Coverage Litigation Costs: Should Reinsurers Pay?


Must reinsurers pay the litigation costs incurred by ceding companies in denying coverage?

John J. Cuff, New York (written in the mid 1990's)

Coverage litigation is on the rise as insurers increasingly become entangled in costly disputes with their insureds over their obligations under their insurance policies. The American Insurance Association recently estimated that insurers spend a minimum of $1 billion a year on litigation with their insureds. Ten years ago the cost of such disputes wasn’t even tracked by the association.

Much of this coverage litigation stems from contested asbestos and environmental claims, which are the subject of hundreds of state and federal court rulings each year. And while it is hoped that the enactment of the absolute pollution exclusion will eventually stem the tide of litigation over environmental coverage issues, disputes in other contentious areas—including directors and officers liability, sexual abuse claims, and lead-based paint exposure—are rapidly moving to the forefront.
 

With expenditures for coverage litigation often running into the millions on a single case, insurers naturally look to their reinsurers to recover a portion of the costs of these disputes. Unfortunately, this is one area where ceding companies often lock horns with their reinsurers. Reinsurance companies often are willing to reimburse the ceding company for the costs incurred in defending an insured against a third-party claim. But when ceding companies incur legal costs in denying coverage, reinsurers may balk at footing any of the bill, even when the insurer has been successful.

Coverage litigation expenses are often called “declaratory judgment” costs because they arise in lawsuits seeking to “declare” whether the insurer must provide a defense to the insured in a third-party claim and whether the insurer must indemnify the insured for damages if the insured is found liable.

Perhaps reinsurers should state in their contracts whether they will cover declaratory judgment costs. Reinsurance contracts are normally short and often devoid of the legalisms that are found in other complex legal arrangements. It is assumed that many issues will be resolved through commercial bargaining between the parties. However, an important issue such as this may need to be specifically addressed    

The key is to negotiate. Seek a compromise. Identify those facts of the specific claim which tip the fairness balance in your favor and present these in your discussions.

But before you even negotiate, keep an open dialogue throughout the life of the claim making your position fully known. The world of reinsurance is as much one of  relationships and good faith dealing as it one of legalistic contractual clauses and arguments. If the other side at least understands your position throughout the claim, it will have the chance to get more comfortable with it over time. It may even look for ways to reach a compromise with you. Consider the following examples of tangled coverage webs:

·        A soup manufacturer asks its liability insurer to defend it against employment discrimination charges by the federal government. The insurer denies coverage, and in the ensuing coverage litigation, which costs $120,000, it prevails in court. But when the insurer asks its reinsurer to pay its share of the legal fees, the reinsurance company declines. It  contends that these costs do not qualify as  “expenses incurred in the investigation and settlement of claims or suits” which are reimburseable.
 

·        A chemical manufacturer is denied coverage from its liability carrier for claims involving toxic torts. The insurer incurs legal costs of $1 million in a declaratory judgment coverage action and eventually settles the claim $5 million. The reinsurer agrees to pay its share of the settlement and any cost of defending the insured, but  refuses to pay any part of the $1 million that was spent disputing coverage. The reinsurer maintains that the ceding commission is meant to compensate the cedant for declaratory judgment costs.

The Case Against Payment

Reinsurers and insurers each put forth strong arguments to justify their sharply divergent positions on  whether the reinsurance contract covers expenses incurred in denying coverage. For reinsurers, the case against payment of legal expenses rests on the following points:

Reinsuring Clause.  Reinsurers maintain that their contracts reinsure no more and no less than the coverage provided by the ceding company under original policy issued to the insured. Since declaratory judgment costs are incurred by ceding companies in an effort to show that no obligation exists under the policy, reinsurers say such expenses are not covered by the contract. 

Definition of Expenses. Reinsurance contracts normally provide that the reinsurer will pay its share of all expenses incurred in the investigation and settlement of claims and in the defense of third-party suits against the insured. Since declaratory judgment costs are incurred not to investigate a claim, but to avoid the investigation altogether, reinsurers say they do not fall under the definition of expenses.

Ceding Commission. The ceding company typically receives a commission for ceding premiums to the reinsurer. This commission is for general overhead and for duties performed by the cedant in addition to its normal obligations under the policies, including the cost of salaries for underwriters and claims staff. According to some reinsurers, these additional duties also include payments made to defend standard policy forms from misinterpretation (i.e., coverage litigation expenses.) Thus, reinsurers assert that ceding companies have already been reimbursed for declaratory judgment costs through the ceding commission.

The Case Supporting Payment

For ceding companies, the arguments supporting coverage center on the following points:

Definition of Expenses. Reinsurers normally agree to pay their share of expenses incurred in the “investigation and settlement of claims or suits.” Insurers argue that the first step in investigating and settling a claim is determining whether coverage exists in the first place, and often the only way that can be done is through a declaratory judgment action. Consequently, such costs are a part of the investigation and settlement of a claim and should be covered under the reinsurance contract.

Follow the Fortunes. The Loss Settlement Clause, found in many reinsurance contracts, requires the reinsurer to be bound by the ceding company’s payments even if they are open to question. Insurers contend that under this clause the reinsurer agrees to follow the cedant’s fortunes and not second guess its actions. This clause is meant to save the insurer from relitigating a claim all over again with its reinsurer and gives the cedant wide latitude in handling its claims. Declaratory judgment costs fall within the spirit and letter of the loss settlement clause, insurers argue.  

Benefit to Reinsurers. Finally, insurers contend that reinsurers derive a considerable benefit from the strategic use of coverage litigation and should pay their proportionate share of the costs. Otherwise they would receive a free ride from the efforts of the ceding company. From the perspective of ceding companies, it is inequitable to lay the entire burden on the insurer when the reinsurer reaps part, and sometimes all, of the rewards. Also in cases of uncertain coverage an insurer may decide that it is more profitable to simply settle the claim rather than incur additional costs to defeat coverage.

Guidelines for Resolving Disputes

Given these contrasting viewpoints, what can insurers and reinsurers do to resolve disputes over payment of legal costs? In a word, negotiate. Marshall the facts, maintain a dialogue, and seek a compromise. Look for reasons that distinguish your case from other cases. Above all, demonstrate that fairness and justice are on your side. A good way to begin your assessment is to ask the following questions:

What does the reinsurance agreement say? While the terms of a reinsurance contract can vary widely, reinsurance agreements almost always contain a reinsuring clause (defining what is reinsured), a loss settlement clause (binding the reinsurer to the reinsured’s settlements), and a definition of covered expenses. Read the entire contract carefully. Often, the presence or absence of a phrase or word can make a million-dollar difference.

Is the contract facultative or treaty?  The type of contract also is significant. With a treaty contract, the reinsurer is standing behind all of the policies in a particular class and therefore has a stronger stake in upholding policy terms. A facultative agreement, in contrast, is a one-shot deal on a specific insured, so the reinsurer has less interest in seeing that the terms of all similar policies are defended.

Is the contract written on a pro-rata or on an excess-of-loss basis? With contracts written on a pro-rata basis, the reinsurer agrees to pay a share of every loss paid by the insurer. This arguably implies an intention to share fully in the fortunes of the reinsured, and the reinsurer may therefore have a greater exposure than would be the case if the agreement were written on an excess-of-loss basis, under which the reinsurer pays losses above a certain amount.

Are expenses paid in the same ratio as indemnity under the contract? Under some excess-of-loss contracts, the reinsurer agrees to pay expenses in the same proportion that it pays indemnity. If an insurer successfully denies coverage, it has paid no indemnity and therefore cannot recover expenses from the reinsurer, even if it has spent millions to deny coverage.

What has been the practice between the parties been regarding reimbursement in the past? Review the correspondence leading up to the agreement to see whether the issue of coverage litigation costs was ever discussed. Also, review earlier cases to determine whether the reinsurer has knowingly paid for such costs in the past. If so, it may be prevented from changing its mind now. If not, it may be in a stronger position.

Who stands to benefit most from the coverage litigation? Fairness is important in to arbitrators and negotiators. The chief beneficiary of a successful coverage suit may look greedy if it does not want to share the load. 

Was the reinsurer notified early and given an opportunity to comment on the best course of action?  Here again, arbitrators and negotiators may think it unfair for the reinsurer not to pay its share of the costs if it has been involved in the claim and has agreed to how it should be handled. On the other hand, it may seem unjust for the cedant to keep the reinsurer in the dark and at the last moment demand payment.

Nipping Conflicts in the Bud

Going forward, companies should consider taking steps to prevent disputes over the costs of coverage litigation by stating explicitly in the reinsurance contract how these costs are to be handled. Ceding companies that becomes involved in coverage litigation should provide early notification to their reinsurers, make their position on the litigation known, seek the reinsurers’ advice on the proper course of action, and make every attempt to allocate costs to reinsurers as fairly as possible.

Reinsurers, for their part, should make their own position on the litigation known to the ceding company after receiving notification, reserve their rights, and provide input where appropriate.

Following these guidelines should help ceding companies and reinsurers minimize situations in which they become adversaries and achieve a better understanding of their mutual rights and obligations under reinsurance contracts. Both parties benefit when the degree of financial protection provided by the contract is clear and unambiguous, allowing the reinsurance mechanism to fulfill its purpose.