Are Punitive Damage Awards Recoverable under Reinsurance Agreements?
June 2000
When an insured's bad faith claim against
its insurer is successful and the court awards punitive damages, does the reinsurer
have to reimburse the insurer for the punitive damages judgment? The answer
to this question depends on the reinsurance contract provisions and whether
punitive damages are reinsurable under the public policy of the relevant jurisdiction.
by Larry
P. Schiffer
LeBoeuf,
Lamb, Greene & MacRae, L.L.P.
Nothing strikes fear in the hearts of insurance professionals more than an
allegation of bad faith coupled with a demand for punitive damages. A bad faith
case and punitive damages demand often follow when an insurer takes too much
time to respond to a claim, fails to specify the reasons for a reservation of
rights, ignores settlement opportunities, disclaims all defense or coverage
obligations, or otherwise mishandles a claim. But what happens when an insured’s
bad faith claim against its insurer is successful and the court awards punitive
damages? Does the reinsurer have to reimburse the insurer for the punitive damages
judgment the insurer paid? The answer to this question depends on whether the
coverage provisions of the reinsurance contract are broad enough to include
punitive damages awarded against a cedent and whether punitive damages are reinsurable
under the public policy of the relevant jurisdiction.
Extracontractual Obligations
The market dictates whether reinsurers will offer broad coverage to their
cedents. A standard reinsurance contract provides that the reinsurer will reimburse
the cedent for a certain portion or dollar amount of the settlements and judgments
actually paid by the cedent on claims arising under the policies of insurance
that it issued. Loss adjustment expenses incurred by the cedent in adjusting
and defending the claims may be reinsured under the limit of liability provided
by the reinsurance contract or in addition to the reinsurance limits.
In a soft market, cedents will demand and reinsurers will offer various enhancements
to the reinsurance protections normally provided. One of those enhancements
is the extracontractual obligations (ECO) clause.
The typical ECO clause provides that the reinsurer will reimburse the cedent
for payments made by the cedent on a claim that goes beyond the four corners
of the coverage provisions of the underlying insurance contract. Punitive damages
awarded on bad faith claims are precisely the type of claim that falls outside
the underlying insurance contract, but which the reinsurer likely has to pay
under an ECO clause. Where the reinsurance contract does not have an ECO clause,
a cedent will find it much more difficult to prevail on its reinsurer to reimburse
it for punitive damages.
Typically, the ECO clause has a limit of liability or a percentage recovery
provision of its own. ECO liability generally is not limited by the reinsurance
contract’s general limit of liability. The clause also might have a provision
for determining the date of loss, although the original date of loss is often
used. More recently, ECO clauses have been amended to provide that the clause
is only valid in jurisdictions where the insurability of punitive damages is
not prohibited. It is this latter provision that leads us to the public policy
debate.
Public Policy and Insurability of Punitive Damages
Punitive damages exist to punish a wrongdoer for aggravated, intentional,
or willful acts against the public. Different states alter the availability
of punitive damages to varying degrees. Essentially, where punitive damages
are assessed, the wrongdoer must have acted in such a way that punishment beyond
compensatory damages is appropriate. Typically, that punishment is meted out
because of the direct acts of the insurer in handling the underlying claim or
because of the acts of its employees and agents, which subject the insurer to
vicarious liability for those wrongful acts.
Whether one may insure against punitive damages is a question of public policy.
The majority of the states allow parties to insure against punitive damage awards.
In those states, reinsurability of punitive damages is not an issue as long
as the reinsurance contract has an ECO clause or other coverage provision broad
enough to encompass punitive damages. Other states permit the insurance of punitive
damages only where the assessment of punitive damages results from vicarious
liability imposed upon the party against whom the punitive damages are assessed.
In an important minority of states, however, punitive damages may not be
insured against. In those states, public policy prohibits reimbursing a wrongdoer
for its intentional acts because the purpose behind assessing punitive damages
is to punish the wrongdoer for its acts. To allow for the reimbursement of punitive
damages through insurance would run counter to the deterrent purpose of punitive
damages. California, Connecticut, and New York are examples of the minority
of states that do not permit the insurance of punitive damages assessed for
the direct acts of the wrongdoer.
Logic dictates that if a state’s public policy prohibits the insurance of
punitive damages, then reinsurance coverage is not permitted either. Conversely,
if a state permits a wrongdoer to insure itself for punitive damages, then reinsurance
coverage for punitive damages assessed against a cedent should also be permitted.
Choice of Law Rules
Whether a claim for punitive damages will be covered under a reinsurance
contract will depend on which state’s law governs the interpretation of the
contract. In a reinsurance dispute, these issues may become complicated. For
example, if the underlying claim arose in state A, the insurer is domiciled
in state B, and the reinsurer is domiciled in state C, it may not be readily
apparent as to which state’s law applies. As many reinsurance contracts are
negotiated through brokers, the state where the broker resides also may become
relevant to the analysis.
If the reinsurance contract has a choice of law provision, the matter is
simplified. But if the arbitration clause in the reinsurance contract relieves
the arbitrators from following the strict rules of law, the issue becomes more
complex. If the arbitration panel chooses not to apply the public policy of
a state that prohibits the insurance of punitive damages, the cedent may seek
to vacate the arbitration award for the panel’s manifest disregard of the law.
This ground for vacating an arbitration award, however, is very difficult to
establish, especially where the arbitration panel is given wide latitude under
the arbitration clause in the reinsurance contract to formulate a just result
for any dispute.
One court has created an exception to the minority rule prohibiting indemnification
of punitive damages awarded against a cedent. In Hartford
Fire Ins. Co. v Lloyd's Syndicate, 1997 US Dist LEXIS 10858, a Connecticut
federal court held that where an ECO clause specifically provides for indemnification,
the court would not seek to impose the law or policy choices of the forum state
over that agreement. The ECO clause in Hartford provided for "liabilities which arise from the handling of any claim . . . including
but not limited to bad faith," and the provision was accompanied by an arbitration
agreement relieving the arbitrators of the responsibility of following the strict
rules of law. Id at *1.
In reaching its conclusion, the court reasoned that chapter 2 of the Federal
Arbitration Act preempted state law provisions and that there was no national
public policy concerning the indemnification of punitive damages. "If contracting
parties agree to include claims for punitive damages in the issues to be arbitrated,
the FAA insures that their agreement will be enforced according to its terms
even if a rule of state law would otherwise exclude such claims for arbitration." Id at *10.
The implications of Hartford are still unclear,
as no other court has had the issue presented to it. However, Hartford does provide a foundation for arguing
that reinsurers agreeing to similar ECO clauses may not rely on the policy of
states such as California, Connecticut, and New York to escape their contractual
obligations to indemnify their cedents for punitive damages.
Where no choice of law provision exists in the reinsurance contract—which
is more typical than not—then conflict of law rules should be used to determine
which state’s law applies. If the arbitration clause gives the arbitration panel
broad powers to fashion a remedy by using the custom and practice of the reinsurance
industry, the panel may not analyze the choice of law issue using the conflict
of law principles that would have been used by a court.
Final Considerations
Insureds and their risk managers must keep in mind the differing public policy
positions of the states when considering commencing a bad faith action against
their insurer. Settlement considerations may differ depending on whether the
insurer is able to seek reimbursement for any punitive damages judgment rendered
against it for its bad faith claims handling. Cedents must be cognizant of the
public policy issues that their reinsurers may face when confronted with a notice
of claim that includes a punitive damages award. Under certain scenarios, a
reinsurer may correctly assert that to provide reimbursement for punitive damages
violates state law and, therefore, the ECO provision in the parties’ reinsurance
contract is void for that limited purpose in that state. Reinsurers must be
aware of these public policy issues as well and must weigh the denial of punitive
damages claims against its market position in the reinsurance industry.
The reinsurability of punitive damages is a very tricky issue. The ECO clause
was supposed to eliminate the confusion, but the public policy of a minority
of states still stands in the way of the business decision by reinsurers to
provide enhanced coverage to its clients.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.