Originally published in September 2003
In law, a captive insurer is an insurance company like any other. A statement of the obvious, perhaps, but nonetheless a technicality that many in the industry have been known to lose sight of from time to time.
Typically, a captive insurer will enter into two contractual insurance relationships, that is to say the inwards insurance, either directly from the parent or from a fronting insurer, and its outwards reinsurance. Even those captives that have been adequately capitalised to bear a large proportion of their own risk will almost certainly need recourse to XL or stop loss reinsurance, in order to preserve the integrity of the security provided to the parent or the fronting insurer.
At the very least, therefore, there will be two links in the chain from the insured parent to the traditional reinsurer, as ultimate risk bearer, and three where a front is interposed. In practice, of course, a captive’s reinsurance programme is frequently more complex than a single outward contract. It will often be structured in such a way that XL cover is superimposed on a proportional quota share treaty, and hence the handling of individual direct claims will impact on both proportional reinsurance and horizontal XL. On any view, there will be multiple parties involved in the structure, and the inevitable opportunity for disputes to arise.
Managers of group or association captives are accustomed to reviewing inward claims with a critical eye. They owe an obligation to the captive in its own right, and in turn to other parent policyholders, to ensure that only recoverable claims are agreed. As such, they can be expected to behave in much the same way as any traditional insurer, and this will often include the retention of outside advisers to assist with difficult coverage issues where necessary.
The same, however, is not always true in the case of single parent captives, where the process is often viewed as a simple risk transfer from the insured parent to the external reinsurer. Under the latter analysis, the intervening steps are little more than an accounting exercise, in which the captive is but a handy conduit through which the risk (or, at least, the excess risk) is channelled to the traditional insurance markets. The temptation to apply this holistic approach should be resisted, particularly when it comes to claims processing, not least because it overlooks the true legal relationships, and obligations, between the various parties.
In the event of a claim, both parent and captive must take steps consistent with an arm’s length relationship, at least if they hope to effect a recovery under the captive’s reinsurance. The paper trail may end up looking contrived at times, particularly where the directing minds of the parent and the captive are one and the same. In those cases, effective Chinese walls should be established, since any attempt to short circuit the process at this early stage can lead to some unfortunate consequences along the chain.
In the first instance, the parent should be careful to notify a claim in accordance with the policy terms. This may be to the captive directly, or to the fronting insurer where one exists. Remember that the front (and only the front) assumes the primary liability to the parent, and with it the credit risk in the event that the captive’s security defaults. That is the reason for charging a commission. If the system fails, the parent will want to look to the front to make good the loss. But the front, naturally, will do everything possible to resist paying a claim under a risk for which it, effectively, never received a commercial premium. The battle lines are drawn, and the parent’s failure to notify the claim can provide the fronting insurer with the handiest of defensive weapons.
Assuming the claim has been properly notified along the chain, the next task is to review issues of coverage under the policy terms. Ask any lawyer to construe a contract and the first thing he will look for is the governing law, and then perhaps the jurisdiction in which any differences in interpretation are to be resolved. Typically, a Cayman Islands captive will exist to insure a US parent, perhaps under a policy that expressly provides for the law and jurisdiction of the parent’s state domicile. The position can be complicated where a fronting insurer is interposed, particularly where the front is domiciled in some other state. Clearly, it is of some importance to ensure that the policies do not contain divergent law and jurisdiction clauses.
Where the risk is written directly by the captive, the policy terms will very often nominate the law and jurisdiction of the captive’s own domicile, for example that of the Cayman Islands. Once a claim arises, it may come as a considerable surprise to many US insureds to learn that Cayman Islands insurance law, based as it is on English law, contains several material differences to that prevailing in many US states. Consider, for example, the case of breach of warranty. The position in Cayman, as in England, is governed by the common law principle that any breach of warranty by the insured will give insurers the right to deny the instant claim and to treat the entire insurance contract as discharged from the date of the breach.
By contrast, the position in New York is regulated by statute, namely s. 3106 of the New York Insurance Law, whereby the right of rescission and/or denial in the case of non-marine insurance claims is limited to those cases where the breach "materially increases the risk of loss, damage or injury within the coverage of the contract". Similar statutory provisions exist in many other of the United States. A Cayman captive that could have denied the inwards claim for reason of a non-material breach of warranty under Cayman Islands law, but does not do so, may well find that its recourse to reinsurance has been prejudiced.
Indeed, it is at the reinsurance level that the more obvious potential for conflict arises. London market reinsurers, for example, will often insist on English law and jurisdiction in respect of the captive’s reinsurance. And even if the contract is silent on the point, it does not follow that the overseas reinsurers have thereby rendered themselves amenable to the captive’s local law or jurisdiction. The common expression ‘as original’ is insufficient to import into the reinsurance contract the choice of law and jurisdiction prevailing in the underlying policy1, and reinsurers are extremely adept at wrong footing cedants by commencing pre-emptive proceedings in their home jurisdiction, seeking judgment against their reinsured by way of declaration as to non-liability.
Reinsured captives must be careful to ensure that any claim they agree is properly recoverable under the inwards policy terms, in accordance with the governing law of that contract. Even where the reinsurance is clearly intended to be back to back with the original cover, the reinsurers are still perfectly entitled to revisit the question of underlying policy liability, and they frequently do. The reinsurance claim will therefore stand or fall on whether the captive was right in its original assessment that the direct claim was payable under its own governing law. The temptation for reinsurers to be ‘wise after the event’ may be difficult to resist.
From the captive’s perspective, this problem can be alleviated by involving the reinsurers in the claim assessment from the outset, and thereby flush out any concerns they may have. Where the reinsurance contract contains a claims control or claims cooperation clause, there will of course be a positive obligation to involve reinsurers from an early stage. The effect of these provisions is to pass control of the underlying claim up to the reinsurers, or at least to require the reinsured to obtain the prior approval of reinsurers before agreeing or compromising a claim.
Compliance with the stipulation is often expressed as a ‘condition precedent’ to recovery, and hence any reinsured captive that settles claims in breach of the clause does so at its peril. It may find the reinsurance recovery is lost, even in cases where the underlying claim is one which would have been payable had the relevant approval been sought when it should have been.
Many reinsureds take solace in the fact that their reinsurance contracts incorporate a ‘follow the settlements’ provision, but again their confidence can be misplaced. Where the clause appears alongside a claims control clause, the latter will effectively emasculate the former2, and even if the follow settlements provision appears on its own, it does not provide the captive with a blank cheque. Agreed claims must still fall within the four corners of the reinsured risks, as a matter of law, and there remains an obligation on the part of the captive, in settling the underlying claim, to do so honestly and in a ‘proper and businesslike’ manner3.
Any captive that agrees its parent’s claims without proper and objective review, or otherwise improperly colludes with the parent in the settlement of claims, will fall foul of this requirement. In the same way, a captive that voluntarily submits to its parent’s jurisdiction, where it was not obliged to do so under the policy terms, will also find itself in difficulty if the court is persuaded that this amounted to an attempt to align its interests with those of the parent to the disadvantage of reinsurers.4
Like many other insurance practitioners, I have written previously in this and other publications on the economic advantages for companies in transferring risk through the medium of their own captive insurer. The benefits are now beyond argument. However, for those who decide to go the captive route, it is important that they understand the business of insurance. In establishing a captive, they are entering into an industry with which they may be unfamiliar, and one which conceals a multitude of traps for the unwary. Few areas of commercial activity have generated quite as much litigation over the years, and this is a reflection of the fact that the handling of insurance claims is fundamentally an adversarial experience.
In setting up the structure, captives and their parents need to do everything possible to minimise these potential points of conflict. This requires tightly controlled policy wordings, which should remain consistent along the risk chain, and in particular free of discrepancies as to governing law and jurisdiction. Bear in mind that the same policy wording can yield very different outcomes, depending on the governing law under which it is to be interpreted.
As regards claims handling, the parent and captive would be well advised to remain estranged. The captive’s obligations under the reinsurance may require it to adopt positions which are entirely adverse to that of the parent, and it follows that too much filial familiarity can be a dangerous thing. Any claims protocol agreed between the parties should respect the independent identity of the captive, and it should clearly specify who is to do what in the event of a claim. Captive insurers, or their outsourced managers, must understand the obligations owed by the captive under its inward and outward contracts, and should be free to consult professionals who are qualified to advise on policy coverage issues under the relevant governing law, without interference from the parent.
Coming from a Cayman insurance lawyer, this no doubt sounds like a covert sales pitch, but it is important to remember that reinsurers will usually reserve the right to inspect the captive’s underlying claims handling records, and they may well deny liability (or worse, avoid the reinsurance altogether) if they find anything untoward. Even small claims that do not, individually, trigger the XL cover on a per loss basis, may well impact on the stop loss or aggregate XL reinsurance, not to mention of course any quota share treaty. It can pay, therefore, to apply the same standing procedure for every claim, large or small.
First Published in International Captive Review, March 2003
1Forskringsaktielskapet Vesta v. Butcher  1 Lloyd’s Rep 331; GAN Insurance Company Ltd v. Tai Ping Insurance Company Ltd  Lloyd’s Rep IR 229, affirmed  Lloyd’s Rep IR 472; AIG Europe (UK) Ltd v. Anonymous Greek Insurance Company of General Insurances, ("The Ethniki")  2 All ER (Comm) 65.
2Insurance Co of Africa v. Scor (UK) Reinsurance Co Ltd  1 Lloyd’s Rep 312; GAN Insurance Company v. Tai Ping Insurance Company (supra).
3The Insurance Co of Africa v. Scor (UK) Reinsurance Co Ltd (supra); Hill v. Mercantile & General Reinsurance Co Ltd  3 All ER 865.
4Insurance Corporation of Ireland v. Strombus International Insurance Co  2 Lloyd’s Rep 138.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.