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Insurance Law

Reinsurance Intermediaries – New Appleman on Insurance Law Library Edition, Chapter 75

By Marc J. Pearlman, Mark A. Kreger, and Steve Nunn

This chapter begins with a description of the key functions performed by reinsurance intermediaries.  (Note that intermediaries can be individuals or entities.) Section 75.01 notes that these functions must be distinguished from those performed by ordinary retail insurance brokers.  In exchange for their role in the design, placement, and implementation of complex reinsurance transactions, they are typically compensated through a commission paid by the reinsurer, but may also be compensated through fees paid by the ceding company.  A reinsurer may also retain an intermediary, either in the course of reinsuring its own risks, or less often to develop business for the reinsurer.

In Section 75.02, the functions of reinsurance intermediaries are explored in greater depth.  An intermediary is often retained in the first instance to develop a program of reinsurance for a ceding company.  Such a program may involve either one or both main types of reinsurance coverages:  facultative and treaty reinsurance.  The intermediary must have a sound knowledge of the original policy being reinsured (in the case of facultative reinsurance), or the cedent's policy forms, coverage, perils and jurisdictions in which the policies are issued (in the case of the treaty reinsurance), as well as an understanding of the risk of bundling policies.  The intermediary must understand the cedent's reasons for wishing to purchase the coverage it seeks, as well as the cedent's broader goals and objectives.  The cedent's goals will be designed to achieve its stated risk tolerance, as well as the requirements of regulators or rating agencies.  Once the company's goals are articulated, the intermediary may use various statistical models, tools and quantitative methods to determine which of several alternatives will achieve the goals at the most efficient price.  The most commonly used tools are catastrophe models and stochastic models.  Such models produce distributions reflecting probabilities of potential loss outcomes.

The next step is to estimate the expected cost of one or more of the alternative reinsurance programs.  Cost estimates may be made using experience rating models (involving the use of the company's actual historical data) and exposure rating models (involving the use of industry data for the classes of business that the company writes).  In placing any given reinsurance contract, the intermediary will utilize its own internal market intelligence concerning current market forces as well as the appetite for risk of prospective reinsurers.  The most competitive pricing for any given risk is likely to come from reinsurers whose appetite for the particular risk is stable or growing.  It is important to have accurate intelligence regarding which underwriters are likely to take a "leading" role on a particular placement, as well as an understanding of both the "direct" and "broker" markets.

The process of actually placing the reinsurance contract or program begins with the development of a package of information which will be submitted to prospective reinsurers.  This information will be provided by the ceding company based upon the intermediary's knowledge of what will be required by reinsurers.  The required information typically includes underwriting data such as background information on the company and its personnel, the cedent's underwriting policies and procedures, manuals, guidelines and risk selection profiles, rate schedules and policy forms, historical and projected premium income, and various breakdowns of the data by class, territory, limits and type of insured.  Detailed historical claim information is also provided, including both bordereau figures for insured and paid claims and individual large loss descriptions.  The information may vary somewhat with respect to property as contrasted with casualty contracts.  Using this information, the intermediary will solicit participation on the placement from reinsurers who appear on a list prepared by the intermediary with the approval of the cedent.  The financial strength of reinsurers appearing on the approved list will typically be evaluated by the intermediary's market security department or committee.  The intermediary will prepare a placing slip or a full contract wording which will form the basis of negotiations regarding the terms and conditions of the coverage being sought.  Once a preliminary indication of interest is received, the underwriting information will be provided to a prospective reinsurer.  Reinsurance underwriters may respond with a request to serve as a "lead" or a "following" market, or they may decline to quote on the proposal altogether.  The terms offered by the responding reinsurers will be reviewed by the intermediary and the cedent.  Based on that review a reinsurer may be selected who is willing to accept all or virtually all of the placement; otherwise a lead underwriter may be selected.

Typically, the intermediary will attempt to achieve uniformity of terms and conditions among all the participating reinsurers.  In the case of facultative reinsurance, the original policy terms and conditions will apply, and typically a certificate will be issued by the reinsurer containing the details of the reinsurance transaction.  Treaty reinsurance, however, is a more manuscripted transaction, and the terms and conditions of the deal will be memorialized in a "contract" or "agreement."  Contract drafting services are typically offered by intermediaries.  After the contract is executed, reinsurance intermediaries typically act as the conduit for all communications between the cedent and the reinsurer, including the payment of premium by the cedent, as well as information regarding claims under the contract.  The intermediary is typically responsible for collecting losses payable under the contract from each participating reinsurer and forwarding the funds collected to the cedent.  Intermediaries should act as the ceding company's advocate in developing, maintaining and possibly expanding a mutually beneficial relationship with the reinsurer over time.

Section 75.03 describes the basics of the regulatory framework within which intermediaries operate in the United States and the United Kingdom.  The Reinsurance Intermediary Model Act, promulgated by the National Association of Insurance Commissioners, has been adopted in many states and is the cornerstone of the regulation of intermediaries in the U.S.  The act recognizes and defines two types of intermediaries:  a "reinsurance broker" and a "reinsurance manager."  The difference between the two is that a broker solicits reinsurance cessions or retrocessions on behalf of a cedent without the authority to bind coverage, while a manager has the authority to bind coverage on behalf of a reinsurer and acts as the agent for the reinsurer.  Section 3 of the Model Act relates to licensing of intermediaries by state insurance commissioners, but the Act sets forth few specific criteria by which commissioners should decide whether to issue, suspend or revoke a license.  Section 4 of the Model Act requires the use of certain provisions in written agreements between intermediaries and their clients.  Section 11 of the Model Act establishes fines and penalties for violations of the Act.

New York was the first state to enact legislation regulating intermediaries.  Section 2106 of the New York Insurance law represents an example of the implementation of the Model Act, and contains its own provisions governing such issues as license applications and fees, renewals and expiration dates.  New York Insurance Law Section 2110 contains provisions for the suspension and revocation of an intermediary's license.  In the U.K., intermediaries are regulated by the Financial Services Authority ("FSA").  The FSA has regulated intermediaries in the U.K. since 2008 pursuant to the European Community's Insurance Mediation Directive.  Lloyd's Brokers are also regulated by the Council of Lloyd's under the Lloyd's Intermediaries Byelaw.

Section 75.04 discusses the contractual framework within which intermediaries operate, which today relates primarily to the standard Intermediary Clause incorporated in virtually all reinsurance contracts in the U.S.  The origin of the clause was the insolvency of a prominent reinsurance intermediary named Pritchard & Baird ("P&B").  The principals of P&B looted the company, as a result of which it was unable to pay premiums to reinsurers that had been collected from its ceding company clients.  In P&B's bankruptcy proceeding, an issue arose as to whether P&B was acting as the agent of the cedent or the reinsurers when it collected premiums.  The resolution of this issue would determine whether the reinsurers would have to pursue claims against P&B in the bankruptcy to recover the premiums paid, or whether claims could be made directly against the cedent for nonpayment of premiums, even though the cedent had already paid the premiums to P&B.

The court determined that P&B was acting as the agent of the cedent for all purposes, including collection of premiums, thereby placing the risk of the intermediary's insolvency on the ceding company.  Regulators reacted against this decision in order to protect the balance sheets of ceding companies and the standard Intermediary Clause was developed to reallocate the risk of an intermediary's insolvency or financial misconduct.  The clause provides that funds collected by the intermediary from the ceding company (such as premiums) are deemed to have been paid to reinsurers, but that funds paid by reinsurers to the intermediary (such as claims) are only deemed to constitute payments to the cedent if they are actually received by the cedent.

Section 75.05 broadens the discussion of the principles of agency law which are applicable to the role of reinsurance intermediaries.  Agency is a relationship whereby one party, the agent, acts on behalf of another party, the principal, in dealing with third parties.   As the discussion regarding the Pritchard & Baird insolvency demonstrates, the question of agency is of central importance in determining an intermediary's legal duties and liabilities.  A principal is bound by the acts of its agent when the agent is acting within the scope of its authority.  An agent's authority may be "actual," which may be either express or implied, or "apparent," meaning whatever authority a principal has held the agent out as having, based upon the principal's acts or conduct.  A principal may also be deemed to have "ratified" an agent's unauthorized acts if it accepts them after having a full and fair opportunity to repudiate them.  A leading case in which these principles of agency law are discussed in the context of a reinsurance transaction in Sphere Drake Insurance Ltd. v. American General Life Insurance Co.  The United States District Court in Illinois found that the intermediary lacked actual and apparent authority to bind the reinsurer to a retrocessional cover where he knew that the cedent had exceeded its underwriting authority.  The court further found that the reinsurer had not ratified the intermediary's actions in respect of the contract.  The reinsurer appealed the district court's ruling to the Seventh Circuit Court of Appeals, which affirmed the district court's decision in an opinion in which each of the three types of agency are discussed in detail.  Based on this ruling, the reinsurer was entitled to rescind the retrocession agreement, and its liability was limited to returning the premium which had been paid for the cover.

Application of the principles of agency law to reinsurance transactions may result in an intermediary being held to act as the agent of the cedent, the reinsurer or, in some cases, both parties to the reinsurance contract.  Agency relationships may be determined by statute, regulation or contract, but in most cases, the question of whether an agency exists with respect to a particular transaction is determined by an examination of all of the facts of the situation.  An examination of the facts will typically lead to the conclusion that the intermediary acts as the agent of the ceding company for most purposes.  The leading case illustrating this basic rule is the Pritchard & Baird decision.  After examining all the facts and the conduct of the parties to the reinsurance transactions at issue, the bankruptcy court concluded that an agency relationship existed solely between the cedent and P&B, and not between P&B and the reinsurers.  This decision was affirmed by the United States District Court in New Jersey.  In support of its decision, the court focused on the cedent's control over P&B's actions, and the authority it had delegated to P&B.  Conversely, the court found that the reinsurers never exercised control over P&B, nor did P&B consent to the exercise of control of its actions by the reinsurers.

Notwithstanding the Pritchard & Baird decision, an intermediary does not always act as the agent of the cedent.  For example, an intermediary may act as the agent of the reinsurer in the case of a "fronting" arrangement, and may act as a "dual agent" of both the cedent and the reinsurer in certain circumstances.  (Fronting arrangements are described in Section 75.05[5].) A reinsurance intermediary may act as the cedent's agent for most purposes and the reinsurer's agent for other purposes, as illustrated by the Second Circuit Court of Appeals decision in the case of Arkwright-Boston Manufacturers Mutual Insurance Co. v. Calvert Fire Insurance Co.  Once the existence of an agency relationship is established, an intermediary's knowledge will be imputed to its principal with resulting adverse consequences for the principal.

Section 75.06 spells out the legal duties of reinsurance intermediaries.  The duties of intermediaries are said to fall into three main categories:  security, care and loyalty, and accounting.  There are multiple specific duties which an intermediary may owe to ceding companies.  Prior to being retained, an intermediary must provide security, usually in the form of a license, a fidelity bond, and proof of errors and omissions insurance.  The most fundamental duty which the intermediary assumes on a cedent's behalf is to place the coverage requested by the cedent.  In placing coverage, the intermediary owes to the cedent a duty of reasonable care.  The intermediary is required to clearly communicate the proposed terms of the coverage, disclose all facts and circumstances which might reasonably impact the respective obligations of the parties, negotiate the terms and conditions of the coverage, assist in memorializing the agreement of the parties, and maintain appropriate records of the transaction.  The intermediary must comply with the cedent's instructions and any limitations on its authority.  An important aspect of the intermediary's  duty to the cedent is to investigate and disclose information regarding the financial solvency of potential reinsurers.  The intermediary holds funds in a fiduciary capacity for its principal, and must account for all funds received from either party to the reinsurance transaction.  Even with respect to reinsurers, reinsurance intermediaries are said to have certain common law duties, including the duty to disclose material facts which are known, or ought to be known, with respect to the risk being reinsured.

The potential liabilities of intermediaries, as discussed in Section 75.07, follow from the duties discussed in the preceding section.  The intermediary owes its principal a duty of reasonable care.  The failure to exercise reasonable care will expose the intermediary to liability based upon a theory of professional negligence or breach of contract.  Liability may be based upon the intermediary's failure to devise or recommend a suitable reinsurance program, to comply with the client's instructions, or to keep the client advised of all relevant matters.  Liability may exist whenever the intermediary fails to obtain the coverage requested, particularly if it fails to inform the client that the coverage was unavailable in whole or in part.  The intermediary may be liable for negligently or intentionally misrepresenting facts to reinsurers that results in denial of a claim or rescission of the contract.  Once coverage is placed, the intermediary typically plays some role with respect to documenting the transaction, and may be exposed to liability if it imperfectly performs that function or gives erroneous advice with respect to the meaning of particular contract terms.

Intermediaries are exposed to liability to cedents if they place coverage with reinsurers who later become unable to meet their financial obligations.  At a minimum, an intermediary may face liability for failing to disclose to its client information which the intermediary receives regarding the financial vulnerability of a reinsurer, if the client suffers a loss as a result of the reinsurer's insolvency.  Such information typically comes from rating agencies and other publicly available sources, and is typically evaluated by an intermediary's market solvency department or committee.  A question exists as to whether the intermediary's duty to investigate and disclose to its client information regarding the solvency and financial condition of reinsurers continues after the coverage is placed.  It seems universally accepted, however, that intermediaries are not guarantors of the financial solvency of reinsurers, and that a cedent may knowingly elect to place coverage with a financially insecure reinsurer, especially when its options are limited.

Intermediaries may also face liability if they fail to account for or transmit funds for which they are responsible under the terms of the reinsurance agreement.  Generally, when both parties to an agreement owe money to one another, it is permissible for an intermediary to render a full accounting, offset the debits and credits, and remit the net balance due.  Instances of intermediary defalcation and other forms of fraud by intermediaries are rare.  There are, however, cases in which a knowing misrepresentation of fact by an intermediary may be sufficient to give rise to a claim of common law fraud.  An intermediary may also be liable to a reinsurer for failure to remit premiums collected from a cedent. Liability may also be imposed if an intermediary negligently misrepresents facts regarding a risk, given the fact that she is in the business of providing advice for others in a business transaction, and assuming she knows that the reinsurer will rely on the information she provides.

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Marc J. Pearlman is the Managing Partner of Kerns, Frost & Pearlman, LLC, based in Chicago.  For more than 20 years Marc's practice has focused on complex commercial disputes with a concentration in all aspects of insurance and reinsurance law including insurance and reinsurance program development and contracting, complex claim analysis, coverage analysis and disputes, insolvency, captive formation and issues, and the management of run-off business.  In addition to providing his clients business and legal advice, Marc has served as trial counsel in state and federal courts throughout the United States and in arbitrations worldwide.

Mark A. Kreger is a senior partner in the insurance and reinsurance practice of Kerns, Frost & Pearlman, LLC, based in Chicago.  For more than 30 years his practice has been concentrated in complex commercial disputes and counseling in the fields of reinsurance law, insurance and reinsurance coverage, insurance and reinsurance claim analysis, insurance insolvencies, captive insurance company issues, run-offs and commutations.  His clients have included several of the world's leading insurers, reinsurers and retrocessionaires.  He has served as lead trial counsel for foreign and domestic insurers and reinsurers in major litigation and arbitrations throughout the United States.

Steve Nunn is a Director of BMS Intermediaries in London.  He has over 30 years' experience in the design and placement of complex specialty casualty reinsurance treaty and program accounts.  BMS is an independent, employee-owned specialist intermediary and client advocate/adviser, offering innovative and high-quality products, services and analytics.

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