When an insurance company pays a claim, it typically has a contractual, if not a legal, right to subrogation (unless waived). Subrogation, as defined in the IRMI Glossary, is the assignment to an insurer by terms of the policy or by law, after payment of a loss, of the rights of the insured to recover the amount of the loss from one legally liable for it.
On the property insurance side, when an insurance company pays for a loss to property, it typically has a right to salvage—to sell off the damaged property in an effort to recover something against the loss it paid. This commentary discusses how those recoveries apply to reinsurance.
The Reinsurance Contract
The reinsurance contract is a contract of indemnity. A typical property and casualty reinsurance contract obligates the reinsurer to indemnify the ceding insurer for losses the ceding insurer actually pays that come within the insurance policies ceded to the reinsurance contract and within the terms of the reinsurance contract itself. Most reinsurance contracts have salvage and subrogation clauses, which delineate how the reinsurer will share in any recoveries made by the ceding insurer.
Consider the circumstances if there were no salvage and subrogation clause in the reinsurance contract. The ceding insurer pays $100 on a loss and bills the reinsurer for $50 (assuming a 50 percent quota share contract). The reinsurer pays $50 to the ceding insurer, fulfilling its obligation under the reinsurance contract. The ceding insurer, exercising its subrogation rights, subsequently recovers $100 from the party that actually caused the loss. The ceding insurer is not only made whole by the recovery but actually obtains a windfall because of the $50 reinsurance payment.
Most reinsurance contracts contain salvage and subrogation clauses that require the ceding insurer to share any recoveries with the reinsurer. Logically, if the reinsurer is only obligated to indemnify the ceding insurer for its actual loss payments, when the ceding insurer obtains a full recovery of its loss payment, the right to cede the loss is eliminated, and the reinsurer no longer has a contractual obligation to pay anything. Generally, most reinsurance contracts provide that the reinsurer's obligation to indemnify the ceding insurer is net of any recoveries.
Many salvage and subrogation clauses require that the recovery be applied to the loss as if the reinsurance billing had not been made, thus resulting in an accounting reconciliation and recalculation of the loss for reinsurance purposes by taking into account the recovery as if it occurred before the loss was paid. For example, if, in the example above, the recovery were $80, then the ceding insurer would apply the $80 to the $100 loss reducing the loss to $20. The loss cession to the reinsurer would then be $10, not $50. The accounts would be realigned to reflect the net result of the recovery.
Salvage and Subrogation Clauses in Reinsurance Contracts
As in all things reinsurance, there are myriad versions of the salvage and subrogation clause. Often, the type of reinsurance dictates how the clause will read. For example, application of a recovery to a proportional quota share reinsurance agreement is different than applying a recovery to an excess-of-loss catastrophe reinsurance agreement.
To illustrate the point, below are some examples from the Brokers and Reinsurance Markets Association (BRMA) model clauses.
BRMA 47 A SALVAGE AND SUBROGATION
The Reinsurer shall be credited with its proportionate share of salvage or subrogation recoveries (i.e., reimbursement obtained or recovery made by the Company, less the actual cost, excluding salaries of officials and employees of the Company, of obtaining such reimbursement or making such recovery) on account of claims and settlements involving reinsurance hereunder.
Note: For use in Pro Rata Contracts.
BRMA 47 C SALVAGE AND SUBROGATION
The Reinsurer shall be subrogated, as respects any loss for which the Reinsurer shall actually pay or become liable, but only to the extent of the amount of payment by or the amount of liability to the Reinsurer, to all the rights of the Company against any person or other entity who may be legally responsible in damages for said loss. The Company hereby agrees to enforce such rights, but in case the Company shall refuse or neglect to do so, the Reinsurer is hereby authorized and empowered to bring any appropriate action in the name of the Company or its policyholders, or otherwise to enforce such rights.
Any recoveries, salvages or reimbursements applying to risks covered under this Contract shall always be used to reimburse the excess carriers (from the last to the first, beginning with the carrier of the last excess), according to their participation, before being used in any way to reimburse the Company for its primary loss.
In the event there are any salvages, recoveries or reimbursements recovered subsequent to a loss settlement, it is agreed that if the loss adjustment expense incurred in obtaining salvage or other recoveries is less than the amount recovered, such expense shall be borne by each party in the proportion that each party benefits from the recoveries, otherwise, the amount recovered shall first be applied to the reimbursement of the expense of recovery and the remaining expense shall be borne by the Company and the Reinsurer in proportion to the liability of each party for the loss before such recovery had been obtained.
Note: For use in Excess of Loss Contracts when loss adjustment expense is prorated.
The differences between these two clauses are clear. For the proportional reinsurance contract, the recovery is allocated to the reinsurer proportionately. For the excess-of-loss agreement, the recovery works its way down from the last excess to the first excess before it benefits the ceding insurer. This "top-down" method of recovery is only fair because higher-level excess insurers and reinsurers do not expect to pay a loss unless the underlying layers have been exhausted by payment of loss. Thus, if there is a recovery, the top layer excess-of-loss reinsurers will benefit from the recovery first.
The examples above also point out that the allocation to reinsurers will be net of expenses incurred to obtain the recovery. The actual cost to the ceding insurer to obtain the recovery will be deducted from the recovery prior to its allocation to reinsurers.
The second example also provides that if the ceding insurer does not pursue subrogation, the reinsurer has the contractual right to do so. The ceding insurer is obligated to seek the recovery, but sometimes there are circumstances where it makes more sense for the reinsurer to step into the ceding insurer's shoes (essentially two pairs of shoes given that subrogation is stepping into the policyholder's shoes in the first instance). For example, if the ceding insurer ceded substantially all of its liability to its reinsurers, it may make more sense for the reinsurers to pursue the recovery. This is especially true if the ceding insurer was merely a fronting insurer for the real party in interest acting as a reinsurer.
The second example also addresses expenses in the context of a less than 100 percent recovery subsequent to a loss settlement. The clause covers the scenario where the expenses to obtain the recovery are less than the recovery itself (proportional allocation) to the scenario where the expenses exceed the recovery (allocation to reimburse expense recovery, with parties keeping net the loss based on their proportional liability before recovery).
In a third example below (not from BRMA), the reinsurers participated on an ultimate net loss basis, so the recovery is allocated based on that basis (with a sharing of the costs for obtaining a recovery). In this clause, the recoveries are applied as if received prior to the loss, and the accounts are adjusted accordingly.
SALVAGE AND SUBROGATION
The Cedents jointly and severally agree to pay to or credit the Reinsurer with 75 percent of any recovery connected with an Ultimate Net Loss which is obtained from salvage, subrogation, or other insurance or any other recovery, after charging the Reinsurer with 75 percent of the expenses directly incurred by the Cedents in obtaining any such recovery. Any such recoveries received subsequent to any loss or claim settlement hereunder shall be applied as if received prior to the aforesaid loss or claim settlement and all necessary adjustments in such regard shall be made accordingly.
Recoveries under Catastrophic Loss Scenarios
The topic for this Expert Commentary came to mind because of the recent California wildfires in both northern and southern California. Ceding insurers have paid billions in losses to property owners and, in turn, have ceded billions in losses to the reinsurance market and, ultimately, to the retrocessional market. Recently, PG&E, the California electric utility, which was forced into bankruptcy because of 2017 and 2018 wildfire claims, reached an $11 billion settlement with 85 percent of the subrogation insurers. While it is likely that these and other settlement payments will not be made until the bankruptcy court approves the payments, and PG&E emerges from Chapter 11 with a plan of reorganization, the settlement, if it goes forward, does mean that ceding insurers will obtain a little over a 50 percent recovery if the settlement is approved.
Assuming that this settlement goes forward (there is some significant doubt about that given recent developments), it begs the question of how that recovery will be allocated to reinsurers. First, the $11 billion will be allocated among the ceding insurers that exercised their subrogation rights. Those ceding insurers will then need to allocate their recovery to the policies that paid the losses. They then will have to examine their reinsurance programs to determine how to allocate a share of those recoveries to their reinsurers.
Given that this was a catastrophic loss implicating excess insurance and reinsurance, the "top-down" methodology will likely apply to both the allocation among the ceding insurers and the excess-of-loss reinsurers. Then there is the question of allocating the cost of obtaining the settlement with PG&E among the parties. Typically, the expenses will come off the top of any recovery (unless there is some sharing), and the net amount will be allocated after expenses are paid on a proportional basis (because the recovery is less than the total loss, plus expenses).
The allocation of the $11 billion recovery will be complicated, given the number of ceding insurers and assuming reinsurers, and will take some time. We can be sure, however, that reinsurers will share in that $11 billion settlement or whatever the ultimate settlement may be.
Salvage and subrogation are an essential part of the risk-spreading feature of insurance. This applies equally to reinsurance. The direct writing company generally has a duty to seek recoveries where appropriate to help mitigate the insured and reinsured loss. Because reinsurers would never pay anything unless the ceding insurer actually pays a loss, any recovery will inure to the benefit of the reinsurers, net of expenses in obtaining the recovery and either on a proportional or "top-down" basis, depending on the nature of the reinsurance provided.
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