In a traditional reinsurance agreement, the reinsurer agrees to reinsure a portion of the reinsured's risk, while the reinsured agrees to maintain its retained share of the risk. In agreeing to do so, the reinsured and reinsurer both share the risks and rewards of the proper underwriting and claims management of the business. This commentary will discuss this sometimes symbiotic relationship between the reinsured and the reinsurer, and the reinsurance contract provisions that affect this relationship.
In a typical quota share or proportional reinsurance contract, the reinsurer agrees to reinsure a percentage of the reinsured's policies on one or more lines of business. The reinsurer trusts that the reinsured will underwrite the business and manage the claims so that both the reinsured and the reinsurer will earn a profit from the business. Breaking it down further, the reinsurance underwriter really underwrites the reinsured's underwriter and relies on the reinsured's underwriter to price the business properly, obtain rate increases where necessary, and manage the business profitably.
The reinsured's incentive to manage the business for a profit is self-evident when the reinsured retains a significant share of the risk on the policies underwritten. If the reinsured fails to underwrite properly, does not obtain appropriate rate increases on the policies where necessary and permitted, or does not manage the claims effectively, the reinsured will lose money on the book of business. In a proportional reinsurance relationship (quota share for property and casualty risks or co-insurance for life and health insurance risks), where the reinsured loses money, the reinsurer generally loses money, so both parties have an incentive to see that the business is managed properly.
In an excess of loss relationship, where the reinsurer only comes on risk when a loss exceeds a particular threshold, the alignment of interest between the reinsured and the reinsurer is not exactly the same. Depending on how the excess reinsurance is structured, there is some incentive for the reinsured to have losses breach the reinsurer's attachment point and the reinsurer has a greater interest in seeing losses remain below the attachment point. Nevertheless, the reinsured still has an incentive to manage the business properly because allowing losses to breach the attachment point and reach the reinsurer means that the losses have burned through the reinsured's retention.
By negotiating a retention clause, the reinsurer is better able to assess more accurately its reinsurance risk. That is because the reinsurer understands that the reinsured will be keeping a set portion of the risk, which necessarily limits the exposure to the reinsurer and allows for more accurate pricing of the reinsurance exposure. Thus, the pricing and underwriting decision of the reinsurer will depend on the retention provision. If negotiations for a retention fail, a reinsurer may chose not to reinsure the risk.
All of this is consistent with the view that reinsurance is a long-term relationship and that the reinsured and reinsurer will share in the premiums and losses on the business with the obvious goal being profitability for both parties. Of course, not all reinsurance relationships warrant or anticipate that the reinsured will retain any risk. A fronted program is an example of a reinsurance relationship where the reinsured's retention is meaningless. Those relationships, which are varied and many, go beyond the scope of this commentary.
Retention Provisions in Reinsurance Contracts
As one might imagine, retention provisions come in all shapes and sizes. A typical quota share retention clause may simply state that the "Company" shall retain for its own account 25 percent of all business written. Courts have interpreted "shall retain for its own account" and similar language to mean that the reinsured has committed contractually to maintaining 25 percent of the risk and is not allowed to separately reinsure that 25 percent of the risk. In other words, in using that type of clause the reinsured has warranted to the reinsurer that it will maintain its interest in 25 percent of the risk and will not separately reinsure that 25 percent with another reinsurer.
Other clauses are even more explicit and use the word "warranty" in the retention clause and make it clear that the reinsured's retention is an express condition precedent to the payment of any loss by the reinsurer. Still other clauses state that the reinsured shall not reinsure any portion of its retained share unless written permission is granted by the reinsurer. Similar clauses go further and require that the reinsurer's permission shall not be unreasonably withheld. These clauses give the reinsurer the option of considering whether the proposed reinsurance of the retention is consistent with the reinsurer's interest in having the reinsured maintain risk.
Where the reinsured decides to reinsure all or part of its retention, the reinsurer may consent if it is satisfied that the underlying business will be managed by a party with "skin in the game," meaning that the party managing the business will suffer the immediate economic consequences of poor management. From the reinsurer's perspective, as long as the party managing the business will incur the economic effects of its management (as the reinsurer will), it is similar to the reinsured maintaining its retention.
Another area where retention comes up is what some call "net retention clauses," which limit the reinsurer's responsibility only for its share of losses retained by the reinsured net of all other applicable reinsurance. Net lines or net retained lines or net retention clauses anticipate that the reinsured has purchased other reinsurance, but is reinsuring only that portion of the reinsured's risk that it has retained. Permitted reinsurance may be in the form of a quota share treaty for the primary layer of the business, excess insurance for losses in excess of a certain retention, or facultative reinsurance under specified conditions. In these cases, the reinsurer has agreed to allow certain reinsurance (often including intra-group reinsurance) and is covering only the net exposure kept by the reinsured. Often the net retention clauses require a careful calculation of exactly what portion of the risk is being retained net either before or after allowable reinsurance. Care is necessary in drafting net retention provisions so that there is no ambiguity about what reinsurance is allowed and what business is being retained.
Breach of the Retention Provision
Where there is no question that the reinsured must retain a certain percentage or levels of risk as a condition of its ability to seek recovery from its reinsurer, disputes about the reinsured's compliance with an unambiguous retention provision rarely arise. Where, however, the retention clause is less than explicit, disputes have occurred and courts have found in many instances that the retention provision is a material provision of the reinsurance agreement.
Disputes arise where the reinsured purchases reinsurance in violation of its retention warranty. Courts have held that a breach occurs when a reinsured engages in an unauthorized transfer of its retained risk to another reinsurer. This is because the retention provision is considered a material term of the contract that is reasonably expected to influence the reinsurer's decision to enter into the contract.
Where the evidence establishes that the parties intended for there to be a retention and that the reinsured entered into another reinsurance contract without authorization, courts typically void the reinsurance contract. This is because the breach of a material provision of a contract that clearly affects the decision to enter into the contract voids the entire contract. Alternatively, if the breach of the retention provision occurs after the contract has been in force for a number of years, the remedy may be termination of the contract without the reinsurer having to perform any further. This remedy is based on the theory that the non-breaching party may terminate a breached contract and no longer has to perform its obligations.
Conclusion
Retention provisions generally are material terms of reinsurance contracts that are important to a reinsurer's decision to enter into the reinsurance agreement. Breach of a retention provision is a fundamental breach of the reinsurance contract and, if proven, may result in rescission or termination of the reinsurance contract. Carefully drafted retention provisions avoid disputes. Ambiguities in retention provisions breed conflict.
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