Should Reinsurance Contracts Be Construed Against Reinsurers?

By Robert M. Hall*

*[Mr. Hall is a former insurance and reinsurance executive.  He is of counsel with the Washington D.C. office of Piper Marbury Rudnick & Wolfe LLP and has a separate consulting and arbitration and mediation practice.   This article does not necessarily represent the opinions of Piper Marbury Rudnick & Wolfe or its clients.  Copyright Robert M. Hall 2000.  Comments and questions can be addressed to Mr. Hall at robertmhall@erols.com.]          

I.            Introduction                                                                                                             

Notwithstanding the best efforts of the insurance industry’s contract drafters, insurance and reinsurance contracts are sometimes found to be ambiguous when bathed in the light of the specific facts of a claim or other dispute.  When alternative means of resolving a contractual ambiguity fail, the construction doctrine of “contra proferentem” (literally “against the offeror”) is sometimes used to resolve the matter.^[1]  This doctrine is often used to construe policy language against an insurer in a dispute with a policyholder on the basis that the policy is a contract of adhesion with the policyholder having little bargaining power with the insurer.  The purpose of this article is to examine the application of the contra proferentem concept to reinsurance contracts.

II.            Drafting Reinsurance Contracts

A.               Nature of the Marketplace

While sophistication varies among ceding insurers, they certainly bear little resemblance to the vast majority of policyholders.  Insurers cannot be licensed in a state without demonstrating that they are staffed by insurance professionals.  These professionals have ready access to reinsurance experts, such as intermediaries, to assist in negotiating and drafting reinsurance contracts. 

In addition, the large majority of cedents are also reinsurers.  Those primary companies which do not maintain a specific reinsurance profit center commonly assume reinsurance as a matter of reciprocity with trading partners and within their holding company systems.  Professional reinsurers also cede risk to retrocessionaires who, in turn, cede their own risk.  The analogy to unsophisticated insureds is tenuous when the issue is whether a reinsurance contract should be interpreted in favor of one financial institution over another based simply on which institution happens to be the cedent in the relevant transaction.

B.            Clauses Required for Credit for Reinsurance

All states have laws and/or regulations that determine the circumstances under which a cedent may take financial statement credit for reinsurance.  These laws have a considerable impact on the language of reinsurance contracts.  For instance, they require, as a condition for credit for reinsurance, that reinsurance contracts contain provisions that:

·                      establish the criteria for an acceptable trust fund;

·                       identify the contracts for which trust funds are established;

·                      stipulate that certain type of assets are to be maintained in the trust fund;

·                      require the cedent take all steps necessary to a liquidate the assets placed in trust;

·                      stipulate that assets in the trust may be withdrawn at any time by the cedent and used for specified purposes;

·                      establish the criteria for an acceptable letter of credit:

·                      identify the contracts for which a letter of credit is established;

·                      allow a letter of credit to be drawn at any time by the cedent and be used for specified purposes;

·                      in the event of insolvency of the cedent, require payment of reinsurance “without diminution” to the receiver of the cedent; and

·                      constitute a consent by the reinsurer to service of suit in any court of competent jurisdiction.^[2]

While not technically a part of the credit for reinsurance laws and regulations, the Examiner’s Handbook of the National Association of Insurance Commissioners requires an “intermediary clause” which places credit risk on the reinsurer if the reinsurance intermediary converts premium or loss funds to the intermediary’s own use.  Similarly, state regulators have declined to grant or renew licences when they believe setoff clauses in reinsurance contracts were out of step with state receivership law or policy.^[3]

Credit for reinsurance laws and regulations and the Examiners Handbook do not require specific language for the above clauses relying instead on a general description.  However, standardized language has coalesced over time based, in part, on insurance regulators withholding credit for reinsurance due to language which they believed did not comply with relevant laws and regulations.

Given that clauses required for credit for reinsurance are mandated by law, it is questionable whether they should be construed against reinsurers.  Since the presence of these clauses works a substantial financial benefit to the cedent, an opposite construction might be considered.

C.            Intermediaries

Most reinsurance in the world is placed through reinsurance intermediaries.  One of the functions of intermediaries is to negotiate and draft treaty language.  While the intermediary clause places the credit risk of the intermediary on the reinsurer, the intermediary is the agent of the cedent for other purposes.^[4]  In this circumstance, it must be questioned whether a reinsurance contract should be construed against the reinsurer when it is drafted by the agent of the cedent.

D.            Treaty Reinsurance

Reinsurance treaties, which cover many risks of a predetermined nature, are often negotiated by the parties over months, if not years.  There is often considerable give and take between the cedent and reinsurer as to its final form.  Cedents often present the reinsurer with desired clauses and, in some cases, an entire reinsurance contract as an example.  As a result, the final product is often a blend or compromise of language desired by the cedent and reinsurer making problematical attribution of authorship of the contract or particular clauses thereof.            

E.            Facultative Reinsurance

Facultative reinsurance, traditionally written on individual risks, is considerably different from treaty reinsurance.  Facultative reinsurance is much more immediate in that it focuses on a specific risk presented for coverage in the near future rather than large blocks of business which turn over annually at a predetermined time.  As a result, there is seldom months of time to craft a facultative reinsurance agreement.

For these reasons, facultative reinsurance is usually written on a “facultative certificate” which contains the variable information concerning the risk on the front and the contractual language on the back.  Given the effort to limit the contract language to one page, extensive elaboration is not possible.  However, this is counterbalanced by the fact that a specific risk with specific characteristics is being reinsured rather than a general class of unknown risks as is the case with treaty reinsurance. 

The contractual language on the certificate is standardized on a reinsurer by reinsurer basis.  While cedents and reinsurers sometimes negotiate side agreements dealing with difficult issues (e.g. declaratory judgement expenses), this is not generally the case.  As a result, facultative certificate language commonly receives less input from cedents than does treaty language.  Nonetheless, cedents are free to negotiate the terms of facultative certificates and to direct their business to other reinsurers offering more favorable terms.

III.       Impact of Case Law

A.            Cases Finding a Presumption Against Reinsurers

The rule in the Seventh Circuit is that ambiguous reinsurance contracts are construed against reinsurers.  The recent case of Zenith Insurance Co. v. Employers Insurance of Wausau^[5] dealt with the interpretation of a prompt notice requirement in a facultative certificate under Wisconsin law.   Construing the clause against the reinsurer the court stated:

In cases dealing with primary insurance contracts and insured parties, Wisconsin follows the common rule that ambiguities in the contract are to be construed in favor of the insured party. [citations omitted] (noting that Wisconsin’s rule for construing ambiguities against the drafter “has particular force . . . where there is a substantial disparity of bargaining power between the parties.”)

. . . Almost fifty years ago, this court, contrary to the view adopted by the Second Circuit in Unigard, concluded that under Wisconsin law the court must construe ambiguities in reinsurance contracts in favor of the reinsured.  Employers Mutual Liability Ins. Co. v. Underwriters at Lloyd’s, 117 F.2d 249, 252 (7^thCir.1949) aff’g 80 F.Supp. 353, 355 (W.D.Wis.1948).  We can find nothing in Wisconsin law that indicates Wisconsin courts believe that we had misstated the law in Employers Mutual. . .  From a policy standpoint, some of the interests protected by the general rule that insurers bear the brunt of contractual ambiguities are just as applicable to reinsurance cases, and others are not.  For example, one important reason why Wisconsin courts construe insurance contracts in favor of the insured party relates to that party’s reasonable reliance interests.  That interest is similar whether one is speaking of a primary policy and the beneficiary or a reinsurance policy and a primary reinsurer. . . We would need more recent evidence from Wisconsin contradicting Employers Mutual to justify a carve-out that would free reinsurance policies from Wisconsin’s general rules of interpretation for insurance policies. ^[6]                                                                                                

In essence, the court followed the earlier case in the absence of any Wisconsin case law to the contrary.  However, the case followed does not appear to turn on the contra proferentem concept.

Employers Mutual Liability Ins. Co. v. Underwriters at Lloyd’s^[7] involved a product liability claim which was paid by the cedent and for which the cedent sought reimbursement from its reinsurer.  The reinsurer claimed that the loss did not fall within the product liability coverage of the policy and should not have been paid.  This 1949 decision presents what the industry now regards as a classic follow the fortunes / settlement issue: Can the reinsurer second guess the cedent’s reasonable coverage decisions?  While the court was not conversant with industry phraseology, it clearly recognized the issue: “In other words, Lloyd’s by their reinsurance contract stepped into the shoes of Employers Mutual to the extend of the latter’s liability to the insured.”^[8]   In its holding, the court declined to apply the contra proferentem rule:

Stated differently, the court ruled against the reinsurer, not because it issued the reinsurance contract but because it assumed the risk of close coverage calls by the cedent i.e. follow the fortunes.     

Employers Mutual was cited favorably in a footnote in Fontenot v. Marquette Casualty Co. ^[10] which involved a direct action by a claimant against the reinsurer of an insolvent reinsurer.  Despite the favorable citation, the court rejected the notion that any ambiguity in the reinsurance contract authorized a recovery from one not in privity with the reinsurer.  As a result, contra proferentem was not the basis of the court’s holding.

The contra proferentem concept was cited in Mountain States Mutual Casualty Co. v. Peerless Casualty Co. ^[11] which was a suit for reformation or interpretation of an amendment to the reinsurance contract brought by the cedent.  The court granted the interpretation desired by the cedent but cited a number of factors for its conclusion including its own interpretation of the amendment in question, the correspondence between the parties, the good faith obligation between cedent and reinsurer, the obligation of the reinsurer to follow the fortunes of the cedent and the rule “that contracts of reinsurance should be liberally construed in favor of the reinsured.” ^[12]   As a result, it is difficult to determine what factor the concept of contra proferentem had in the court’s decision.

The contra proferentem concept also appeared in Justice v. Stuyvesant Ins. Co. ^[13] which

involved a dispute over a minimum annual premium.  The court observed, in dicta, that ambiguities in the reinsurance contract should  be interpreted against the reinsurer, citing to a 1946 edition of C.J.S. Insurance, before interpreting the contract in favor of the reinsurer.

In Transit Casualty Company in Receivership v. Certain Underwriters At Lloyd’s, ^[14] the receiver of Transit sued the reinsurers who petitioned the court to compel arbitration.  The case turned on a perceived conflict between the arbitration and service of suit clauses.  The court initially observed that ambiguities in reinsurance contracts will be construed against the party who drafted the contract, citing as support a case that did not involve reinsurance. ^[15]  The court stated that the reinsurers admitted to drafting the service of suit clause and then proceeded to construe it against them on the basis that they could have drafted it in a fashion which would have had the desired interaction with the arbitration clause.  The court failed to consider (see Section II B, supra) that the service of suit clause is a standardized provision based on credit for reinsurance law and one which the cedent would have surely have demanded for financial statement purposes if the reinsurer had not included it in the contract.

Of the several cases which mention the contra proferentem concept with respect to reinsurance contracts, several are dicta and several more are the product of murky reasoning which fail to apply or confuse more appropriate doctrines or business realities.  As a result, application of the concept to reinsurance must be regarded as having weak case law unpinning.

IV.       Case Law Finding No Presumption Against Either Party

The Second Circuit is the leading source of authority for the proposition that contra proferentem should not be applied to reinsurance contracts.  The earliest case on point is Great American Ins. Co. v. Fireman’s Fund Ins. Co.^[16] which involved a dispute over a cancellation notice.  The court stated: “Although ordinarily we would be disposed to interpret the language of an ambiguous notice in favor of the insured and against the insurer, we consider that this general rule should not apply when both the insured and insurer are ‘large insurance companies long engaged in far flung activities in that field of economic endeavor.’”^[17]

The next Second Circuit case in the series is United States Fire Ins. Co. v. General Reinsurance Corp.^[18]  This was a suit between two excess insurers to allocate a loss between them.  The court stated:

Presently, “contra preferentem [sic] is used only as a matter of last resort after all aids to construction have been employed and have failed to resolve the ambiguities in the written instrument.” [citations omitted] The New York courts have specifically stated that the rule “is not applicable in a contest between two insurance companies.” [citations omitted]

. . . Where the dispute is between two insurance companies, both parties are sophisticated business entities, familiar with the market in which they deal and armed with relatively equivalent bargaining power; hence the contra insurer rule serves little purpose.^[19]

The final Second Circuit case is Unigard Security Ins. Co. v. North River Ins. Co.^[20] in which the reinsurer asserted a late notice defense. A certain question was certified to the New York Court of Appeals.  With respect to the contra proferentem concept, the Second Circuit stated:

(W)e believe that this canon of construction does not apply in this matter.  In answering the certified question, the New York Court of Appeals used an analysis based on “general contract principle[s]” [citation omitted] and made no reference whatsoever to such a canon of construction.  We believe that the Court of Appeals was implicitly recognizing that reinsurance contracts are negotiated at arm’s length by two sophisticated parties [citation omitted] and that canons of construction that protect individual purchasers of original insurance policies do not apply to reinsurance. [citation omitted] . . . Indeed, reinsurers are so dependent upon ceding insurers for information, that application of a canon construing the reinsurance contract against the reinsurer would be highly anomalous.^[21]

Massachusetts has rejected the contra proferentem concept for reinsurance contracts.  Boston Ins. Co. v. Fawcett^[22] was a dispute over the application of a retention.   The court stated:

This position was confirmed more recently by the Supreme Judicial Court in Affiliated FM Ins. Co. v. Constitution Reinsurance Corp. ^[24] which focused on declaratory judgement expenses under a facultative certificate.  The court stated:

Similarly, the federal district court for Massachusetts did not apply the contra proferentem concept against a reinsurer with respect  to a facultative certificate in Commercial Union Ins. Co. v. Seven Provinces, Inc.. ^[26]   “Although the first page of the certificate bears the name of Seven Provinces, both parties acknowledged that the certificate was made up of a series of standardized forms routinely used by Sayre &  Toso, who was at the time the agent of each.” ^[27]

An early case, Vera Democrazia Soc. v. Bankers Nat. Life Ins. Co. ^[28] involved a claim by a mutual benefit society for reimbursement and a misrepresentation defense by the reinsurer.  The court stated:                         

Case law rejecting the application of the contra proferentem concept to reinsurance contracts demonstrates a better understanding of the business realities of the reinsurance marketplace and the manner in which reinsurance contracts are drafted.  As a result, the better reasoned case law appears to support the non-application of contra proferentem to reinsurance contracts.

V.        Conclusion

Contra proferentem is a rule of construction which interprets an ambiguous contract against its drafter.  This rule is used frequently with respect to insurance policies, often due to disparate bargaining power between the insurer and the insured. In contrast, cedents are large financial institutions who also act as reinsurers.  Clauses which benefit cedents have become standardized to meet regulatory requirements. As least with respect to treaty insurance, there is extensive opportunity to negotiate and craft contract language so that it is a common product of the parties.  In any event, most reinsurance contracts are negotiated and drafted by reinsurance intermediaries who are the agents of the cedent.  Under these circumstances, there is little policy justification for a rule that interprets reinsurance contracts against reinsurers under a presumption that reinsurers control the content of these contracts.

While there is a split of authority in case law, the better reasoned cases reject a rule that reinsurance contracts should be interpreted against reinsurers.  They take a more realistic view of the relationship of the parties and the realities of the marketplace.  In addition, several courts which have applied the rule tend to confuse it with the concepts of utmost good faith and follow the fortunes / settlements which have developed their own separate and distinct case law.  As a result, a preferable approach to contra proferentem is one in which the reinsurance contract is not interpreted for or against either party to the contract.

Endnotes