1. The scope of Article 6.3.1
C1 Article 6.3.1 refers to defence expenditures, declaratory judgment expenses and pre- and post-judgment interest incurred by the reinsured. These costs typically arise when the reinsured rejects a claim made by its insured for coverage. Such costs are addressed in Article 6.3.1. In contrast, administrative costs of the reinsured connected to claims handling are general operational costs of the reinsured and are generally not passed on to the reinsurer. They are not subject to Article 6.3.1.
C2 If the contract of reinsurance provides cover for the reinsured’s liability under a liability insurance contract, a reinsured in its capacity as insurer will typically incur costs for the defence of the insured against claims brought by the third-party claimant. This is because liability policies typically cover such costs. As a consequence, those costs will, absent express terms or circumstances to the contrary, generally be within the scope of the contract of reinsurance and within its limits. Article 6.3.1 is not concerned with such costs and does not state a rule of decision regarding such costs. These types of expenditures incurred by the reinsured to defend the insured from a third party’s claim are generally covered as a matter of course as part of the underlying duties of the reinsured. In contrast, if a liability insurer, i.e. the reinsured, refuses cover to its policyholder and costs are incurred in disputing the existence or extent of coverage, these “disputing coverage” costs are subject to Article 6.3.1. First-party insurers, such as those providing property damage coverage or life/health/disability insurance do not incur costs defending claims made against their policyholders but may equally expend costs disputing the existence or amount of coverage. Article 6.3.1 addresses these types of “defence expenditures”, as the term is used in the Article.
2. The general rule
C3 A reinsured’s expenditures for defending a claim or seeking a declaratory judgment to avoid coverage of a claim are considered within the scope of a contract of reinsurance, as is any pre- or post-judgment interest that the reinsured is required to pay as a result of the late payment of a valid claim for coverage. The reinsured may recover from the reinsurer any expenses properly incurred pursuant to this provision, irrespective of the policy limits. This recognizes that, in making such expenditures, the reinsured is acting in both its interests and those of the reinsurer. These expenditures are incurred in order to mitigate the loss. This rationale aligns to mitigation in primary insurance (see e.g.: PEICL (Article 9:102 and Article 14:101), the UK Marine Insurance Act 1906 (section 78), the German Versicherungsvertragsgesetz (VVG) (Article 82) and the Swiss Versicherungsvertragsgesetz (VVG) (Article 38c(1))). This is a default rule that can be changed by the contracting parties. In particular, where there are layers of reinsurance in a structured program, the reinsurers at higher layers of coverage may seek to avoid or modify this general rule on the ground that a reinsurer closer to the risk should bear all or a greater proportion of these ancillary costs of defending claims.
C4 Article 6.3.1 deals with situations in which there is a single contract of reinsurance. Article 6.3.1 does not deal with the allocation of costs as between participating reinsurers inter se – this issue should be dealt with in their subscription agreement.
Illustrations
I1. Reinsured A, which has purchased reinsurance from Reinsurer B, provides builder’s risk insurance for a major highway construction project involving roads and bridges. The project is roughly 50 percent finished when the surface roads of a major bridge begin buckling and become uneven. In addition, various connections in the bridge fail a government engineering inspection and are deemed unsafe. Demolition and subsequent rebuilding of this portion of the project is recommended by engineers. The policyholder general contractor makes a claim for coverage, contending that the defects result from record-breaking heat during construction. Reinsured A denies the claim and prosecutes a declaratory judgment action seeking a determination that the loss is not covered because it resulted from (uncovered) poor workmanship and not (covered) externally imposed injury. Reinsured A prevails and therefore is not required to pay the claim but has incurred substantial expenses prosecuting the declaratory judgment action. Absent agreement to the contrary, Reinsured A’s declaratory judgment expenses are within the coverage of the contract of reinsurance. The successful declaratory judgment action provided economic benefit to both Reinsured A and Reinsurer B by avoiding coverage.
I2. Same facts as in the previous Illustration, but the policyholder claimant prevails in Reinsured A’s declaratory judgment action and the court orders Reinsured A to pay the claim. Even though the declaratory judgment action by Reinsured A was unsuccessful, it is still within the contract of reinsurance. Although unsuccessful, the action was a good faith effort by Reinsured A to avoid coverage, which if successful would have accrued to the benefit of both Reinsured A and Reinsurer B.
I3. Same facts as in Illustration 1, but the bridge is damaged by an earthquake. The builder’s risk policy issued by Reinsured A does not contain an earth movement exclusion of any type. Reinsured A nonetheless commences a lawsuit seeking a declaration of no coverage. Reinsured A contends that notwithstanding the earthquake, the damage to the bridge results from poor workmanship by the policyholder and is therefore not covered. Reinsured A has no basis for making this claim and actually is in possession of engineering information demonstrating that the construction was well done and that the damage was solely the result of the earthquake. Unsurprisingly, the policyholder prevails in the action and the court orders Reinsured A to provide coverage. The coverage required by Reinsured A’s policy is within the coverage of the contract of reinsurance. However, Reinsurer B is not liable for the expenses of the frivolously filed unsuccessful declaratory judgment lawsuit. Filing a clearly unmeritorious declaratory judgment is a breach of the reinsured’s duty of utmost good faith owed to the reinsurer.
I4. Same facts in as Illustration 1, and the contract of reinsurance is one of proportional reinsurance providing for Reinsurer B to share 50 percent of the risk in return for 50 percent of the premium received by Reinsured A. The costs of prosecuting the successful declaratory judgment action resulting in a finding of no coverage amount to a total of USD 300,000. Reinsured A and Reinsurer B are each responsible for USD 150,000 of these defence costs.
I5. Reinsured A has issued a blanket property insurance policy for a chain of grocery stores heavily concentrated in Florida. Reinsured A has purchased excess of loss reinsurance from Reinsurer B that has an attachment point of USD 10 million and policy limits of USD 10 million. A strong hurricane during the night damages three of the grocery store buildings. The policyholder makes a claim for USD 6 million of insurance benefits. Reinsured A denies coverage on the ground that hurricane damage occurred after the property insurance policy expired at midnight and prevails in litigation. As the policyholder’s claim was below 10 million USD, it did not implicate the contract of reinsurance, and Reinsured A is solely responsible for the funds expended in defeating coverage.
I6. Same facts as in the previous Illustration, but the hurricane damaged a dozen of its grocery store buildings in the Miami metropolitan area, and the policyholder is claiming USD 24 million in damage. The costs of Reinsured A’s successful defense to coverage should be shared by Reinsured A and Reinsurer B on a 50-50 basis.
I7. Same facts as in Illustration 6, except there is another contract of reinsurance (with Reinsurer C) for USD 10 million that attaches at USD 20 million. The defence costs of defeating coverage because damage to the stores took place after expiration of the underlying policy should be apportioned among Reinsured A, Reinsurer B, and Reinsurer C according to their respective exposure to the defeated claim.
I8. Same facts as in Illustration 6, except that the policyholder’s claim is for USD 20 million in coverage. Reinsured A and Reinsurer B will share the defence costs of defeating the claim on a 50-50 basis. Reinsurer C will not be responsible for defence costs related to this matter.
3. Defence costs
C5 Defence costs within the scope of Article 6.3.1 are the external costs that the reinsured incurs in defending its denial of coverage for a claim vis-a-vis its policyholder. External costs are costs owed by the reinsured to a third party incurred in respect of defending the denial of coverage (e.g. costs of attorney). The scope of defence costs does not include internal costs and costs for investigating and assessing the claim. These costs are to be considered as the reinsured’s administrative and operational costs.
4. Declaratory judgment costs
C6 Declaratory judgment costs are the expenses a reinsured incurs by a judicial determination regarding its obligation to provide insurance coverage to its policyholder and to pay claims under an insurance policy. They are expenses incurred by the reinsured that, like the reinsured’s general administrative costs, are not used directly for claim payments. These legal expenses can arise, for example, when either the insured or the insurer initiates a lawsuit to determine whether an insurance claim is covered. Reinsureds often seek indemnity from their reinsurers for declaratory judgment expenses. A reinsurer’s obligation to reimburse its reinsured for declaratory judgment expenses is often addressed in the contract of reinsurance, frequently defined as “allocated loss expenses” or “loss adjustment expenses” to be paid by the reinsurer.
Unless otherwise agreed between the reinsurer and reinsured, the costs of a declaratory judgment regarding the reinsurer’s obligation to provide cover are subject to the contract of reinsurance. This provision of the Principles differs from the law of some jurisdictions. For example, under English law, declaratory judgment expenses and defence costs arising from litigation between the reinsured and its insured are not covered as a matter of course as part of the reinsurer’s liability. In Baker v Black Sea & Baltic Gen Ins Co Ltd [1998] Lloyd’s Rep IR 327, the House of Lords declined to imply a term that such expenses should be recoverable in addition to the reinsured’s indemnity as a matter of law, but acknowledged that such a term could arise as a result of market practice.
C7 In the absence of specific language in the contract of reinsurance providing for payment of these expenses, declaratory judgment expenses were traditionally viewed as outside the scope of the contract of reinsurance. However, recent reported decisions evidence an arguable trend towards allowing reinsureds to recover declaratory judgment expenses. Although these can be classified as an ordinary cost of doing business (like the administrative expenses of the reinsured), apt investment in declaratory judgment litigation that results in a declaration that the insurer is not liable can result in a net gain for both reinsureds and reinsurers. See Gerber, Kingsley & Waterman § 74.03[3]. Consequently, the Principles reject the English approach to this issue and provide a default rule in favour of reinsurance coverage for declaratory judgment expenses.
C8 Where the reinsurer wishes not to cover the reinsured’s declaratory judgment costs, the contract can easily so provide. See, e.g. Employers Ins Co of Wausau v American Reins Co, 256 F Supp 2d 923, 925 (WD Wis 2003) where the court found that there was “no question” that the allocated loss expense provision requiring payment for “all expenses incurred in the investigation and settlement of claims or suits” included the declaratory judgment expenses incurred by a reinsured attempting to avoid coverage for a claim. In reaching this result, the court said that a provision in the contract stating that “allocated loss expenses shall not include expenses incurred by [the reinsured] in regard to any actual or alleged liability that is not within the circumscribed provisions of the policy reinsured” was simply an exclusion of expenses relating to the reinsured’s ECOs or tortious (i.e., bad faith) conduct, but did not exclude declaratory judgment expenses per se.
5. Interest
C9 In the US and many other jurisdictions, a prevailing claimant is entitled to recover pre-judgment interest on the award for the time during which the claim was pending so that a defendant is not incentivized to delay resolving meritorious claims merely to hold funds for a longer time period. Similarly, many jurisdictions permit recovery of post-judgment interest so that a losing defendant is not incentivized to delay paying a valid judgment or engage in frivolous but time-consuming challenges to the judgment. Notwithstanding the policies underlying the availability of pre- and post-judgment interest, legal systems recognize that the validity or value of a claim may be subject to reasonable disagreement or that an initial judgment may be in error. As a result, a reinsured will often have legitimate reasons for contesting a claim, including challenges to a judgment through post-trial motions or appeals. Where successful, these actions reduce or may even eliminate the payment obligations of a reinsured. Whether or not successful, such challenges take time, which in the case of an unsuccessful challenge results in a larger amount of post-judgment interest, just as contesting the claim results in pre-judgment interest that is avoided if the claim is settled without trial. Since reasonable disputing of a claim and reasonable challenge to a judgment may reduce the liability of the reinsured, it potentially accrues to the advantage of the reinsurer. As a result, Article 6.3.1 makes a reinsurer liable in the absence of agreement to the contrary.