1. General remarks
C1 Article 6.2.1 sets out the rule on retention. The rule also applies where instead of “retention” the parties refer to “deductible” or “priority” or any other equivalent term. A retention is defined as a portion of the insured risk transferred to the reinsurer under the contract of reinsurance that the reinsured is willing to bear for its own account (Carter, Ralph & Lucas 375). The upper limit of a retention is referred to as an “attachment point” or “excess point”. Where the parties agree on a retention, the reinsured retains liability for the entire loss below the attachment point and transfers liability for the part of the loss above that point. Hence, the reinsurer promises to indemnify the reinsured against the losses above the attachment point.
C2 The purpose of a retention is to ensure that the reinsured has a genuine and adequate interest in the risk. It aligns the reinsured’s interests to those of the reinsurer during the term of the contract of reinsurance in relation to losses and claims handling under the insurance contract. The obligation to maintain a retention also serves to control the reinsurer’s loss levels and frequency because losses solely within the retention will not be indemnified. As a result, administrative expenses are not incurred by the reinsurer for these claims.
C3 Retention arrangements vary among the specific types of reinsurance. For example, in quota share reinsurance, the retention is a fixed percentage of all losses borne by the reinsured, whereas, in surplus reinsurance, the retention is a fixed amount (“retained line”). In excess of loss reinsurance, the reinsurer is liable for all losses above the excess point up to an agreed amount.
C4 Although most contracts of reinsurance on the market contain some kind of retention, there are also instances of contractual arrangements where the parties agree that the reinsured is not required to keep any retention. This may be the case in fronting and/or captive arrangements.
C5 The parties agree on the amount of the risk retained by the reinsured in the contract of reinsurance. It is usually based on the sum insured, the maximum loss (Pfeiffer 44) and, most importantly, on the subjective intent of the parties (e.g. maximizing premium income retained by the reinsured, minimizing the reinsured’s exposure to losses, and/or taking into account the reinsured’s capital, free reserves, and the reinsured’s gross premium income, nature and quality of originally written risk) (Pohl & Iranya 160–162).
2. Operation of the rule
C6 Where the contract is silent on retention, there is no obligation of the reinsured to maintain a retention (either gross or net – in relation to which see Comments 10 and 11 below) and the reinsurer accepts the liability for the entire loss up to the coverage limit (paragraph (2)). Where the parties agree on the obligation to maintain a retention, but the contract is silent, or the interpretation of the contract of reinsurance is unclear, on whether the agreed retention is net or gross, it is understood that the parties intended to agree on a duty to maintain a gross retention. Accordingly, the parties’ intention to agree on a net retention must be clearly provided for in the contract of reinsurance. Furthermore, the Principles neither define the amount of an appropriate retention nor the terms of maintaining it. These elements should be expressly and clearly provided for in the contract of reinsurance.
3. No obligation to maintain retention as a default rule
C7 National laws differ as to whether there is an obligation to maintain a retention in the absence of a clear agreement in the contract of reinsurance. For instance, under German law, the duty to maintain a retention is considered a legally binding trade custom (Klimke no 13c; Cannawurf & Schwepcke no 94; Schwepcke no 54; Katschthaler, Topsch & Kappler no 83; Franz & Keune 22; Looschelders 6), and it is described as one of the fundamental characteristics of a contract of reinsurance (Pisani no 3; Deutsch & Iversen no 129). Hence, under German law, the duty to maintain a retention is implied in a contract of reinsurance in the absence of an express retention clause. By contrast, English law does not imply a term that imposes a duty to maintain a retention, and therefore such a duty must be expressly provided for in the contract of reinsurance. Otherwise, there is no duty of the reinsured to maintain a retention (see Phoenix General Insurance of Greece v Halvanon Insurance [1985] 2 Lloyd’s Rep 599).
C8 The Principles follow the English reinsurance tradition where there is no implied duty of the reinsured to maintain a retention. The choice to follow the broadly accepted English approach on retention in contracts of reinsurance is justified because introducing an implied duty requiring a retention introduces uncertainty as to the size and scope of the retention.
4. Gross and net retention
C9 If the parties agree to maintain a retention, it is necessary to specify whether or not the reinsured must retain that retention for its own account, or may cede part or all of the agreed retention to a third party.
C10 The term “net retention” refers to a retention maintained by the reinsured, for its own account without any reinsurance. The reinsured is not allowed to transfer any part of that retention to a third party. Under the Principles, the term “net retention” applies to any type of reinsurance. In practice, depending on the type of reinsurance, the terms “net retained liability”, “net loss retention”, “self-insured retention (SIR)” or “first loss retention” are used as synonyms to net retention.
C11 The term “gross retention” refers to a retention maintained by the reinsured for its own account where a part or all of that retention can be transferred to a third party.
C12 The Principles do not prescribe any type of retention. In accordance with the principle of freedom of contract, it is up to the parties to agree on a gross retention, a net retention, or no retention at all. If the parties agree on the duty of the reinsured to maintain a retention, the type of retention – whether net or gross – should be clearly specified. As explained in Comment 6, in the absence of a clear expression as to whether the retention is net or gross, the retention is gross.
5. Interpretation of retention clause
C13 In the past, retention clauses have frequently given rise to interpretational issues. Contract wordings on retention were subject to disputes before the courts in several instances (see e.g. Kingscroft Ins Co Ltd Walbrook Ins Co Ltd & others v The Nissan Fire & Marine Ins Co Ltd (No 2) [1999] CLC 1875, Great Atlantic Ins Co v Home Ins Co [1981] 2 Lloyd’s Rep 219 (Lloyd J)). This is due to an inherent tension between the reinsured’s interest to obtain reinsurance cover without restrictions and the reinsurer’s preference that the reinsured remains engaged in the risk, both at underwriting and claims stage (that “the reinsured has skin in the game”). Given this tension and the various factors relevant to interpreting retention clauses, it is not surprising that retention clauses can introduce contractual uncertainty.
C14 The interpretation of retention clauses in contracts of reinsurance subject to the Principles will follow the rules of contract interpretation as provided in Chapter 4 PICC.
C15 Where the interpretation of the retention clause leads to the result that a net retention has not been agreed, there is no room for the implication of a duty to maintain a net retention. For the sake of clarity, this is explicitly confirmed by Article 6.2.1(2). The outcome is consistent with the overarching principle of freedom of contract supported by the Principles. A retention clause which cannot be interpreted as a net retention clause is a gross retention clause, to which the remedies provided for in Article 6.2.2 do not apply.
Illustrations
I1. Reinsured A and Reinsurer B agree on quota share treaty for Reinsured A’s life insurance portfolio. According to the retention clause in the contract of reinsurance, Reinsured A shall retain, net and unreinsured, for its own risk and liability, a 10 percent share of the general account liabilities. This is a typical example of a net retention. It is clear that Reinsured A must maintain the retention for its own account and cannot reduce the amount of the retention by reinsuring part or all of it with another reinsurer. The net retention must remain unreinsured.
I2. Reinsured A places an 80 percent quota share treaty for its property insurance portfolio in the US with Reinsurer B. The contract states: “Reinsured A will retain fifty percent (50 percent) not exceeding its twenty percent (20 percent) participation of the policies as herein defined “for its own account”. The wording “retain for its own account” on its own is not enough to show conclusively that it was the parties’ intention to agree on a net retention as defined in paragraph (1). “Retain for its own account” is ambiguous as it could be understood as merely preventing Reinsured A from ceding a further share of its retention under another quota share treaty but Reinsured A is free to transfer risk to a third party (e.g. to another reinsurer under a non-proportional contract of reinsurance – as is common market practice (Kingscroft Ins Co Ltd Walbrook Ins Co Ltd & others v The Nissan Fire & Marine Ins Co Ltd (No 2) [1999] CLC 1875)), or alternatively, it could mean that Reinsured A is obliged to keep the retention on its own underwriting account and unreinsured. As there might be different interpretations as to what “retain for its own account” means, it is advisable for the parties to make clear whether the reinsured is allowed to further reinsure the participation retained for its own account or not. Paragraph (1) defines net retention as the part of the risk under the contract of reinsurance retained for the reinsured’s own account without any reinsurance. Accordingly, under the Principles, when the parties use the term “net retention”, they signal their intention that the part of the risk represented by the retention must not be subject to reinsurance with a third-party reinsurer.
I3. Same facts as in Illustration 2, but Reinsured A agrees to retain for its own account the balance of 20 percent of all business subject to the benefit of excess of loss catastrophe reinsurance. In contrast to Illustration 2, the parties specifically agree on an exemption. Reinsured A must retain the retention for its own account and is not allowed to cede its retention to a third party, except that Reinsured A may take out an excess of loss catastrophe reinsurance.
I4. Reinsured A requests reinsurance cover for a short-term hazardous transport risk. To deliver the goods in time, the transport has to depart as soon as possible. Reinsured A and Reinsurer B agree on an excess of loss reinsurance with a coverage limit of USD 2 million in excess of USD 1 million. The contract is recorded on a slip only, stating in one line: “Excess of loss: USD 1 million. Retention: USD 1 million.”. The type of retention is not a matter discussed by the parties. On the available facts, the amount below the attachment point would be interpreted as a gross retention and, according to paragraph (2), a duty to maintain a net retention cannot be implied.
I5. Same facts in the previous Illustration, but during negotiations Reinsurer B expressly demands Reinsured A to retain the retention for its own account because of Reinsurer B’s limited time to verify the information about the transported goods and accompanying risks. Reinsured A agrees and the slip states “Net retained excess of loss: USD 1 million”. The retention obligation would be interpreted as a net retention on the basis of the express inclusion of the word “net” and given the preliminary negotiations between the parties.
I6. Same facts as in Illustration 4, but the slip states: “Excess of loss: USD 1 million. Retention (on the account of the reinsured): USD 1 million”. Due to time pressure on placing the reinsurance, Reinsurer B could not carry out a detailed risk assessment. This is why Reinsurer B mentioned to Reinsured A that the retention of USD 1 million serves the purpose that Reinsured A continues to have sufficient “skin in the game”. The wording of the slip does not sufficiently express that the parties agreed to a net retention. However, the wording of the slip taken together with the circumstances of the contract formation allows the conclusion that the parties intended the retention to be net.