Are Punitive Damage Awards Recoverable under Reinsurance Agreements?

Extracontractual Obligations

The market dictates whether reinsurers will offer broad coverage to their cedents. A standard reinsurance contract provides that the reinsurer will reimburse the cedent for a certain portion or dollar amount of the settlements and judgments actually paid by the cedent on claims arising under the policies of insurance that it issued. Loss adjustment expenses incurred by the cedent in adjusting and defending the claims may be reinsured under the limit of liability provided by the reinsurance contract or in addition to the reinsurance limits.

In a soft market, cedents will demand and reinsurers will offer various enhancements to the reinsurance protections normally provided. One of those enhancements is the extracontractual obligations (ECO) clause.

The typical ECO clause provides that the reinsurer will reimburse the cedent for payments made by the cedent on a claim that goes beyond the four corners of the coverage provisions of the underlying insurance contract. Punitive damages awarded on bad faith claims are precisely the type of claim that falls outside the underlying insurance contract, but which the reinsurer likely has to pay under an ECO clause. Where the reinsurance contract does not have an ECO clause, a cedent will find it much more difficult to prevail on its reinsurer to reimburse it for punitive damages.

Typically, the ECO clause has a limit of liability or a percentage recovery provision of its own. ECO liability generally is not limited by the reinsurance contract's general limit of liability. The clause also might have a provision for determining the date of loss, although the original date of loss is often used. More recently, ECO clauses have been amended to provide that the clause is only valid in jurisdictions where the insurability of punitive damages is not prohibited. It is this latter provision that leads us to the public policy debate.

Public Policy and Insurability of Punitive Damages

Punitive damages exist to punish a wrongdoer for aggravated, intentional, or willful acts against the public. Different states alter the availability of punitive damages to varying degrees. Essentially, where punitive damages are assessed, the wrongdoer must have acted in such a way that punishment beyond compensatory damages is appropriate. Typically, that punishment is meted out because of the direct acts of the insurer in handling the underlying claim or because of the acts of its employees and agents, which subject the insurer to vicarious liability for those wrongful acts.

Whether one may insure against punitive damages is a question of public policy. The majority of the states allow parties to insure against punitive damage awards. In those states, reinsurability of punitive damages is not an issue as long as the reinsurance contract has an ECO clause or other coverage provision broad enough to encompass punitive damages. Other states permit the insurance of punitive damages only where the assessment of punitive damages results from vicarious liability imposed upon the party against whom the punitive damages are assessed.

In an important minority of states, however, punitive damages may not be insured against. In those states, public policy prohibits reimbursing a wrongdoer for its intentional acts because the purpose behind assessing punitive damages is to punish the wrongdoer for its acts. To allow for the reimbursement of punitive damages through insurance would run counter to the deterrent purpose of punitive damages. California, Connecticut, and New York are examples of the minority of states that do not permit the insurance of punitive damages assessed for the direct acts of the wrongdoer.

Logic dictates that if a state's public policy prohibits the insurance of punitive damages, then reinsurance coverage is not permitted either. Conversely, if a state permits a wrongdoer to insure itself for punitive damages, then reinsurance coverage for punitive damages assessed against a cedent should also be permitted.

Choice of Law Rules

Whether a claim for punitive damages will be covered under a reinsurance contract will depend on which state's law governs the interpretation of the contract. In a reinsurance dispute, these issues may become complicated. For example, if the underlying claim arose in state A, the insurer is domiciled in state B, and the reinsurer is domiciled in state C, it may not be readily apparent as to which state's law applies. As many reinsurance contracts are negotiated through brokers, the state where the broker resides also may become relevant to the analysis.

If the reinsurance contract has a choice of law provision, the matter is simplified. But if the arbitration clause in the reinsurance contract relieves the arbitrators from following the strict rules of law, the issue becomes more complex. If the arbitration panel chooses not to apply the public policy of a state that prohibits the insurance of punitive damages, the cedent may seek to vacate the arbitration award for the panel's manifest disregard of the law. This ground for vacating an arbitration award, however, is very difficult to establish, especially where the arbitration panel is given wide latitude under the arbitration clause in the reinsurance contract to formulate a just result for any dispute.

One court has created an exception to the minority rule prohibiting indemnification of punitive damages awarded against a cedent. In Hartford Fire Ins. Co. v. Lloyd's Syndicate, 1997 US Dist LEXIS 10858, a Connecticut federal court held that where an ECO clause specifically provides for indemnification, the court would not seek to impose the law or policy choices of the forum state over that agreement. The ECO clause in Hartford provided for "liabilities which arise from the handling of any claim ... including but not limited to bad faith," and the provision was accompanied by an arbitration agreement relieving the arbitrators of the responsibility of following the strict rules of law. Id at *1.

In reaching its conclusion, the court reasoned that chapter 2 of the Federal Arbitration Act preempted state law provisions and that there was no national public policy concerning the indemnification of punitive damages.

"If contracting parties agree to include claims for punitive damages in the issues to be arbitrated, the FAA insures that their agreement will be enforced according to its terms even if a rule of state law would otherwise exclude such claims for arbitration."

Source: Id at *10.

The implications of Hartford are still unclear, as no other court has had the issue presented to it. However, Hartford does provide a foundation for arguing that reinsurers agreeing to similar ECO clauses may not rely on the policy of states such as California, Connecticut, and New York to escape their contractual obligations to indemnify their cedents for punitive damages.

Where no choice of law provision exists in the reinsurance contract—which is more typical than not—then conflict of law rules should be used to determine which state's law applies. If the arbitration clause gives the arbitration panel broad powers to fashion a remedy by using the custom and practice of the reinsurance industry, the panel may not analyze the choice of law issue using the conflict of law principles that would have been used by a court.

Final Considerations

Insureds and their risk managers must keep in mind the differing public policy positions of the states when considering commencing a bad faith action against their insurer. Settlement considerations may differ depending on whether the insurer is able to seek reimbursement for any punitive damages judgment rendered against it for its bad faith claims handling. Cedents must be cognizant of the public policy issues that their reinsurers may face when confronted with a notice of claim that includes a punitive damages award. Under certain scenarios, a reinsurer may correctly assert that to provide reimbursement for punitive damages violates state law and, therefore, the ECO provision in the parties' reinsurance contract is void for that limited purpose in that state. Reinsurers must be aware of these public policy issues as well and must weigh the denial of punitive damages claims against its market position in the reinsurance industry.

The reinsurability of punitive damages is a very tricky issue. The ECO clause was supposed to eliminate the confusion, but the public policy of a minority of states still stands in the way of the business decision by reinsurers to provide enhanced coverage to its clients.