Adventures in Contract Wording: The Effect of Ambiguous Reinsurance Contract Language
Larry Schiffer | September 1, 2000
Sloppy contract drafting breeds disputes, disputes result in litigation, and it is dangerous indeed to leave it to the courts to determine the provisions of a reinsurance contract. This article examines some of the problems that can occur because of imprecise reinsurance contract language and what can be done to avoid this scenario.
To some, reinsurance contracts seem at once arcane and boilerplate—arcane because reinsurance terminology goes back hundreds of years, and boilerplate because "standard" clauses appear in contract after contract, year after year. Like all contracts, however, it is crucial that a reinsurance contract set forth the intent of the parties clearly and precisely to avoid legal disputes years later.
High quality cedents and reinsurers have contract wording specialists whose job it is to make sure that the wording for that particular reinsurance contract properly expresses the parties' intent. Sometimes, however, because of the press of business, the volume of reinsurance contracts renewing at the same time, or by the use of reinsurance intermediaries to prepare draft contract wordings, reinsurance contracts are drafted using the old cut-and-paste method. Clauses may be carried over from sample or older contracts that may have no relevance to or meaning in the contract being drafted. Under these conditions, the intent of the parties may not match the contract wording. And if the losses exceed expectations, a dispute will arise.
Sloppy contract drafting breeds disputes, and disputes distract cedents and reinsurers from the business at hand. Ambiguities in reinsurance contracts also may result in a judicial interpretation of the contract that is contrary to the custom and practice in the industry or one that was never even contemplated by the parties. Clarity in reinsurance contract drafting, therefore, is extremely important to a long and stable relationship between a cedent and its reinsurers.
Ambiguity Breeds Disputes
There have been a number of reinsurance disputes over ambiguous reinsurance contract terms. For example, in a recent case, a dispute arose concerning whether the cedent's use of quota share reinsurance to cover part of a loss that came within the cedent's retention was a breach of the cedent's net retention warranty in the reinsurance agreement [Commercial Union Ins. Co. v Seven Provinces Ins. Co., 217 F3d 33 (1st Cir 2000)]. The facultative certificate issued by the reinsurer required that the cedent retain $225,000 out of the $450,000 excess of $50,000 amount reinsured. The retention, however, could be reduced by "any general excess loss or excess catastrophe reinsurance."
The language used in the net retention clause was extremely difficult to follow (and is not worth repeating here). The cedent took the position that it properly reduced its retention by using its general quota share treaty to cover part of the loss without a proportional reduction in the amount required to be paid by the facultative reinsurer.
The court found that the net retention provision was ambiguous and allowed expert testimony to help clarify whether the quota share treaty qualified as a general excess of loss reinsurance contract. Ultimately, the courts agreed with the cedent's expert and held that the use of the quota share treaty to reduce the cedent's net retention did not violate the net retention clause.
All of this, of course, could have been avoided if the net retention clause was written more precisely. The ambiguity, according to the court, was the phrase "general excess of loss reinsurance contract," which the court did not find to be a term of art in the reinsurance industry as was the phrase "excess of loss reinsurance." Had the parties made clear in the contract precisely what reinsurance protection the cedent could purchase without violating the net retention warranty, this issue would not have been raised in the dispute. While it is far from clear that the use of quota share reinsurance by the cedent violated the net retention warranty, one has to wonder how the court could equate "general excess of loss reinsurance contract" with a quota share reinsurance contract.
Another issue arising out of the perceived ambiguity in reinsurance contract wordings is whether declaratory judgment expenses are covered under reinsurance contracts. This issue has generated case law and significant industry commentary because of its economic impact on environmental and other long-tail, continuous exposure types of claims.
In Affiliated FM Insurance Co. v Constitution Reinsurance Corp., 416 Mass 839 (1994), the Massachusetts Supreme Court found the language in the facultative certificate unclear on whether the parties intended the contract to include litigation expenses for declaratory relief brought by an insured against its insurer to determine coverage. The word "expenses" was at the crux of this dispute. The court held that because "expenses" was a word with broad import and no fixed definition, it was ambiguous in the context of the facultative certificate. Had the certificate made clear how declaratory judgment expenses would be handled, there would have been no dispute.
Conflicts between Contract Provisions
Other disputes have arisen because of a perceived conflict between the arbitration and service-of-suit clauses in reinsurance treaties. The typical arbitration clause makes arbitration the exclusive means of dispute resolution between the cedent and the reinsurer. Most reinsurance treaties—particularly ones involving international reinsurers—also contain a service-of-suit clause, which provides that the reinsurer shall submit to the jurisdiction of any U.S. court at the request of the cedent if the reinsurer fails to pay.
Some reinsurers have argued that the dispute must go to court because the service-of-suit clause overrides the arbitration clause. Most recently, an Ohio federal court rejected this argument and found that the service-of-suit clause was meant to apply to litigation to compel arbitration or to confirm or vacate an arbitration award, and did not override the broad arbitration clause in the reinsurance treaty [Credit Gen. Ins. Co. v John Hancock Mut. Life Ins. Co., No. 1:99 VC 02690, 2000 U.S. Dist. LEXIS 9003 (ND Ohio May 30, 2000)].
The ambiguity here arises not from the lack of clarity of particular phrases, but because provisions in the same contract appear to conflict. While the Ohio federal court did not find a conflict, other courts have held that the service-of-suit clause overrides the arbitration clause where the arbitration clause is not broad. Often, conflicts between contract provisions occur when older agreements are marked up and edited. If care is not taken to make sure that only the relevant clauses are present and that no internal conflicts exist, disputes will arise, and courts may interpret the contract in a way the parties did not contemplate.
The Dangers of Short-Form Contracts
Another area where ambiguities arise is when the reinsurance contract is merely a slip policy. A slip is a short-form method of documenting the main terms and conditions of a reinsurance contract in advance of the preparation of the full contract wording. The slip itself stands as an enforceable contract should the formal contract not be drafted. While in most cases a formal reinsurance treaty will be signed by the parties, certain reinsurance markets rely on slips and cover notes as the final expression of the parties contractual arrangements.
Slip policies are fraught with potential ambiguities. If not drafted carefully, they often refer to underlying wordings that might not exist or reference specific forms that are no longer in use. We have seen slips in loss portfolio reinsurance contracts that refer to the arbitration clause "as in the original" when there is no "original" to refer to. We have seen other slips where the parties express the reinsurance limits only, without clarifying the cedent's retention.
These drafting lapses lead to disputes, which are more difficult to resolve because of the ambiguities in the contract. While some courts have no trouble enforcing an arbitration provision merely based on the words "arbitration clause" in a slip [Allianz Life Ins. v American Phoenix Life & Reassurance, Civ. No. 99-802 (DWF/AJB), 2000 U.S. Dist. LEXIS 7216 (D Minn March 28, 2000)], it is dangerous indeed to leave it to the courts to determine the provisions of a reinsurance contract.
Concluding Thoughts
The law of contracts applies to reinsurance contracts with equal force. While the rules of contract interpretation allow the use of extrinsic evidence to determine the parties' intent should a provision be found ambiguous, resorting to extrinsic evidence is unnecessary if the contract is devoid of ambiguity. It is better and less expensive to be clear and precise when drafting a reinsurance contract then to await an expensive arbitration or litigation to find out what a third party thinks the parties originally intended.
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