Expert Commentary

Privity of Contract in Reinsurance: It's All in the Relationship

As those familiar with reinsurance know, reinsurers assume all or part of the risks of their ceding insurers' customers—the insureds.


Reinsurance
August 2010

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:

  1. Whether the ceding insurer was solely a fronting company;
  2. Whether the ceding insurer entered the transaction to generate fees as opposed to premium revenue;
  3. Whether the reinsurer functioned as a direct insurer by funding and processing claims;
  4. Whether the ceding insurer or policyholders selected the reinsurer; and
  5. 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.


*The author gratefully acknowledges the contributions of Moshe Mandel, a 2010 summer associate at Dewey & LeBoeuf LLP and now a third year student at Harvard Law School, for his research and initial drafting of this Commentary.


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.

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