1. Relationship to the PICC
C1 Article 2.1.2 expresses a duty of utmost good faith superseding the duty to act in good faith as expressed in Article 1.7 PICC. Article 2.1.2 thereby follows a concept and terminology well-established in reinsurance practice. The term “utmost good faith” is particularly common in Anglo-American jurisdictions and implies extensive pre-contractual disclosure duties generally not required for non-insurance contracts. In view of this established practice in Anglo-American jurisdictions, Article 2.1.2 uses the term “utmost good faith”.
C2 Notwithstanding the different terminology, Article 2.1.2 is consistent with the concept set forth in Article 1.7 PICC. Article 1.7 PICC establishes a robust duty of good faith but does not specifically address duties of pre-contractual disclosure as contemplated by the duty of utmost good faith under Article 2.1.2 and expressly established in Article 2.2.1. In the PRICL, the term “utmost good faith” is used to avoid any suggestion that the PRICL limits the duties of parties to a contract of reinsurance as compared with existing reinsurance contract law. However, this is not to say that the same duties would not follow from Article 1.7 PICC.
2. “Good faith” and “utmost good faith”
C3 The duty of good faith and fair dealing set forth in Article 1.7 PICC applies to all commercial contracts. The Comments to Article 1.7 PICC mention that the prohibition of an abuse of rights as well as the specific prohibition of inconsistent behavior set forth in Article 1.8 PICC flow from the general good faith requirement. Several other provisions of the PICC also refer to good faith (cf. Article 1.7 Comment 1 PICC). However, the PICC does not define good faith in general or give a list of applications of the principle. Different national jurisdictions use slightly differing nomenclature to describe the same essential concept and may differ regarding the type of conduct owed one another by contracting parties. Yet while some jurisdictions may have less stringent requirements of good faith, most generally view contractual obligations as containing a corresponding covenant of good faith and fair dealing. For example, the American Law Institute’s Restatement (Second) of the Law of Contracts, § 205, imposes “upon each party a duty of good faith and fair dealing in its performance and its enforcement.” Comment (a) of § 205 states in view of this provision that
[t]he phrase ‘good faith’ is used in a variety of contexts, and its meaning varies somewhat with the context. Good faith performance or enforcement of a contract emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party; it excludes a variety of types of conduct characterized as involving ‘bad faith’ because they violate community standards of decency, fairness or reasonableness.
The term “utmost good faith” is one largely associated with English-speaking jurisdictions and is well-established regarding marine insurance and reinsurance in the UK and the US, and to some degree in nations that were formerly British colonies (e.g. India, Singapore). In other industrial nations, there appears to be a tendency to refer simply to “good faith” without the use of the “utmost” modifier (see generally IBA Report, reviewing the use of the term and the good faith standard in Argentina, Australia, Belgium, Brazil, Canada, China, Costa Rica, Denmark, France, Germany, Hungary, India, Ireland, Italy, Malaysia, Malta, the Netherlands, Nigeria, Poland, Singapore, Spain, Sweden, Switzerland, Thailand, Turkey as well as in the UK and the US (States of California, Illinois, Massachusetts, New Jersey, New York, and Ohio). In some jurisdictions eschewing the use of the “utmost” label, the prevailing concept of “good faith” requires conduct akin to that of countries with an utmost good faith standard (see, e.g., IBA Report 23).
C4 In most of the jurisdictions in the US, contracts of (non-marine) insurance are considered contracts of good faith but not of utmost good faith. As a consequence, an applicant or policyholder is usually required only to answer questions truthfully and generally need not volunteer adverse information unless this amounts to impermissible concealment (see Stempel, Swisher & Knutsen 478; Stempel & Knutsen §§ 3.07–3.11). The Principles of European Insurance Contract Law (PEICL) apply an equivalent standard of good faith (Article 2:101(1) PEICL: “…subject of clear and precise questions… by the insurer”). However, the duty of utmost good faith as set forth in Article 2.1.2 requires the party seeking reinsurance cover to inform the reinsurer of all facts material to the risk, even if the reinsurer has not posed a specific question on that topic (see Article 2.2.1).
3. The special circumstances of reinsurance that support imposition of a duty of utmost good faith
C5 The nature of reinsurance provides a compelling case for imposing a duty of utmost good faith, which likely explains why jurisdictions that may not require this high a standard for primary insurance (e.g. the US) require utmost good faith in the context of reinsurance. First, as with (non-marine) direct insurance, a contract of reinsurance is an aleatory contract, the fate of which will largely depend on the evolvement of future uncertain events. Information asymmetries may give rise to opportunistic behavior. This is well expressed in, e.g., Travelers Indem Co v Scor Reins Co, 62 F3d 74, 76 (2d Cir 1995) (applying New York law): “Reinsurers depend on ceding insurers to provide information concerning potential liability on the underlying policies.” Reinsurance underwriters tend to be considerably more removed from risks than (non-marine) insurance underwriters and are thus more dependent upon receiving adequate disclosure of material information from reinsureds. As a result, reinsurance law has long imposed rigorous duties upon parties to a reinsurance agreement, particularly in respect of the reinsured’s disclosure obligations. Second, reinsurers traditionally rely to a large extent on the risk evaluation and handling of claims by their reinsureds. They invest a high degree of trust in their contractual partners. This is well expressed in, e.g. Unigard Sec Ins Co, Inc v North River Ins Co, 4 F3d 1049, 1054 (2d Cir 1993) (applying New York law):
Historically, the reinsurance market has relied on a practice of utmost good faith to decrease monitoring costs and ex ante contracting costs. [R]einsurers cannot duplicate the costly but necessary efforts of the primary insurer in evaluating risks and handling claims. [...] They are protected, however, by a large area of common interest with ceding insurers and by the tradition of utmost good faith, particularly in the sharing of information.
C6 It follows that contracts of reinsurance should be subject to the duty of utmost good faith and the PRICL expressly adopts this standard. Consequently, the PRICL encourages full disclosure of material information. The PRICL embraces the traditional view that because of the nature of reinsurance, the reinsurer should be permitted to rely completely on the degree of material disclosure provided by the reinsured. Although the duty of utmost good faith is primarily stated in terms of duties of disclosure imposed upon a prospective reinsured, the duty applies throughout all aspects and stages of a contract.
Illustrations
I1. Prospective Reinsured A applies for facultative reinsurance for its program of excess insurance for a major pharmaceutical company. The company has given notice to Reinsured A that the company has collected roughly 200 reports of adverse consumer reactions when using a particular drug and that local health authorities have commenced an investigation. Reinsured A fails to share that information with prospective Reinsurer B, and a contract is formed in which Reinsurer B agrees to reinsure fifty percent of Reinsured A’s product liability coverage of the drugmaker. Reinsurer B never inquires as to whether Reinsured A has knowledge of any problems regarding the drugs manufactured by Reinsured A’s policyholder. Reinsured A has not made a misrepresentation to Reinsurer B because Reinsured A has not made any false representations to Reinsurer B. According to the law of some jurisdictions, neither has Reinsured A engaged in concealment. But Reinsured A has violated the duty of utmost good faith by failing to disclose to Reinsurer B facts a reasonable reinsurer would want to know. Reinsured A as an insurer should have known that this information would be deemed material by Reinsurer B and should have made disclosure without the necessity of a specific question (see Article 2.2.1 Comments 6 et seq. regarding materiality).
I2. Same facts as in the previous Illustration, but the underlying drug company policyholder has told prospective Reinsured A of only two adverse reactions to the drug and there has been no hint of a government investigation. Reinsured A’s failure to disclose this information would probably not be deemed a breach of the duty of utmost good faith by most tribunals. For even perfectly safe and effective pharmaceuticals, there will be some adverse reactions. Some adverse reactions in a population are inevitable. A prescription medicine is not defective or unreasonably dangerous simply because some users have such reactions. A mere two such cases would ordinarily not trigger Reinsured A’s duty to disclose. However, if prospective Reinsurer B specifically asked about adverse reactions, Reinsured A would be required to answer truthfully and non-deceptively.
I3. Prospective Reinsurer B might ask prospective Reinsured A: “Did anyone call you about any risks not previously discussed?” Reinsured A answers “No” and it is a technically correct answer because no one called Reinsured A regarding this matter. But Reinsured A had in fact itself made a call and during the call was informed about additional risks that were not disclosed to Reinsurer B. As Reinsured A’s answer is technically correct (it made the call but was not called), most jurisdictions in a case involving an ordinary contract – and perhaps even an insurance contract – would find no fraud or misrepresentation and many would find no bad faith. However, this sort of tricky and literal answer evades the essence of the inquiry and clearly constitutes a failure to act in utmost good faith.
4. The touchstone of the concept of utmost good faith is honest and reasonable conduct in the context of the situation
C7 Very generally, the duty of utmost good faith is often considered to operate as something of a “golden rule”, in which each party treats the other as it would itself want to be treated under the same circumstances. For example, if a reinsured fails to provide to the reinsurer information that the reinsured would have wanted had it been in the position of the reinsurer, the reinsured has breached the duty of utmost good faith. Conversely, where a reinsurer construes an underlying claim to present the least exposure possible and then argues that the reinsured has overpaid, the former breaches the duty of utmost good faith by failing to give the reinsured the reasonable benefit of the doubt. Summing up, utmost good faith requires honest and reasonable conduct in the context of the situation.
C8 Where either party propounds clear, precise and reasonable questions to the other, the party receiving the inquiry has a duty to answer fully and truthfully based on the circumstances of which the party is aware or should be aware if exercising reasonable care in its response.
5. Reciprocity of the duty of utmost good faith
C9 Although most discussion of the duty of utmost good faith in judicial decisions involves alleged breach by the reinsured, the duty is reciprocal. It applies to reinsurers as well as reinsureds even if the circumstances in which breach by the reinsurer is alleged may be comparatively less frequent than situations in which it is alleged that the reinsured failed to provide required information during the contracting process. The reinsurer is subject to a duty of utmost good faith.
Illustration
I4. Reinsured A, which has a contract of reinsurance with Reinsurer B, specializes in providing workers compensation and general liability insurance to FactoryCo, a producer of widgets. Reinsurer B becomes aware that a chemical used in the widget manufacturing is suspected of causing both severe injury to exposed workers engaged in making the product and minor injury to consumers using products manufactured with the chemical, and that in the Western United States, workers compensation and consumer injury claims are being filed on this basis at a rapidly increasing rate. Reinsurer B should share this information with Reinsured A so that Reinsured A may take appropriate steps such as increasing reserves or counseling FactoryCo to modify its production methods.
C10 Reinsurance agreements often expressly stipulate that the reinsurer is obligated to advise the reinsured of particular financial situations to ensure that the reinsured is sufficiently advised so that it can make informed decisions regarding its rights of cancellation. As an example, the reinsurer might be required to notify the reinsured of a loss of a substantial amount of the reinsurer’s surplus or capital. Even in the absence of specific language imposing such a requirement, the PRICL requires disclosure of this sort.
6. The duty of utmost good faith imposes core requirements of disclosure, particularly upon the prospective reinsured
C11 A particularly important duty of utmost good faith involves disclosure of material information as outlined in Article 2.2.1. Prior to formation of the contract of reinsurance, risk has not been transferred. The decisions of the parties regarding risk transfer depend upon adequate disclosure of information.
7. The duty of utmost good faith during the contract period is not burdensome
C12 The fact that the duty of utmost good faith applies throughout the contract and not solely to pre-contract negotiations does not mean that the reinsured is required to continually provide the reinsurer with updates on all information that was required to be disclosed as part of contract formation. Once a contract is formed, risk has been transferred and allocated among the parties, and the reinsurer, having accepted that risk, is bound to pay covered claims absent a valid defense. For treaty reinsurance in particular (as contrasted to facultative reinsurance that is specifically underwritten), it would not be practical to expect an ongoing duty of providing information as extensive as that attending contract formation. By contrast, if a contract is due for renewal, the situation of the parties resembles a pre-contractual situation and will be treated the same way (see Article 2.1.2 Comments 3 and 4).
Illustrations
I5. Reinsured A, a general liability insurer, contracts with Reinsurer B at a time when the amount of “non-economic” damages or “pain and suffering” damages were limited to USD 250,000 in the state where Reinsured A has almost all of its exposure. During the term of the policy, the state legislature increases the damages cap to USD 1 million. Reinsured A does not advise Reinsurer B of the change in the law. Reinsured A has not violated the duty of utmost good faith by failing to inform Reinsurer B of this change in the law that increases Reinsured A’s exposure and hence also increases Reinsurer B’s exposure. The situation changes once the contract is due for renewal. Now, Reinsured A must inform Reinsurer B about the change in legislation.
I6. Reinsured A, an automobile liability insurer, has its policies in a state which has clear state supreme court precedent that bars punitive damages against automobile policyholders, regardless of how reckless the driving or other misconduct of the driver. This anti-punitive-damages precedent is overruled during the period of the contract. Reinsured A does not advise Reinsurer B of the change in the law. This failure to disclose is not a material omission. Its failure to advise Reinsurer B of the change in legislation is not a breach of the duty of utmost good faith. The situation changes once the contract is due for renewal. Now, Reinsured A must inform Reinsurer B about the change in legislation.
I7. Reinsured A and Reinsurer B have contracted for reinsurance for Reinsured A’s portfolio of life insurance. The statute of limitations on life insurance claims in Reinsured A’s jurisdiction of operations is four years; the limitations period generally applies to breach of contract claims. A period of war drove many immigrants from a war-torn country to Reinsured A’s jurisdiction, where the immigrant community has become well-established and now seeks to pursue recovery of life insurance benefits owed to them as beneficiaries of their dead relatives, many of whom had purchased life insurance from Reinsured A. The claims would otherwise be barred by the statute of limitations, but the jurisdiction’s legislature extends the statute of limitations. Seeing an unexpected upsurge in life insurance claims, Reinsurer B argues that the principle of utmost good faith required that this information be transmitted from Reinsured A to Reinsurer B and that Reinsured A’s failure to disclose the extended statute of limitations constitutes a breach of the duty of utmost good faith. Most tribunals would regard this argument as unpersuasive notwithstanding the unusual circumstances. The situation changes once the contract is due for renewal. Now, Reinsured A will have to inform Reinsurer B about the change in legislation.
Note: Illustrations 5–7 assume a situation where the reinsurer neither knows nor ought to know about the legal changes. This may particularly apply to foreign reinsurers not established in the country where the risk is located.
8. Consent provisions in a contract of reinsurance are subject to the duty of utmost good faith and must be reasonably exercised
C13 Where a contract prohibits settlement or payment by the reinsured without the reinsurer’s consent, the duty of utmost good faith requires that the reinsured shall abide by such provision unless the reinsurer’s consent is unreasonably withheld, which would be a breach of the duty of utmost good faith by the reinsurer. The reinsurer is required to exercise any such powers of consent reasonably. It would violate the reinsurer’s duty of utmost good faith for the reinsurer to exercise its rights of consent in a manner that unfairly favors the reinsurer’s interest (e.g. attempting to delay payment in order to serve investment or business objectives, even though this imposes hardship on the reinsured) or deprives the reinsured of the benefit of the bargain made by the reinsurance agreement.
C14 Ordinarily, a reinsurer is not responsible for extra-contractual liability to the insured occasioned by misconduct of the reinsured (e.g. bad faith conduct, statutory violations, wrongdoing by the reinsured independent of the contract obligations between reinsured and insured).
C15 Where a reinsured is presented with a claim that the reinsured regards as within coverage and sufficiently meritorious to merit payment but the reinsurer unreasonably refuses consent to payment, the reinsured should be permitted to pay the claim without prejudice to the reinsured’s rights to collect reinsurance payments, notwithstanding that the reinsured in such a situation paid a claim in spite of the reinsurer’s refusal to consent.
Illustration
I8. Reinsured A has a policyholder facing a catastrophic injury claim in the United States. The plaintiff suing Reinsured A’s policyholder offers to settle the claim in return for payment of the USD 500,000 policy limits of Reinsured A’s automobile policy. The settlement demand would be regarded as reasonable by most informed observers. Reinsured A would like to accept the plaintiff’s offer; Reinsurer B unreasonably refuses to consent to the proposed settlement and thereby breaches its duty of utmost good faith.
9. A party asserting breach of the duty of utmost good faith bears the burden of proof on the issue
C16 Where there is a dispute regarding whether the duty of utmost good faith has been breached, the burden of proof or burden of persuasion to demonstrate breach rests with the party asserting breach.
Illustrations
I9. Reinsured A alleges that Reinsurer B unreasonably withheld its consent to a settlement of the underlying insurance claim for the purpose of delaying payments only and that withholding consent resulted in damage to Reinsured A. Reinsured A has the burden of proving facts supporting this allegation.
I10. Reinsurer B contends that Reinsured A has failed to disclose facts material to the risk assumed by Reinsurer Band seeks avoidance. Specifically, Reinsurer B contends that Reinsured A’s failure to advise Reinsurer B of demand letters from product users of Reinsured A’s insureds constitutes a failure to provide material information. Reinsurer B must demonstrate that the missing information was material to the risk assumed by Reinsurer B and should have been disclosed. In other words, Reinsurer B must show that the type of injuries alleged due to use of the product of Reinsured A’s insured and the volume of complaints are the types of information that would have affected Reinsurer B’s decision to enter into the contract. Reinsurer B also has this burden of persuasion even if it is seeking a less drastic remedy, such as an increase in premium payment (rather than avoidance), to compensate for the alleged higher risk it assumed.