In my March 2009 Expert Commentary, I discussed clash coverage in the traditional sense of catastrophic losses and economic disasters, such as the Bernard Madoff Ponzi scheme. Clash covers, however, have been written for other types of situations, including extra contractual damages and excess of policy limits (bad faith) claims brought against the ceding insurer that would otherwise not be covered by the ceding insurer's reinsurance program. In other words, clash covers can be used to prevent against the unusual runaway bad faith situations, just like a property catastrophe loss.
Clash covers are meant to provide reinsurance protection for the unusual or catastrophic claims situation where the ceding insurer's standard reinsurance program does not provide adequate protection. Typically, these are situations where there are multiple claims arising from the same event, causing some of the loss to be unprotected because of aggregate limitations.
But clash covers can also be used to protect the ceding insurer from a different type of catastrophic loss: one where a bad-faith verdict or settlement causes the ceding insurer to pay well in excess of its policy limits because of its alleged claims-handling activity. An example would be a catastrophic loss occurs, injuring or killing multiple individuals. The policyholder may be faced with multiple wrongful death or serious injury claims that have to be managed by the ceding insurer. Should the claims situation deteriorate and a runaway verdict occur, the ceding insurer may be faced with claims of bad faith claims handling and failure to settle within policy limits. Those kinds of claims may result in a judgment or settlement well in excess of the ceding insurer's policy limits. Will the ceding insurer's reinsurance program cover the situation?
Protecting Against the Runaway Verdict
Clash programs are written a myriad of ways. One example is a situation where the reinsurance structure for the ceding insurer is built in layers. The first layer covers the ceding insurer for losses up to $500,000, with a $100,000 self-insured retention. The second layer may cover the ceding insurer for losses in excess of $500,000, but with an excess limit of $500,000. A third layer may provide excess-of-loss coverage for $1 million excess of $1 million. Finally, a fourth layer may be placed, providing for an $8 million reinsurance policy limit in excess of $2 million, but may include a warranty that the ceding insurer will purchase errors and omissions (E&O) insurance of $5 million, which inures to the benefit of the fourth-layer reinsurance agreement.
If the ceding insurer sustains a $2 million loss, the loss will be covered by the first three layers of reinsurance, with the ceding insurer participating in the first $100,000 of loss. If the ceding insurer incurs a $5 million loss because of an excess of policy limits jury verdict, the fourth layer reinsurer will not have to respond because of the inuring $5 million E&O policy—that is, assuming that the excess of policy limits loss is attributable to an error or omission covered by the E&O policy.
So, what does the fourth layer do? The fourth layer reinsurance contract protects the ceding insurer from a catastrophic bad faith verdict or settlement that exceeds the limit of the warranted E&O policy. For example, if the bad faith settlement is for $6 million, then the E&O policy will cover the first $5 million of the bad faith loss, and the fourth layer will cover $1 million of the bad faith loss.
This type of protection is especially important to smaller ceding insurers that could suffer a ratings downgrade if faced with a significant bad faith claim. Paired with an E&O policy, the ceding insurer is protected from moderate and significant bad faith claims. Of course, the actual policy limits will differ from company to company and from reinsurance structure to reinsurance structure, depending on the ceding insurer's book of business, capitalization, and buying power.
Knowing Your Reinsurance Program
One of the problems smaller ceding insurers often run into when addressing complicated claims is fully understanding the company's reinsurance program. A company might purchase a program like the one described above and have many years in which the clash cover protection is never accessed. In fact, a smaller ceding insurer is less likely to run into a catastrophic bad faith situation. But, if and when it happens, it is important to review all applicable reinsurance programs and notify all reinsurers of any loss that is likely to reach their layer.
Many reinsurance contracts, especially excess-of-loss and clash cover contracts, provide for notice of loss provisions that require the ceding insurer to notify the reinsurer if the ceding insurer thinks that the loss might implicate the reinsurance contract. With liability coverage, it is not unusual for the loss reporting provision of a reinsurance contract to require immediate reporting of any loss that resulted from a death.
When a ceding insurer has purchased clash cover protection that is meant only to cover a catastrophic bad faith loss in excess of inuring E&O insurance, it is easy to forget to notify the clash cover reinsurer of a personal injury loss resulting from a death. While the law of late notice in most jurisdictions will rarely penalize a ceding insurer for late notice in this situation, the better practice is to be aware of the notice requirements of all reinsurance protections and to provide notice, even if there is only a remote possibility that the loss will ever reach the full extent of the reinsurance program. Notifying an insurer or a reinsurer of a potential claim is always the smart way to go and rarely results in any downside.
Insurance losses are more than just the indemnity payments of the judgment or settlement to resolve the claim, but include the expenses associated with investigating and defending the claim. These expenses will include defense costs to defend the underlying insured and related costs associated with judgments and settlements. When coverage actions are brought by the policyholder or the insurer, additional expenses are incurred to resolve any disputes between the policyholder and the insurer, including bad faith claims and claims of failing to settle a claim within the policy limits.
Different reinsurance agreements address expenses differently. Typically, however, expenses are paid as a percentage or ratio to the indemnity payments paid. Sometimes, if there is no indemnity payment made (for example, a defense verdict in the underlying claim), the ceding insurer may not receive reinsurance protection from its reinsurers. Expenses often make up a large percentage of the total expenditure to resolve a claim, so fully understanding how reinsurance contracts, including clash covers, respond to expenses is very important.
Application of Inuring E&O Recoveries
In the example above, the clash cover provides that the warranted E&O insurance inures to the benefit of the reinsurance contract. If a bad faith claim is made and the E&O insurance has to respond, it becomes important to understand how that E&O recovery is then allocated to the loss for reinsurance purposes. Let us assume the clash cover contains the following provision.
Recoveries or collectibles from any other form of insurance or reinsurance which protect the Reassured from ECO [extracontractual obligations] shall inure to the benefit of the Reinsurers and shall be deducted from the total amount of ECO obligations for purposes of determining the Net Loss.
Assume also that net loss is defined as follows.
The term "Net Loss" shall mean the actual loss incurred by the Reassured under policies covered hereunder but shall exclude allocated loss adjustment expenses. Such loss shall include sums paid in settlement of claims and suits and in satisfaction of judgments.... Such loss also shall include 90% of any Losses in Excess of Policy Limits and Extra Contractual Obligations, incurred by the Reinsured.
Under this formulation, net loss is defined to include the amounts paid in the underlying personal injury action and also includes 90 percent of ECO losses, but excludes expenses. Assume that the underlying loss was settled before the bad faith claim and that significant expenses were incurred before the ECO claim was finally settled. How is the E&O recovery allocated to the loss?
At least one ceding insurer in a recent dispute took the position that the E&O recovery should be allocated to both indemnity and expense, in the order in which the indemnity and expense was paid. This resulted in a significant billing to the clash cover reinsurer. While there is a certain simplistic logic to that position, it is belied by the reinsurance contract wording in our example. The ceding insurer cannot allocate any of the E&O recovery to expenses paid, regardless of the timing.
In this example, net loss specifically excludes expense, and the E&O recovery must be deducted from the total amount of ECO obligations in determining the net loss. Thus, net loss is the total of the underlying indemnity payments ($2 million) and the ECO loss ($6 million) (totaling $8 million). The underlying excess-of-loss reinsurance covers the $2 million indemnity losses, which is subtracted from any reinsurance recovery calculation. The $5 million E&O recovery must then be subtracted from the remaining $6 million net loss (the ECO loss), regardless of whether the bad faith settlement was paid after the ceding insurer incurred millions in allocated loss adjustment expenses. In this example, the clash cover would only be responsible for $1 million (and a proportion of the expenses because of the net loss payment).
Clash covers offer catastrophic protection to ceding insurers, including catastrophic bad faith claims. Where a clash cover is being used to protect against bad faith claims, it is crucial to understand how the clash cover limits apply, whether inuring E&O insurance effectively increases the attachment point of the clash cover, and how any recovery from the E&O insurance will apply when calculating net loss under the clash cover reinsurance contract.
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