A typical reinsurance contract provides that the reinsurer will reimburse the reinsured for an agreed-upon amount or percentage for each loss ceded to the reinsurance contract.
In a typical insurance claim, an insured event triggers a single claim by a policyholder—a factory worker injures her hand on the job and proceeds to file a workers compensation claim with her company's insurance company. Assuming the workers compensation insurer purchased reinsurance for the type and quantum of claim made by the injured worker, the reinsurance contract will likely reimburse the workers compensation insurer for some or all of its payment to the injured worker.
But sometimes an insured event is catastrophic and triggers numerous substantially similar claims against multiple policyholders all insured by the same insurer. Take, for example, a hurricane in South Florida that damages several factories and causes injuries to thousands of workers, many of whom bring claims that are presented by the policyholders to the same insurer. These accumulated losses may cause the reinsurer a problem when they are paid and ceded to the insurer's reinsurance contracts.
In other situations, the reinsurance purchased by an insurance company may have an aggregate cap limiting the number or dollar amount of claims that may be ceded to the reinsurance contract. This means that if there are numerous losses presented to the reinsurer, the reinsurance may run out (reach its aggregate cap) and the reinsured is left "bare" on the remaining similar, but now unreinsured claims. These restrictions may present problems in the context of certain catastrophic events if the reinsured has suffered an overaccumulation of losses arising from its policies.
Let us suppose that an insurer enters into a reinsurance contract in which the reinsurer caps coverage for a single event at $10 million no matter the number of occurrences or claims. In the event of a catastrophe, the insurer's liability to each individual insured may be relatively small, but when you add up the total aggregate amount paid to all insureds affected by the disaster, the total dollar amount could far exceed the available reinsurance coverage. To protect themselves from this type of exposure, insurance companies may purchase additional reinsurance in the form of clash coverage.
In this Commentary, we will discuss the concept of clash coverage and its traditional usage, and then discuss how this type of coverage could be used beneficially by reinsureds to protect themselves from economic catastrophes like the recent Madoff "Ponzi" scheme.
Clash coverage is a type of reinsurance designed to protect an insurance company from the loss of its normal reinsurance recoveries when it is faced with multiple claims from multiple insureds arising out of the same catastrophe and where its reinsurance does not fully reimburse the insurer for these related losses. In some instances, multiple insureds file claims based on substantially similar policies. In other cases, a single insured files multiple claims based on more than one policy. Clash coverage is targeted at protecting the direct insurer burdened by these multiple claims arising from truly exceptional events, beyond those contemplated by basic primary and excess-of-loss policies.
Given that clash coverage protects the reinsured from multiple claims arising out of a single event, the definition of "clash event" is critical in the reinsurance contract. To some extent, the definition of "clash event" varies according to the intentions of the parties. But the core definition often has three main components. First, there must be loss arising out of multiple policies held by one insured or similar policies by multiple insureds. Second, all the damage must be traceable to—and the direct consequence of—a particular event. And third, clash coverage contracts require that the event takes place in its entirety within a specific timeframe.
Traditionally, clash coverage has been purchased in the context of major natural disasters, such as hurricanes, floods, fires, or earthquakes. But insurance companies continue to explore the application of clash coverage to "business disasters" like the savings and loan crisis, the collapse of Enron, the subprime crisis, and the stock option grant cases, all of which resulted in many businesses filing clams with their insurance companies under various professional, directors and officers, and errors and omissions policies. With the advent of additional economic disasters like the Madoff "Ponzi" scheme and its progeny, insurance companies that have been able to purchase clash cover reinsurance with broad terms and conditions, may find that purchase will inure to their benefit as the claims from this economic disaster come flowing in.
If clash coverage can be extended to apply to business disasters, it is difficult to think of circumstances in which it would have been more useful than the recent financial catastrophe caused by Bernard Madoff's alleged $50 billion "Ponzi" scheme. The Madoff situation has already generated a flood of litigation. As of February 20, 2009, approximately 40 separate lawsuits have been filed in federal and state courts across the country, principally in the Southern District of New York, with one court watcher identifying over 119 cases worldwide. These claims have been brought against not only Madoff and his firm (which is in bankruptcy), but also against the investment firms and other financial institutions that placed their client's or their own money in Madoff's care. Many litigants allege violations based on Rule 10b-5 of the Securities and Exchange Commission, promulgated under Section 10(b) of the Exchange Act, which prohibits fraud or deceit in the purchase or sale of a security. Violations of Section 20(a) of the Exchange Act are also frequently alleged; this provision extends liability to every person who directly or indirectly controls another person liable for a securities law violation. Other legal theories include common law fraud, negligent misrepresentation, and breach of fiduciary duty. (Kevin LaCroix of the D&O Diary blog, is keeping track of "Madoff Investor and Feeder Fund Litigation.")
The immense amount of litigation will surely give rise to many insurance claims by these investment firms and financial institutions under several different types of policies. For example, there will be claims that may fall within the directors and officers coverage of investment adviser companies and other financial institutions. These policies cover loses from "wrongful acts," often including misstatements and errors by officers and directors of insured companies. Another type of insurance implicated here is professional liability and errors and omissions coverage, which effectively insures against claims of "professional" negligence. All brokerage firms and financial advisers likely have either professional liability or errors and omissions coverage. Claims could also likely to be made under fidelity bonds, which provide coverage for criminal acts, general partners' liability policies, and even under homeowners' insurance policies that protect the insured's investments.
Major economic disasters like the Madoff Ponzi scheme are understandably a cause for concern among the insurers that provide liability coverage to the financial institutions, like banks and investment firms, being sued by investors because of this scandal. Large financial institutional policies are written only by a limited number of insurers so the likelihood of accumulation of losses is significant. The reinsurers of those insurers will see even greater accumulation because the claims will come in from multiple reinsureds on various layers of financial institution insurance programs for similar insureds.
Although total possible exposure is hard to calculate, broker Aon Corporation, predicts that the total exposure from the Madoff Ponzi scheme could theoretically exceed $6.4 billion, although this figure is predicated on the unlikely assumption that there will be 100 percent liability for all parties. Aon estimates that the insurance industry's range of direct insured losses is more likely to be between $760 million and $3.8 billion, still an enormous sum for one event.
When the financial institution and other insurers turn to their reinsurers for reimbursement for the massive liability caused by this economic disaster, many of their reinsurance programs will not respond fully or will only respond to a limited number of losses because of the typical reinsurance contract provisions expressly capping the dollar amount available for reimbursing reinsureds on a "per-event" basis. That is, reinsurance companies will likely try to aggregate all losses arising out of the Madoff scandal for coverage limitations purposes under professional liability, errors and omissions, and directors and officers policies because these losses are arguably all caused by the same business disaster or event.
Those insurance companies that have purchased clash cover with definitions broad enough to include the Madoff scandal will suffer much less net loss as a result of this economic catastrophe. Those who for various reasons did not or were unable to purchase clash coverage may find their already strained surplus under further stress.
Reinsureds can protect themselves in anticipation of future economic catastrophic events. One way is to purchase clash coverage reinsurance that is sufficiently broad to encompass economic and business disasters, and not limited to natural catastrophes. This idea is not entirely new. More than a decade ago, in an award-winning article on variations in clash reinsurance contract terms, Emily Canelo and Bryan Ware provided sample terms under which a "business disaster" could be brought under the umbrella of clash coverage protection.
As mentioned, the key to each clash coverage policy is the definition of "clash event," given that the coverage only applies to certain types of disasters. Ms. Canelo and Mr. Ware write that the policy should contain language defining the event as loss covered by one or more policies of insurance, all of which is traceable to the same central loss:
"Central Loss" shall mean the failure (including but not limited to liquidation) or impairment (including but not limited to severe financial loss and/or the need to seek or receive protection under State or Federal statute or regulatory authority) of one or more nonprofit institutions, public entities, or commercial enterprises, without whose failure or impairment there would have been no claim(s) against the original insured(s).
The reinsurance contract should specifically provide that the coverage applies to losses arising out of insured claims under the reinsured's professional liability, directors and officers, and errors and omissions policies. (See the complete article, in which Ms. Canelo and Mr. Ware provide further draft language.) While the reinsurer may want the clash event definition expressed as narrowly as possible, the reinsured will want the maximum amount of exposure covered. In this day and age of repeated economic catastrophes, a broader definition of clash event is needed to cover these disasters. For this reason, it is important that the reinsurer and reinsured come to a very specific agreement about how far they intend coverage to extend, and must be precise in drafting the contours of this coverage in the reinsurance contract.
The traditional notion of clash cover being used only for accumulation of risk in natural disasters needs to be rethought in light of the repeated economic business disasters of the past several years. The ability of an insurance company to protect its net by purchasing clash cover will depend on the availability of that cover in the marketplace and obviously the price of that coverage. Nevertheless, insurers that write professional liability, directors and officers, and errors and omissions insurance for financial institutions and other providers in the financial community need to consider broad clash cover reinsurance as part of their reinsurance programs to protect themselves from the unintentional accumulation of risk arising from economic disasters like the Madoff Ponzi scheme.
The author gratefully acknowledges the valuable assistance of Daniel T. Stabile in the research and drafting of this Commentary.
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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.