Larry Schiffer examines the errors and omissions clause in reinsurance policies, including its history, proper drafting, use and misuse, and court interpretations.
In an ideal world, the contractual relationship between a reinsured and its reinsurer is a long-term, mutually beneficial relationship. The mutual obligations found in the reinsurance contract are derived from the principles of fairness and good faith, which culminate in the standard of utmost good faith between the reinsured and the reinsurer. Indeed, reinsurance agreements are often referred to as "honorable engagements," generally intended to be viewed as statements of industry custom and understanding, and concerned above all with perceived intention of the parties rather than the strict interpretation of contract provisions.
Nevertheless, a strict interpretation of the contract provisions often provides the only method of preserving the viability of the agreement to cede and assume risk. Careful drafting and a clear understanding of the various provisions of a reinsurance agreement are essential. But sometimes errors happen. The wrong risk gets ceded to the wrong reinsurance contract, premium is not ceded, but losses on the underlying contract are, or other inadvertent errors occur during the processing of hundreds or thousands of transactions under the reinsurance agreement.
This commentary will briefly explore one clause in most reinsurance contracts that provides a meaningful method to improve the flow of information between the reinsured and the reinsurer without jeopardizing their relationship, whether newly formed or longstanding.
The Errors and Omissions Clause
Most, if not all, reinsurance agreements contain an errors and omissions clause. This clause allows inadvertent mistakes to be corrected without resulting in a breach of the reinsurance agreement. The errors and omissions clause protects either party from consequences of an inadvertent error or omission as long as the party seeking to invoke the clause rectifies the mistake upon discovery.
History of the Errors and Omissions Clause
Reinsurance commentators tell us that the clause originated in pro rata treaties. Robert Strain's treatise, Reinsurance Contract Wording, has interesting commentary about the history and utility of the errors and omissions clause. See for example, Marilyn J. Laughlin, "General Clauses for Most Treaties" in Reinsurance Contract Wording 40, 89–90 (Robert W. Strain, ed., 1992). Its purpose was to protect the reinsured from being deprived of reinsurance as a result of an oversight in ceding risks to the treaty by way of bordereaux reporting. As one might imagine, it is easy for a lengthy bordereaux to omit information.
The clause was later introduced to excess of loss reinsurance contracts and now relates not only to the bordereaux reporting system, but also to overall treaty administration. Its utility is found in the parties' accounting operations where the reinsurer just as easily might commit an error or omission as the reinsured. The clause protects each party from inadvertent errors but does not, and was never intended to, provide coverage that is otherwise excluded under the treaty.
Drafting the Errors and Omissions Clause
The errors and omissions clause attempts to maintain the contractual relationship between the reinsured and the reinsurer by providing "breathing room" for each party. Not surprisingly, however, the clause is often hastily drafted without consideration of its purpose and intent. When the time comes to invoke the clause, many discover to their surprise that it is either too broad or too narrow to effectively resolve the particular issue they face.
The errors and omissions clause is a requirement for most contracts and should be worded in such a way that all transactions are subject to it. Nevertheless, the clause must not act to override other, specifically negotiated provisions of the contract, for example those pertaining to timely and proper reporting of claims. The clause should be worded so that it applies only to inadvertent errors and omissions, and only where the error or omission is rectified immediately upon discovery. It is designed for clerical errors, such as errors in coding premiums or oversights in late reporting of premiums.
To ensure compliance with the fundamental purpose of honoring the original intent of the parties, the errors and omissions clause assures that clerical errors do not negate coverage that would have existed but for the error, and simultaneously avoids greater coverage on the basis of the mistake. The errors and omissions clause prevents frustration of the contract's purpose by forgiving inadvertent failure to report cessions and incorrect reporting of cessions, provided the error or omission is rectified as soon as possible after its discovery.
Mr. Strain describes the function of the errors and omissions clause as preventing the reinsurer from denying coverage due and requiring the reinsurer to follow the fortunes of the reinsured even when the reinsured omits necessary information or errs in supplying that information, such as failing to cede or renew a risk that should have been ceded or renewed, or improperly ceding a risk, or even erroneously sending a bordereaux or account.
Use and Misuse of the Errors and Omissions Clause
The versatility of the errors and omissions clause presents several pitfalls, which can be avoided by careful drafting and clear understanding of the scope of the clause. Mr. Strain describes a few of these circumstances. See, for example, R. Michael Cass, "Quota Share," in Reinsurance Contract Wording 110, 134-35 (Robert W. Strain, ed., 1992). For example, in quota share treaties, the entire clause can be overridden if the error is prejudicial. Classes of business specifically excluded from the treaty may be covered by the clause for a short period of time and be subject to a dollar limit. The clause may limit its application only to the reinsured, as where, for example, only errors or omissions not related to the loss notice requirements may be covered.
In other treaties, the clause may contain its own condition precedent to recovery, mandating that the reinsured rectify the error as soon as possible after discovery of the error. This requirement attempts to ensure equitable treatment for the reinsured, which will not be charged with the error unless someone with sufficient knowledge of and interest in the company's reinsurance arrangements was aware of the discrepancies in the information supplied to the reinsurer.
In addition, the errors and omissions clause may also contain a waiver provision, rendering the clause inapplicable to incorrect accounts and reinstatement payments or to failures to render notices of claims after a previously determined number of months or years. Because the errors and omissions clause predominantly concerns documentation errors only, it cannot rectify underlying mistakes in the reinsurance agreement such as inception of liability.
These pitfalls can be best avoided by keeping in mind what the errors and omissions clause was not intended to provide and also how the clause can be modified to reflect the true intentions of the parties to the reinsurance agreement. Commentators agree that the clause is not intended to provide a basis for the reinsured to alter its retention after the occurrence of a loss, or to protect the reinsured against an error or omission that results from a faulty business organization or structure of the reinsured. See Laughlin, supra, at 90.
Additionally, the reinsurer's liability will not be extended beyond the limits or the exclusions of the agreement. Neither will the reinsured be protected against late notice to the reinsurer of loss and loss reports as required in the Notice of Loss and Loss Settlements provisions of the contract. The clause also will not protect against failure to give notice of cancellation in continuous contracts.
The fundamental point is that the errors and omissions clause generally has been limited to errors in communications and transmittal of information. The clause generally should not compel the reinsurer to pay losses on cessions erroneously made, even if premium were paid and accepted by the reinsurer, as most reinsurance agreements contain a provision for return of premium for any cession made in error.
Concern about whether the clause was intended or not intended to apply to a particular situation can be alleviated in several ways. For example, the clause may limit its applicability to those transmittals of information that are timely under the Notice of Loss provisions. Another alternative is to specify a date after which delays in reporting initial claims are excluded from the errors and omissions clause. An even more direct approach is to specifically exclude certain provisions of the reinsurance contract from being subject to the errors and omissions clause.
To fully use the errors and omissions clause as a mechanism for maintaining a successful relationship between the reinsured and the reinsurer, keep in mind the consequences of inadequate attention to contract provisions in general and the errors and omissions clause in particular. The usual consequence of inattention results in an overly broad errors and omissions clause, which may unintentionally vitiate the provisions of the claims reporting clause. As one commentator indicated, this complicates the reinsurer's ability to exercise control over claims, reserve for outstanding claims, and calculate premiums. See R.L. Carter, Reinsurance 138 (2nd ed., 1983). Lack of attention may lead to attempts to excuse mistakes that are really fundamental breaches of express or implied terms of a treaty, such as failure to advise the reinsurer of changes in underwriting practice.
Although the errors and omissions clause can be drafted to apply to the entire reinsurance agreement, at least one commentator suggests that it may be better to incorporate it in those contract provisions to which it is intended that the clause should relate. See Carter, supra at 260. These are recording of cessions, preparation and supply of quarterly accounts, and other areas where the likelihood of inadvertent administrative and communication oversights increases due to complicated mechanics of the underwriting process.
Court Interpretations of the Errors and Omissions Clause
How a court will construe the meaning and purpose of an errors and omissions clause in a reinsurance contract will depend on precise wording of the clause. While judicial interpretations of the errors and omissions clause are almost nonexistent, those few located are consistent with this commentary. For example, in Aetna Insurance Co. v Glens Falls Insurance Co., the federal district court in Georgia accepted the errors and omissions clause as a valid provision in the agreement, but held that the clause was inapplicable and incapable of obligating the reinsurer where the error itself was an erroneous action by the reinsured's agent acting outside of the agent's authority [327 F Supp 11 (ND Ga 1971), reversed on other grounds, 453 F2d 687 (5th Cir 1972)].
Similarly, the Eighth Circuit Court of Appeals held that the errors and omissions clause did not excuse material misrepresentations in the procurement of the reinsurance contract [Security Mt. Cas. Co. v Affiliated FM Ins. Co., 471 F2d 238 (8th Cir 1972)].
The errors and omissions clause, like every other clause in a reinsurance contract, should be drafted with care and thought. The clause should be used to fulfill its basic purpose of allowing the reinsurance relationship to continue while inadvertent accounting and information transmittal mistakes are rectified.
The author would like to thank Daniel Gimmel, a law clerk at LeBoeuf, Lamb, Greene & MacRae, L.L.P., for his invaluable assistance in the research for and preparation of this commentary.