When a ceding insurer purchases reinsurance, it generally expects that its reinsurer will respond to the ceding insurer's claims to the same extent that the ceding insurer covers the underlying claim unless otherwise stated in the reinsurance contract. In other words, ceding insurers often expect back-to-back reinsurance coverage. While this is not true in every reinsurance relationship, it is the case more often than not. This commentary will briefly explore the concept of back-to-back reinsurance coverage.
First, a little Reinsurance 101. There are two basic types of reinsurance: treaty reinsurance and facultative reinsurance. Treaty reinsurance covers a portfolio of insurance policies written by an insurance company and issued to the insurance company's policyholders. This could include every underlying insurance policy written by the ceding insurer during a year or just a segment of the insurance policies written by the ceding insurer based on jurisdiction or line of business or type of underlying policyholder. On the other hand, facultative reinsurance covers an individual risk insured by a specific insurance policy issued by an insurance company. Because facultative reinsurance generally covers a specific individual risk, the concept of back-to-back reinsurance coverage makes the most sense from a commercial perspective.
Let's look at an example: A ceding insurer writes a $5 million property insurance policy covering a factory for all risks. It purchases a facultative reinsurance contract covering $2.5 million excess of $2.5 million of the same risk. The facultative reinsurance is documented by a facultative certificate, which has tick boxes that reflect the nature of reinsurance assumption as either concurrent or nonconcurrent. In this case, the concurrent box is checked, reflecting the explicit assumption that the reinsurance coverage is back-to-back.
There is little doubt that the ceding insurer expects the facultative reinsurance to be coextensive with all the ceding insurer's coverage obligations under its underlying property policy. Just by the nature of the facultative purchase, the ceding insurer is seeking to reduce its overall risk exposure from $5 million to $2.5 million. If the facultative reinsurer does not provide back-to-back reinsurance coverage, then the purpose of reducing the ceding insurer's exposure by 50 percent is defeated.
The same concepts may apply to treaty reinsurance, but with treaties, depending on the portfolio makeup, back-to-back reinsurance coverage may not be necessary or warranted. Treaties are sometimes structured to only assume certain liabilities with the ceding insurer keeping other liabilities net. All of this depends on the structure chosen and the ceding insurer's overall reinsurance plan. As always, the specific language of the reinsurance contract will dictate the nature and scope of the reinsurance coverage.
As noted above, when a ceding insurer purchases reinsurance, it generally expects that its reinsurer will cover the reinsurer's share of the losses ceded on a coextensive basis. Unfortunately, this has not always been the case, and some ceding insurers have been left to satisfy policy obligations without the benefit of the reinsurance support they thought they purchased.
Looking at another example: Let's say a ceding insurer issues a policy covering a company's liability under a broad commercial general liability policy. A loss occurs, and the ceding insurer pays the loss because, in the jurisdiction where the loss took place, that type of loss must be paid by the insurance company. The ceding insurer then seeks recovery from its reinsurer, but the reinsurance contract is governed by the law of a different jurisdiction where loss payments for that type of loss are not recoverable. Under this example, the reinsurance is not coextensive and the ceding insurer will have to bear the underlying loss without a reinsurance recovery unless the language of the reinsurance contract provides otherwise.
Unintended consequences can arise where reinsurance contracts are not drafted to take into consideration the ceding insurer's intent that the reinsurance coverage be back-to-back. Those unintended consequences can result in the ceding insurer being forced to take net more losses than the ceding insurer intended to absorb. This could affect the policyholder surplus of the ceding insurer and could affect the ceding insurer's ratings with the rating agencies. In the worst-case scenario, the failure to draft reinsurance contracts correctly to assure back-to-back reinsurance coverage could affect the ceding insurer's solvency.
Whether reinsurance is back-to-back is not a theoretical issue. Reinsurers have rejected loss cessions based on a variety of reasons, including that the law of a particular jurisdiction bars reinsurance coverage. Most recently, the Second Circuit Court of Appeals addressed a reinsurer's claim that it did not have to cover a loss paid by its ceding insurer because of the allocation methodology that the ceding insurer applied to a settlement of environmental losses. In The Ins. Co. of the State of Pa. v. Equitas Ins. Ltd., No. 20-3559-cv (2d Cir. May 22, 2023), the reinsurer rejected its ceding insurer's claim alleging that, under the laws of the United Kingdom, which governed the facultative reinsurance contract, a settlement allocation based on the "all sums" approach would not be permitted under the reinsurance contract. Instead, under English law, the cedent's liability would have been prorated based on the number of years that the cedent provided coverage to its insured. Accordingly, the reinsurer argued that its liability under the reinsurance contract was similarly limited even though the settlement allocation was permitted under California law.
On summary judgment, the district court granted the cedent's motion and denied the reinsurer's motion. The Second Circuit affirmed. The court held that the better reading under English law was that the reinsurer's liability under the facultative certificate was coextensive with the ceding insurer's liability under its policy, not that English law required a different allocation. The court found that:
Under English law, there is a strong presumption that facultative reinsurance policies provide back-to-back coverage, meaning that the liability of the insured is generally equivalent to the liability of the reinsured.…
In the context of facultative reinsurance, the original insurer reinsures part of its risk by paying the reinsurer "a proportional share of the premium." Wasa  1 AC 180 (HL) ¶ 55 (Lord Collins). "[T]he obvious commercial intention" of that arrangement is "for the reinsurer to accept that part of the risk." Id. ¶ 60. "Consequently, the starting point is that normally reinsurance of that kind is back-to-back with the insurance, and that the reinsurer and the original insurer enter into a bargain that if the insurer is liable under the insurance contract, the reinsurer will be liable to pay the proportion which it has agreed to reinsure." Id. ¶ 55.
English law therefore recognizes a "strong"—though not conclusive—presumption that "liability under a proportional facultative reinsurance is co-extensive with the insurance." Id. ¶ 116. Thus, it will "almost invariably be the case" that losses falling within the original insurance policy will also fall within the reinsurance, "even if the losses are payable under a foreign law … which takes a view different from English law" on liability. Id. That "obvious" outcome "is simply commercial common sense." Id. ¶ 60. While a facultative reinsurance contract can deviate from that presumption, "[s]uch a contract would … be wholly exceptional" and constitute "a departure from the normal understanding of the back-to-back nature of reinsurance." Id. ¶ 62 [Internal quotation marks and citation omitted.]
While the presumption of back-to-back reinsurance has not been discussed as extensively under US law, the concept makes sense with the right contract wording and is, as Lord Collins said, commercially reasonable. Given the Second Circuit's analysis, one should expect a similar application under US law with the right contract wording.
The concept of back-to-back reinsurance, especially in the facultative reinsurance context, is one that brings commercial rationality to reinsurance claims obligations. When a ceding insurer purchases reinsurance, it generally expects that its reinsurer will stand with it and pay its reinsurance obligations coextensively with the obligations of the ceding insurer under its policy.
However, relying on presumptions is always dangerous. To ensure that the back-to-back concept is clear, the reinsurance contract should be drafted to reflect the parties' intent.
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