Late Notice in Reinsurance Claims: Does Prejudice Matter?

Prompt Notice in Direct Insurance

Most insurance and reinsurance contracts contain a provision requiring the prompt notice of any occurrence that has or may result in the filing of a claim under the policy. The purpose of the prompt notice provision in a direct insurance contract is to allow the insurer the opportunity to: (1) investigate the claim in a timely manner thereby reducing possible fraud or other abuses by the insured; and (2) establish adequate reserves in the event liability appears imminent.

An insurer's ability to enforce its rights under a notice clause differs by jurisdiction. The states are divided as to whether an insurer must prove prejudice to its interests in order to rely on a late notice defense. In some states, compliance with a notice provision has been held to be a condition precedent to recovery under the policy. Under that scenario, the insurer need not establish prejudice to avoid liability to its insured if the notice condition has been breached.

In other states, however, an insurer must show a likelihood of appreciable prejudice to prevail on a late notice claim. As always, the terms of the contract will affect the analysis concerning the insured's notice obligations and the timing of the notice. Very often this is a factual question that requires a trial.

Notice Clauses in Reinsurance

Most reinsurance contracts generally require that the ceding insurer provide prompt notice to the reinsurer of any claim in which there is a reasonable possibility that the reinsurance will be involved. The form and language of the clause differ from contract to contract. Because reinsurance agreements are considered contracts of indemnity and there is no privity between the insured and the reinsurer, the insured's notice to the ceding insurer of a claim against it is not notice to the reinsurer. The knowledge that the ceding insurer may have about a claim obtained from the insured will not be imputed to the reinsurer.

The purpose of the notice clause in a reinsurance contract is to allow the reinsurer to: (1) reserve properly; (2) adjust premiums to reflect the loss, and (3) determine whether to exercise the option of becoming associated with the ceding insurer in the defense and control of the underlying claim. The ceding insurer's failure to provide prompt notice to the reinsurer may create a defense to indemnification under the reinsurance contract.

Treatment by the Courts

Courts are divided as to whether timely notice should be a condition precedent to coverage under a reinsurance contract or whether some element of prejudice to the reinsurer must be shown for a successful late notice defense. While courts generally recognize the differences between direct insurance and reinsurance, they differ in their application of the law concerning late notice in the context of direct insurance to the reinsurance context. Depending on the prevailing law in the jurisdiction and whether the court applies the law concerning late notice in direct insurance, a reinsurer's success in making a late notice defense may or may not require a showing of prejudice to the reinsurer. And, to make it more confusing, the courts disagree as to the implications and effect of good faith by the ceding insurer on the late notice defense.

Some courts, in jurisdictions where a direct insurer must establish actual and substantial prejudice in order to avoid liability where the notice clause is breached, have applied the same rule in the reinsurance context. These courts reason that the differences between direct insurance and reinsurance present an even more compelling reason to require prejudice in the reinsurance context than in direct insurance. Unlike direct insurers, reinsurers have no right to control a lawsuit and thus have less of a need for early notice. Also, because direct insurers will usually provide an adequate defense to their insureds, the probability of prejudice from late notice to a reinsurer is more remote.

In jurisdictions where the controlling law on direct insurance claims also requires a showing of prejudice, other courts have held that prejudice is not required to be shown to enable a reinsurer to prevail on a late notice defense against a ceding insurer. These decisions are based on the notion that a reinsurance contract is a contract of indemnity, unlike direct insurance contracts, and that the hazards under reinsurance contracts are distinct in nature from the hazard directly insured. As such, these courts have found that the purpose of the prejudice requirement in direct insurance—to protect lay policyholders from the hyper-technical application of notice requirements inserted in forms drafted by insurers—does not extend to the reinsurance context involving two experienced insurance professionals who bargained at arm's length. This interpretation was recently given by a New Jersey federal court.

In jurisdictions where prejudice is presumed in the direct insurance context, some courts have held that a reinsurer must nevertheless demonstrate actual prejudice resulting from the ceding insurer's late notice to assert the defense of noncompliance. These courts note the significant and basic differences between direct insurance and reinsurance, and determined that, while a reinsurer's right to associate may be impaired by late notice, critical distinctions between a primary insurer's right to control the investigation and defense of a claim and a reinsurer's right of association with the ceding insurer, such as the improbability of fraud by a ceding insurer, make the failure to give prompt notice substantially less significant to a reinsurer than to a primary insurer.

The duty of utmost good faith also plays a major role in many courts' decisions regarding late notice in reinsurance. Because information regarding the risk lies with the ceding insurer, the reinsurance market depends on a high level of good faith to ensure prompt and full disclosure. As such, a ceding insurer's failure to provide prompt notice of a claim may relieve its reinsurer from indemnifying the ceding insurer without showing prejudice if the ceding insurer's late notice was due to gross negligence or recklessness amounting to a breach of the duty of utmost good faith. The Second Circuit and the Supreme Court of New Hampshire have adopted this analysis.

Conclusion

The distinctions between direct insurance and reinsurance have a dramatic effect on how courts view the late notice defense. The law in a particular jurisdiction concerning late notice in reinsurance may mirror or oppose the law of late notice in primary insurance. Ceding insurers must be mindful of these differences to avoid providing a reinsurer with a defense to indemnification. Although the decisions vary from jurisdiction to jurisdiction, ceding insurers can protect themselves by performing under the notice provisions of their reinsurance contracts in good faith and by eliminating behavior that might be prejudicial to the reinsurer.