk of having to indemnify the reinsured. If the insured under the primary policy has no insurable interest, the reinsureds will also have no insurable interest and neither policy will be enforceable.³⁰

Reinsurance is frequently formed in advance of insurance. This raises as yet unresolved questions as to the agency of the broker appointed by the assured to place the direct policy—as it is clear that the broker cannot be acting for the assured unless he has been expressly authorised to place reinsurance³¹—and the status of the reinsurance agreement prior to direct policy being allocated to it. The courts have for the most part sidestepped these problems and have resorted to the traditional contractual analysis that an agreement to reinsure amounts to a standing offer which can be accepted by any insurer by accepting the direct risk and thus becoming entitled to the benefit of the reinsurance.³²

Reinsurance agreements are normally the result of protracted negotiations, with formal agreement being reached by the scratching of, in London, the Market Reform Contract. As with other London market placements, the Market Reform Contract constitutes a series of bilateral contracts between the reinsured and each reinsurer. It is possible for a contract to come into existence prior to the scratching of the Market Reform Contract, where the parties have reached agreement on all material points, although this is relatively unusual.³³ Terms cannot be imposed unilaterally after agreement has been reached.³⁴

The duty of disclosure and the duty to avoid misrepresentation apply to reinsurance in the same way as at the direct level.³⁵ The reinsurers thus have to prove that a statement has been made³⁶ or a fact has been withheld, the fact was objectively material and the presentation by the reinsured induced the reinsurers to accept the risk on the specified terms and for the specified premium. There are, however, two important modifications to ordinary principles to be borne in mind. The first is that the facts which may be material for reinsurance purposes are quite different from those which are material under a direct policy. Material facts will include:

The second is that the duration of the duty depends upon the nature of the reinsurance agreement. As far as a treaty is concerned, it was held by Aikens J in HIH Casualty and General Insurance v Chase Manhattan⁴⁶ that no duty of utmost good faith attaches to a treaty, which is a contract for insurance rather than a contract of insurance, and that the reinsurers’ remedies are those generally available at common law, including avoiding for misrepresentation. However, the nature of the treaty in that case was not in issue, and it may be that the duty of disclosure depends upon whether the treaty is obligatory or non-obligatory. If the treaty is obligatory, so that the reinsurers cannot refuse proffered declarations, it is arguable that reinsured’s duty of disclosure exists when the treaty is set up, although it is clear that there is no separate duty of disclosure in respect of each individual declaration. If the treaty is non-obligatory, so that the reinsurers can refuse individual risks, then HIH is plainly right and the duty of disclosure applies only to declarations and not to treaty itself.⁴⁷

4.  Express and implied terms

4.1  Express terms and incorporation of terms

As noted above, the practice of the London market in relation to the creation of facultative contracts is to use a minimal amount of wording, often no more that the full reinsurance clause. The first part of the full reinsurance clause states ‘warranted terms and conditions as original’ or its equivalent. The balance of authority holds that this wording is effective to incorporate the terms of the direct policy into the reinsurance, although there are some comments to the contrary. Lord Griffiths in Forsikringsaktieselskapet Vesta v Butcher expressed ‘regret that so little thought was apparently given to the difference between a primary insurance contract and a reinsurance contract at the time the reinsurance was placed with Lloyd’s’,⁴⁸ and his Lordship, dissenting on this point, concluded that the full reinsurance clause amounted to no more than a warranty by the reinsured that the terms of the direct policy disclosed to the reinsurers were accurately stated. In Toomey v Banco Vitalico de Espana de Seguros y Reaseguros⁴⁹ Thomas LJ speaking for the Court of Appeal refused to reach a concluded decision on the point, and instead held that there had been an express warranty to the effect that the terms of the direct policy were as represented to the reinsurers.

Assuming that the full reinsurance clause does have an incorporating effect, incorporation will plainly extend to the basic cover granted by the direct policy. However, claims conditions and other policy provisions will be incorporated only if consistent with the nature of reinsurance. The precise conditions for incorporation were laid down by David Steel J in HIH Casualty and General Insurance v New Hampshire Insurance⁵⁰ as follows: (i) the term must be germane to the reinsurance; (ii) the term must make sense, subject to permissible ‘manipulation’ of the words used, in the reinsurance agreement; (iii) the term must be consistent with the express terms of the reinsurance;⁵¹ and (iv) the term must apposite for inclusion in the reinsurance. Notice provisions have thus been held to be capable of incorporation only if they make sense in a reinsurance context.⁵² In Home Insurance Co of New York v Victoria-Montreal Fire Insurance Co⁵³ the reinsurance agreement consisted of a slip containing special terms of reinsurance with attached to it a primary fire policy of the type issued by the original insurers, which had been amended to a minimal extent—so, for instance, the syllable ‘re’ had been inserted before ‘insure’. As might be expected, almost none of the terms of the primary fire policy were appropriate for a reinsurance policy, in particular a term which prohibited an action on the policy once twelve months had elapsed since the fire. The Privy Council approached this document on the basis that the primary fire policy was attached merely for information, as showing the origin of the liability which was the subject of the reinsurance policy. Since the reinsurers only became liable once claims had been settled and they had no control over when claims would be settled, the Privy Council concluded that the term could not apply to the reinsurance policy.

The leading authority on the point is now the decision of the Court of Appeal in HIH v New Hampshire,⁵⁴ In HIH the clause in issue was a waiver of defences clause in the underlying contract. The reinsurance was ‘as original,’ and it was held by both David Steel J and the Court of Appeal that the clause had been incorporated into the reinsurance by the general words of incorporation (the Court of Appeal disagreed with David Steel J that there had been incorporation by express reference in the reinsurance to a ‘cancellation clause’ as the clause was held by the Court of Appeal not to relate to cancellation). David Steel J held that the wording incorporated clause could be ‘manipulated’ so as to give it sense in the reinsurance context: accordingly, as manipulated, the clause operated as a waiver of reinsurers’ rights of avoidance in the event of a breach of the duty of utmost good faith by the reinsured. The Court of Appeal rejected this analysis, and held that it was not possible to manipulate the wording of the incorporated clause as it contained references which could not be translated to the reinsurance context. The Court of Appeal’s view was that the clause was incorporated only in unmanipulated form, which meant that it did not amount to a waiver of reinsurers’ rights of avoidance for independent breaches of duty by the reinsured. Instead, it operated only to: (i) allow the reinsured to recover from reinsurers in circumstances where the reinsured’s own right of avoidance against the assured had been lost by reason of the clause (ie it was a form of follow-the-settlements clause); and (ii) allow the reinsured to recover where there had been a common presentation of the risk to the reinsured and reinsurers, so that both parties had agreed to waive their rights and the result was back-to-back cover. Rix LJ pointed out that giving the clause the wider meaning accepted by David Steel J would prevent the reinsurance from being back-to-back with the insurance, as the reinsurance would contain a waiver of rights independent of the insurance itself.

Terms which are ancillary to the direct policy will not be incorporated unless express reference is made to them in the reinsurance agreement. The most important terms which fall into this category involve dispute resolution, namely exclusive jurisdiction clauses,⁵⁵ arbitration clauses⁵⁶ and choice of law clauses.⁵⁷ A leading underwriter clause in the direct policy is also to be regarded as ancillary to reinsurance and thus will not be incorporated by general words: reinsurers will not, therefore, be bound by variations to the direct risk agreed to by the leading direct underwriter for the other reinsureds.⁵⁸

It should be added that the strict rules on incorporation in respect of dispute resolution provisions apply only where there is purported incorporation from one contract into another. If there is incorporation from a document other than a contract involving a different party, eg standard market clauses, then the rule is applied less strictly and incorporation may be recognised even though there is no direct reference in the reinsurance agreement to the clause in question.⁵⁹

4.2  Implied terms

The limited requirement for disclosure under obligatory and facultative/obligatory treaties is justified by the implication of terms to protect the reinsurers from the reinsured’s acceptance of bad risks and settling losses unreasonably: the terms were set out in Phoenix General Insurance of Greece v Halvanon Insurance,⁶⁰ a case involving a proportional treaty. The terms are:

The argument that there is a general obligation on the reinsured to keep the retention for its own account was rejected in Halvanon itself. Baker v Black Sea⁶¹ held that the implied terms are not conditions precedent to the reinsurers’ liability, so that if the reinsured breaks any of the terms the reinsurers remains liable. In Bonner v Cox Dedicated Corporate Member Ltd ⁶² substantial doubt was cast upon the width of the implied terms recognised in Halvanon, at least in respect of excess of loss contracts. In that case the reinsured had engaged in ‘writing against’ the reinsurance, ie accepting risks which were likely to give rise to net losses without reinsurance but which were perfectly profitable with reinsurance. The Court of Appeal rejected the notion that the reinsured under an excess of loss contract owes any duty of care or continuing duty of good faith to the reinsurers, so that it was not a breach of contract for the reinsured to ‘write against’ the insurance by accepting risks which, but for reinsurance coverage, could not have been profitable. In so deciding, the Court of Appeal distinguished proportional from non-proportional reinsurance, so that Phoenix v Halvanon was merely distinguished and not overruled although Waller LJ, giving the leading judgment in the Court of Appeal, doubted that even a reinsured under a proportional contract might owe the various implied duties to the reinsurers recognised by Hobhouse J in Halvanon.

4.3  Interpretation of reinsurance contracts: the presumption of back-to-back cover

Irrespective of incorporation, there is a general presumption that the cover granted by a proportional reinsurance agreement is ‘back-to-back’ with the underlying insurance, as the parties can be regarded as ‘co-adventurers’ even though as a matter of law they are simply contracting parties. This presumption, which is in essence a principle of construction rather than a rule of law, was emphasised in Forsakrings Vesta v Butcher, in order to overcome problems arising where the reinsurance and the insurance are governed by different applicable laws. In that case the direct policy, which was governed by the law of Norway, contained a warranty that the insured fish farm would be under 24-hour watch. The reinsurance, which was governed by English law, incorporated the terms of the direct policy, so that the same warranty was contained in the reinsurance. A loss occurred at a time when the assured was in breach of warranty, which under Norwegian law did not provide a defence to the insurers because it was not causative of the loss, but the reinsurers nevertheless denied liability to the insurers and relied upon the stricter English rule that a breach of warranty has an automatic discharging effect. The House of Lords was unwilling to accept the defence, and resorted to the presumption of back-to-back cover to conclude that it was appropriate to construe the reinsurance agreement in the same manner as the insurance agreement, ie in accordance with principles of Norwegian law, even though the reinsurance was governed by English law. The outcome is welcome but the reasoning is curious.⁶³ The back-to-back analysis has been followed on numerous occasions,⁶⁴ but has two main limitations: as a rule of construction, the notion of back-to-back cover cannot operate to strike out or override those express terms of the reinsurance agreement which are inconsistent with the underlying terms⁶⁵; and there is no similar presumption in non-proportional reinsurance contracts, as in those cases the parties are not co-adventurers and the reinsurance premium is assessed independently of the premium paid to the reinsured.⁶⁶

The presumption of back-to-back cover was arguably taken to extreme lengths in Groupama Navigation et Transports v Catatumbo CA Seguros.⁶⁷