Privity of Contract in Reinsurance: It's All in the Relationship
August 2010
As those familiar with reinsurance know, reinsurers
assume all or part of the risks of their ceding insurers' customers—the insureds.
by Larry
P. Schiffer *
Dewey & LeBoeuf
LLP
For example, the XYZ Company insures its factory for $10 million in property
coverage with ABC Insurance Company. ABC Insurance Company in turn reinsures
50 percent of the $10 million limit with a reinsurer. Yet, if XYZ Company tries
to recover a property loss from the reinsurer instead of ABC Insurance Company,
XYZ Company’s attempt will likely fail. This is because there is no direct contractual
relationship between XYZ Company and the reinsurer: no privity of contract.
What Is Privity of Contract?
Privity of contract is a legal concept that describes the relationship between
parties when there is a contract involved. The doctrine of privity of contract
states that a contract only confers rights and liabilities upon the contracting
parties. As such, privity of contract is required between two parties in order
for one party to have a direct right of action against the other party stemming
from an alleged breach of a contract. In the context of reinsurance, there is
no privity of contract between a reinsurer and an insured, and the insured generally
does not have a direct right of action against the reinsurer if the insured’s
claim is not paid by its direct insurer.
There are, however, limited exceptions that have been recognized by courts in recent
years that allow an insured a direct right of action against a reinsurer where
the direct insurer was unable to satisfy a claim. Furthermore, there are a few
states that have promulgated statutory exceptions, which provide for a direct
right of action even if privity is lacking.
State of the Law
The longstanding rule is that there is no privity of contract between a reinsurer
and the insured. A direct right of action between an insured and a reinsurer
does not exist. When courts have allowed a direct action to be brought, it has
been predicated on a fact pattern in which the contractual provisions or actions
of the party created privity.
A number of cases in recent years have affirmed that the baseline rule in
this area has gone unchanged. In U.S. Fid. & Guar. Co.
v. S.B. Phillips Co. Inc., 359 F. Supp. 2d 189 (D. Conn. 2005), the court
stated quite clearly that a contract of reinsurance does not give to a right
of action by the insured against the reinsurer. The mere existence of a reinsurance
contract does not create privity of contract.
Similarly, the court in Executive Risk Indem., Inc.
v. Charleston Area Med. Ctr., Inc., 681 F. Supp. 2d 694 (S.D. W. Va.
2009), restated the concept that an indemnity reinsurance agreement confers
no rights on the insured unless the language of the reinsurance contract clearly
expresses intent on the part of the reinsurer to be directly liable to the insured.
Finally, the court in General Reins. Corp. v. American
Bankers Ins. Co. of Fla., 996 A.2d 26 (Pa. Commw. Ct. 2009), explained
that the baseline rule is that reinsurance recoveries are general assets of
the insolvent insurer estate. This notion is based "upon the simple fact that
policyholders usually have nothing to do with the insurer's decision on placement
of the reinsurance and do not even know of the existence of reinsurance at the
time they purchase coverage from the insolvent insurer."
Id. at 9.
Therefore, the insured does not have the right to directly access the funds
of the reinsurer.
Exceptions Recognized by the Courts
There are limited exceptions to this rule that provide for a direct right
of action against reinsurers. Certain conduct by a reinsurer can display to
the court that there is a direct relationship between the insured and the reinsurer.
For example, if the reinsurer handles claims directly, that would suggest that
the reinsurer is simply functioning as an insurer.
See Felman Prod.,
Inc. v. Industrial Risk Insurers, 2009 WL 3380345 (S.D. W. Va. 2009)
(stating that the direct handling of an insured's claim by the reinsurer creates
a direct relationship between the parties and allows the insured a direct right
of action). The court in Koken v. Legion Ins. Co.,
831 A.2d 1196 (Pa. Commw. Ct. 2003), listed a number of relevant factors to
be used in examining the extent of the reinsurer's involvement in the insurance
policies of the insured. These factors include whether the insolvent insurer
acted as a pass-through, whether the policyholder chose or purchased the reinsurance
for their own benefit, and whether the reinsurer assumed most or all of the
risk from the original insurer.
Another exception arises if the insured was included in the reinsurance contract
as a third-party beneficiary, in which case the insured is considered a party
to the contract and privity is created. The third party must be identifiable
from the contract, and the contract must clearly create third-party liability.
There is a strong presumption against the creation of a third-party beneficiary
relationship, and "express declaration" of the intended relationship is necessary.
See J.C. Penney
Life Ins. Co. v. Transit Cas. Co. in Receivership, 299 S.W.3d 668 (Mo.
App. 2009). In the absence of express contractual terms, third-party rights
can only be established if the circumstances are so compelling as to require
the recognition of the right in order to effectuate the clear intentions of
the parties. See
Brand v. AXA Equitable Life Ins. Co., 2008 WL 4279863 (E.D. Pa. 2008).
The court in Ario v. Reliance Ins. Co., 981
A.2d 950 (Pa. Commw. Ct. 2009), used a five-part test first discussed in
Koken v. Legion to determine that the insured
was an intended third-party beneficiary of the reinsurance contract. The five
factors are:
- Whether the ceding insurer was solely a fronting company;
- Whether the ceding insurer entered the transaction to generate fees
as opposed to premium revenue;
- Whether the reinsurer functioned as a direct insurer by funding and
processing claims;
- Whether the ceding insurer or policyholders selected the reinsurer;
and
- Whether a balancing of equities favor direct access by policyholders
to the funds of the reinsurer.
Finally, specific contractual language that creates a direct connection between
the insured and the reinsurer can allow for a direct cause of action. The court
in Felman Production explained that the terms
of the reinsurance contract can impact the relationship between the insured
and the reinsurer. The court referenced U.S. to Use
of Colonial Brick Corp. v. Federal Sur. Co., 72 F.2d 964 (4th Cir. 1934),
which states that contracts can be drafted to provide for direct liability where
the insured is a third-party beneficiary or where liability is expressly assumed.
The court found that the terms of the contract were ambiguous as to the role
of the reinsurer relative to the insured, and construed the ambiguity against
the reinsurer.
One example of this kind of language is a cut-through provision, which states
that the reinsurer will pay the claims of the insured directly if the original
insurer is unable to do so. A cut-through provision must clearly create liability
on the part of the reinsurer to be recognized by the court.
See Jurupa Valley
Spectrum, LLC v. National Indem. Co., 555 F.3d 87 (2d Cir. 2009). (The
court found that the cut-through was vague and did not clearly create direct
liability on the part of the reinsurer. Absence of the word "direct" or similarly
definitive language allowed the court to rule that there was no privity of contract.)
See
Playing the Name
Game—An Update on Cut-Through Clauses, August 2009.
Statutory Exceptions
A number of states have statutes that explicitly preclude a direct right
of action by the insured against a reinsurer. For example, the California code,
in Cal. Ins. Code § 922.2(c), states the following:
The original insured or policyholder shall not have any rights against the
reinsurer which are not specifically set forth in the contract of reinsurance,
or in a specific agreement between the reinsurer and the original insured or
policyholder.
Louisiana has a statute that seems to be more open to a direct right of action.
The statute reads:
Whenever an insurer agrees to assume and carry out directly
with the policyholder any of the policy obligations of the ceding insurer under
a reinsurance agreement, any claim existing or action or proceeding pending
arising out of such policy by or against the ceding insurer with respect to
such obligations may be prosecuted to judgment as if such reinsurance agreement
had not been made, or the assuming insurer may be substituted in place of the
ceding insurer.
LSA-R.S. 22:657(A).
The courts have limited those actions to cases where the reinsurance agreement
clearly expresses the intent of the parties to stipulate some advantage for
the third party. See
Donaldson v. United Cmty. Ins. Co., 741 So. 2d
676, 682 (La. App. 1999).
One area of law that provides for a direct right of action between a reinsurer
and the insured is New York’s statute regarding sureties, which states:
(a)(1) In applying the limitation of section one thousand
one hundred fifteen of this chapter to fidelity and surety risks the net amount
of exposure on any one fidelity or surety risk shall, except as provided in
paragraph four hereof, be deemed within the limit of ten percent if the company
is protected in excess of that amount by:
(A) reinsurance in a company authorized to write such business
in this state or reinsurance in an accredited reinsurer, as defined in subsection
(a) of section one hundred seven of this chapter, which is in such form as to
enable the obligee or beneficiary to maintain an action thereon against the
ceding insurer jointly with the assuming insurer or, where the commencement
or prosecution of actions against the ceding insurer has been enjoined by any
court of competent jurisdiction or any justice or judge thereof, against the
assuming insurer alone, and to have recovery against the assuming insurer for
its share of the liability thereunder and in discharge thereof.
N.Y. Ins. Law § 4118(a)(1) (McKinney 2009).
The court in the Matter of Union Indem. Ins. Co.
of N.Y., 200 A.D.2d 99, 108 (1st Dept. 1994), interpreted the statute
to mean that a beneficiary or obligee can commence a direct right of action
against the assuming insurer.
Conclusion
In most cases, there is no privity of contract between a reinsurer and the
insured, and the insured typically does not have a direct right of action against
the reinsurer. Although there are exceptions that have been used by courts in
recent years to allow the insured a direct right of action against the reinsurer,
these are generally limited to instances where the contract clearly created
some form of liability to the insured. Without express language to that effect,
a direct right of action generally is precluded, and the insured generally is
unable to directly access the funds of the reinsurer.
If the intent of the parties is that the insured should have access to the
reinsurer if the direct insurer defaults (or otherwise), that right should be
expressed in clear terms in the reinsurance contract. Many newer reinsurance
contracts, however, have a clause that specifically refutes any consideration
of liability to any third party, including the insured. This clause preserves
in express terms the common law doctrine of privity of contract.
*
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