"'When I use a word,' Humpty Dumpty said, in rather a scornful tone, 'it means just what I choose it to mean—neither more nor less.'" ~Lewis Carroll, Through the Looking Glass.
When addressing reinsurance terms, it seems that many courts take the same view as Humpty Dumpty. Courts are often faced with unfamiliar terms of art or industry jargon. They are regularly called on to interpret or define these terms when reaching a resolution to a dispute about the application of these terms. Sometimes—most times—the courts get it right, but all too often, the meaning given to an industry word or phrase falls short of what industry insiders and practitioners would consider accurate. This certainly has been the case in reinsurance disputes where courts have come up with interesting and unusual definitions for well-known industry terms.
Construction of Reinsurance Terms by the Courts
For years, courts have had to construe the meaning of reinsurance terms of art. When reviewing a reinsurance contract, courts will look to the plain language of the contract in the first instance to decipher the natural meaning of a specific term or word. Courts will also consider what the term or word means to a typical insurer or reinsurer in the general context of the industry. If an ambiguity arises—meaning that there are two or more reasonable constructions of a term or word—courts will look to extrinsic evidence and to custom and practice in the insurance and reinsurance industry to determine the meaning of that ambiguous word or phrase.
Extrinsic evidence means evidence beyond the four corners of the reinsurance contract. Extrinsic evidence may include contemporaneous communications or testimony, expert evidence, or course of deal evidence. If, however, no ambiguity arises—meaning that there is only one natural definition of the term or word—the court will construe that term or word based on its unambiguous meaning.
Types of Reinsurance Contracts
There are many different types of reinsurance contracts. Nevertheless, most industry practitioners divide reinsurance contracts into two main groups: reinsurance treaties and facultative certificates. A reinsurance treaty is a broad contract covering a portfolio of assumed business. For example, this could be all of the property and casualty insurance policies written nationwide by a ceding insurer or all professional liability insurance policies written by the professional liability unit of a ceding insurer. A certificate of facultative reinsurance typically is reinsurance of a specific policy or risk—for example, reinsurance of $5 million of a $10 million excess of $5 million property insurance policy for the Empire State Building.
Reinsurance contracts can also be divided up by line of business or by whether they reinsure the risk proportionally or on an excess-of-loss basis. This commentary is about the meaning of treaty reinsurance.
What Is a Treaty?
As readers of these commentaries know, a treaty is a type of reinsurance contract and not an international agreement between two countries. As much as some parties may wish, a reinsurance treaty is not the supreme law of the land in the United States. Nevertheless, a reinsurance treaty is a commercial contract that may be enforced by the courts.
Many courts have construed and described the term "treaty" in the context of reinsurance. Typically, the courts will define treaty reinsurance as a counterpoint to a certificate of facultative reinsurance. For example, in the federal courts, the US Second Circuit Court of Appeals sitting in New York has construed more than its fair share of reinsurance contracts. In Travelers Indem. Co. v. Scor Reins. Co., 62 F.3d 74 (2d Cir. 1995), the court stated that "[t]here are two broad categories of reinsurance contracts: facultative and treaty. Facultative reinsurance covers part or all of an individual policy. Treaty reinsurance covers specific classes of a ceding insurer's portfolio of contracts."
The Third Circuit Court of Appeals provided a more robust definition of "treaty" in North River Ins. Co. v. CIGNA Reins. Co., 52 F.3d 1194 (3d Cir. 1995). There the court said that "[u]nder a reinsurance treaty, the reinsurer agrees to accept an entire block of business from the reinsured.... Once a treaty is written, a reinsurer is bound to accept all of the policies under the block of business, including those as yet unwritten. Because a treaty reinsurer accepts an entire block of business, it does not assess the individual risks being reinsured; rather, it evaluates the overall risk pool."
In a slightly different formulation, the Second Circuit also has stated that treaty reinsurance "involves an ongoing agreement between two insurance companies binding one in advance to cede and the other to accept certain reinsurance business pursuant to its provisions." Progressive Cas. Ins. Co. v. C.A. Reaseguradora Nacional de Venezuela, 991 F.2d 42 (2d Cir. N.Y. 1993). This latter formulation is relevant because it hints at a time element, binding the ceding insurer in advance to cede and the reinsurer to accept the risks under the reinsurance treaty.
But the essence of a reinsurance treaty, which most commentators and courts agree upon, is that a reinsurance treaty is a reinsurance contract that covers a block or portfolio of underlying insurance policies that may include in-force insurance policies or insurance policies to be written in the future or a combination of both. But what if the reinsurance contract is a fully retrospective contract that covers a portfolio or entire block of insurance policies that have already been written and are generating losses?
Among the more esoteric types of property and casualty reinsurance agreements are those that provide for the reinsurance of existing blocks of underlying business. Certain companies specialize in helping other insurance or reinsurance companies with "legacy" books of business. If an insurance company has many property and casualty insurance policies that are generating losses after many years, the company may wish to find a solution to mitigate the further adverse development of claims on that block of business. One way to do that is to enter into a loss portfolio transfer agreement.
A loss portfolio transfer agreement is a reinsurance contract in which an assuming reinsurer takes on the existing liabilities of a ceding insurer after a certain date in exchange for a premium generally reflective of the existing loss reserves on that book of business with a margin for safety. Loss portfolio transfer agreements may be written on an excess-of-loss basis (covering only those losses in excess of a specific attachment point) or on a proportional basis (covering a certain percentage of all losses from ground up) or by taking on the entire portfolio.
In many cases, reinsurance contracts have a provision by which the ceding insurer warrants that it will "retain for its own account" a certain dollar figure or percentage of the underlying business being reinsured. This retention warranty is often requested by reinsurers to keep the ceding insurer with some "skin in the game" so that the claims handling does not deteriorate because of the existence of reinsurance. Reinsurers also like retention warranties because it gives the reinsurers a cushion before the reinsurance contract is required to perform.
In some contracts, the retention warranty contains exceptions. For example, the retention warranty may provide that in determining the ceding insurer's retained amount, "treaty reinsurance" purchased by the reinsurer does not count toward the ceding insurer's retention: "The Company warrants that it shall retain for its own account, subject to treaty reinsurance only, if any, the amount specified on the face of this Certificate." What happens, however, if the ceding insurer enters into a reinsurance contract for its existing book of business using a retroactive treaty?
Granite State v. Transatlantic
In Granite State Ins. Co. v. Transatlantic Reins. Co., 2014 N.Y. Misc. LEXIS 2686 (N.Y. Sup. Ct. Jun. 18, 2014), a New York state court was asked to determine if retention warranties in a series of facultative certificates were breached when the ceding insurer entered into various loss portfolio transfer agreements that it argued were treaty reinsurance. The court found that the retroactive nature of the loss portfolio transfer agreements precluded them from being defined as treaty reinsurance. Citing cases that defined treaty reinsurance when compared to facultative reinsurance, the court relied on the few times appellate courts stated in describing treaty reinsurance that it was reinsurance "obtained in advance of actual coverage" and "binding one in advance to cede." Because the loss portfolio transfer agreements were not obtained in advance of coverage, the court declined to include the loss portfolio transfer agreements within the definition of treaty reinsurance.
So Is Retroactive Reinsurance Treaty Reinsurance?
The Granite State court's finding that a loss portfolio transfer contract cannot be defined as a reinsurance treaty is on appeal. It will be interesting to see whether the appellate courts accept the Granite State court's analysis.
The question is whether a retroactive reinsurance contract is a treaty or whether a treaty can only be a prospective contract. While it is easy to see why the motion court in Granite State focused on the "advanced" concept mentioned by a few appellate courts, a reading of those appellate cases makes it clear that whether the reinsurance contract was entered into in "advance" was not relevant to the issues in those cases. What was lost in the analysis by the Granite State court was the fundamental nature of a reinsurance treaty, which is that a treaty is a reinsurance contract covering a portfolio or book of business as opposed to an individual risk.
If a reinsurance contract is written to assume a portfolio or book of business as opposed to an individual risk, it is typically seen as a treaty. Whether that contract is entered into in advance of actual coverage or whether it assumes contracts already in existence is irrelevant to whether the contract reinsures a portfolio or block of business. It is not unusual for a reinsurance contract to assume in-force insurance policies as of the effective date of the reinsurance contract. When done on a portfolio basis, most people familiar with reinsurance would define that contract as a treaty. That all the business already exists seems irrelevant to whether the reinsurance contract is assuming a block or portfolio of business as opposed to an individual risk or policy. The question for the appellate court in Granite State is whether a reinsurance contract that does not assume any prospective underlying insurance policies is a reinsurance treaty for purposes of the retention warranty in these facultative certificates.
One of the more difficult tasks that judges have is interpreting industry jargon in the context of a contract dispute. Getting the industry jargon right is not as easy as it looks. Persuasive experts can and have convinced courts to interpret well-known industry terms of art in ways that industry practitioners find shocking. This has happened in reinsurance a number of times. Will the Granite State court's definition of "treaty" prevail? Only the New York appellate courts know.
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