1.          Defining XPL and ECO liabilities and recognizing how they arise

C1        An XPL liability is one in which the reinsured is held responsible in connection with a covered claim for more than the reinsured policy’s limit. In the US, the situation is often referred to as an “excess judgment” matter in which the underlying insurer/reinsured is held responsible for more than the policy limits based on some misconduct such as failing to make reasonable settlement decisions. Such situations may or may not involve bad faith or violation of applicable fair claims handling statutes.

C2        An ECO matter is one in which the reinsured is held liable for injury inflicted on its insured that is different from or in addition to the injury inflicted by unreasonable settlement decisions, such as rejecting a prudent settlement opportunity for a claim that later results in XPL liability.

C3        Although the two types of liability for the reinsured are often present in the same case, the concepts are distinct. This Article treats the concepts as separate even though they may be collapsed by some in the industry. For example, the ECO provision of Brokers & Reinsurance Markets Association (“BRMA”) Form 16A supplies the following definition and example in which an ECO is

defined as those liabilities not covered under any other provision of this Contract and which arise from the handling of any claim on business covered hereunder, such liabilities arising because of, but not limited to, the following: failure by the [reinsured] to settle within the policy limit, or by reason of alleged or actual negligence, fraud, or bad faith in rejecting an offer of settlement or in the preparation of the defence or in the trial of any action against its insured or reinsured or in the preparation or prosecution of an appeal consequent upon such action.

C4        Jurisdictions may differ in their categorization of XPL and ECO liability. For example, the BRMA ECO definition above includes additional reinsured liability for rejecting a reasonable settlement offer, which the US would ordinarily label an XPL liability. In addition, jurisdictions may differ in their doctrinal characterization of XPL and ECO liability. For example, many States in the US consider XPL liability a type of tort damage stemming from the insurer’s breach of its covenant of duty of good faith and fair dealing, while other States treat the XPL liability as a consequential damage for breach of the contractual duty to make reasonable settlement decisions. Most US jurisdictions treat ECO liability as a tort because it commonly stems from an insurer’s breach of the covenant of good faith and fair dealing or violation of a fair claims handling statute rather than mere breach of the insurance contract. Other jurisdictions (e.g. Germany) tend to treat ECO liability as a subset of breach of contract rather than as tort liability. These nuances of classification do not affect the application of the Principles to XPL and ECO liability. Where such liability occurs, the Principles apply to determine whether the reinsurer is required to pay for such liabilities, regardless of the theoretical basis or doctrinal classification of the XPL or ECO liability.

C5        Late payment of claims by a reinsured may result in assessment of interest, damages or other penalties against the reinsured. In some jurisdictions such as the United Kingdom, this is regarded as a subset of contractual liability (see the UK Insurance Act 2015, § 13A(5)), while in others it is viewed as an extra-contractual obligation. The Principles do not consider interest payments, damages or other penalties for the late payment of claims under the underlying insurance contract as XPL or ECO obligations of the reinsured unless the contract of reinsurance so provides.

C6        XPL or ECO liability may be imposed upon a reinsured irrespective of fault by the law applicable to the underlying insurance contract. Most US States have enacted a version of the model Fair Claims Settlement Practices Act promulgated by the National Association of Insurance Commissioners (“NAIC”, an organization composed of the insurance regulators of the individual US States and territories). These laws may impose statutory liability upon a reinsured for errors in claims handling beyond merely ordering payment of the insurance money within the policy limits. Many US States also require an insurer to pay the entire amount of a judgment, irrespective of the reinsured’s policy limits, if the reinsured is deemed to have engaged in unreasonable settlement conduct (e.g., rejecting a clearly reasonable settlement offer within policy limits in connection with a claim having a clear value exceeding policy limits). The most common type of ECO liability is bad faith or unfair claims handling liability imposed upon the reinsured that requires the reinsured to pay compensatory or punitive damages due to its misconduct toward the policyholder.

C7        XPL and ECO liability is largely confined to the US. In Canada, the EU and the UK, policy limits are generally sufficiently large that the misjudgments of a reinsured regarding settlement are unlikely to lead to XPL situations. Many jurisdictions do not have a developed doctrine of XPL and ECO liability. Although the UK Insurance Act 2015 envisages that remedies (including damages) are available in respect of late payment of claims, there have not yet been any reported cases in which the remedies have been tested. The US also has considerably broader ECO liability than most jurisdictions. As a result, statutory and case law regarding XPL and ECO liability is largely confined to the US.

Illustrations

I1.         Reinsured A issues a USD 100,000 general liability policy to SmallCo, a small business sole proprietorship run by Parker Smith, who sells cookies out of a home in a residential neighborhood. The policy is subject to a reinsurance treaty with Reinsurer B that provides for 80/20 quota share reinsurance. Customer C has a rare allergic reaction to one of SmallCo’s cookies and is badly injured, incurring USD 50,000 in medical bills, missing six months of work (at a loss of USD 50,000 in salary) as well as needing extensive ongoing physical therapy to regain neuromotor skills.

Customer C sues. Under the governing law of the jurisdiction in which the claim is made, sellers of edible consumer goods are strictly liable for allergic reactions even if they took appropriate precautions. Consequently, the liability of SmallCo is beyond dispute. Customer C offers to settle for the USD 100,000 policy limits. Reinsured A rejects the settlement offer, denies liability and makes no counter-offer. The case goes to trial where Customer C is awarded USD 450,000 in damages (for medical bills, lost income, ongoing rehabilitation costs, pain, suffering and loss of enjoyment of life). The trial court rejects a motion for new trial that argued that the amount of the verdict was excessive.

Reinsured A’s rejection of the settlement offer was unreasonable in light of SmallCo’s clear liability and the extensive damages to Customer C, which clearly gave the claim a value exceeding the USD 100,000 policy limits. This is an XPL liability of Reinsured A. However, unless otherwise agreed or unless paragraph (4) applies, Reinsurer B is not liable to indemnify for the XPL liability.

I2.         Same facts as in the previous Illustration, but in addition Reinsured A discovers during its investigation of the claim that SmallCo’s operation out of SmallCo owner Smith’s personal residence violates local zoning laws, although there is no evidence that SmallCo’s location or operation affected the safety of its product or posed any risk to public safety or quiet enjoyment of the neighborhood.

Reinsured A reports SmallCo’s zoning violation to the authorities, claiming that SmallCo’s operations are a serious public health threat and recommending that SmallCo be shut down and that SmallCo and Smith be heavily fined for violating the zoning regulations. A local regulator is spurred to pursue SmallCo and seek various punishments.

SmallCo and Smith retain counsel (at their own expense) to contest the proceeding. Smith is very anxious about it, subject to chronic sleeplessness, develops an ulcer and incurs medical costs. As SmallCo is spending money on legal fees, it is unable to lease commercial space to continue the business. The local regulators eventually agree that SmallCo poses no public health problems and should not be punished but can no longer operate out of the Smith home. The business closes. SmallCo and Smith sue Reinsured A for bad faith conduct.

Under prevailing local law, Reinsured A’s conduct violates its duties to the policyholder because Reinsured A interfered with a policyholder’s business operations even though those operations did not affect coverage or settlement issues. Reinsured A is held liable for physical and emotional distress imposed upon Smith and to SmallCo for the destruction of its business. The claim against Reinsured A is founded in both breach of contract and the tort law of bad faith, constituting a breach of fiduciary duty. The court finds Reinsured A’s conduct to have been in conscious disregard of the rights of SmallCo and Smith and awards punitive damages. The judgment against Reinsured A (including compensation for component parts of emotional distress, medical costs, counsel fees fighting the regulator, pain, suffering, loss of enjoyment of life, lost business opportunity and loss of the business as well as punitive damages) exemplifies ECO liability. Unless otherwise agreed or unless paragraph (4) applies, Reinsurer B is not liable to indemnify for the ECO liability.

I3.         Reinsured A issues a USD 1 million professional liability policy to Dr. Shane Smith, a pediatrician. One of the doctor’s young patients goes into a coma the day after a check-up and dies a week later. The family of the child sues the doctor, alleging negligent failure to diagnose a developing infection that brought about the death.

Liability is uncertain, but the plaintiffs have retained a qualified expert concluding that Dr. Smith was professionally negligent. Another expert will testify that had the child lived, the child would likely have become a white-collar professional earning millions of dollars over a working life. The plaintiffs offer to settle for policy limits.

Reinsured A rejects the settlement offer, makes no counter-offer and also conducts a searching examination of Dr. Smith seeking to determine whether he committed child abuse in his practice, even though Reinsured A has no basis for these suspicions. The investigation causes emotional distress to Dr. Smith. It also damages his reputation as word of the insurer’s actions becomes known in the community, resulting in speculative gossip. Many patient families leave the doctor.

The trial produces a USD 4.5 million malpractice judgment. The amount of the judgment exceeding the USD 1 million policy limits is XPL liability for Reinsured A because its decision to reject the policy limits settlement offer was unreasonable. Even if liability was subject to debate, the range of damages likely to be awarded at trial was so large that settlement within policy limits, or at least active efforts toward settlement, were required. Dr. Smith’s subsequent suit against Reinsured A for bad faith based on the emotional distress and reputational injury inflicted by the defamatory conduct of Reinsured A will, if successful, produce ECO liability for Reinsured A (and for the reinsurer vis-à-vis the reinsured only under the conditions of paragraph (4)).

2.          Scope of Article 6.3.2

C8        The preceding analysis of XPL and ECO claims has focused on US law and insurance practice. However, Article 6.3.2 is not confined to US situations and would be equally applicable to similar scenarios arising in other jurisdictions.

C9        In some of the cases decided under US law, an insured has been granted a direct claim against the reinsurer by way of “cut-through”. In contrast, Article 6.3.2 only deals with a liability of the reinsurer towards the reinsured. The Principles do not purport to establish a cause of action for the underlying policyholder against the reinsurer.

3.          Paragraph (1): Default rule

C10     Paragraph (1) makes it clear that unless there is specific language to the contrary in the contract of reinsurance, XPL and ECO liabilities are outside reinsurance coverage and are the responsibility of the reinsured. As a general rule, a reinsurer is not vicariously liable to policyholders for reinsured conduct leading to XPL and ECO liability. Under prevailing law in almost all jurisdictions, reinsurers are not in privity with policyholders, and there is a strong presumption against permitting a reinsured’s policyholder to make a claim directly against a reinsurer. However, a reinsurer may be liable to a policyholder where the reinsurer’s own conduct has contributed to XPL or ECO liability as addressed in paragraph (4).

C11     The US market uses ECO and XPL clauses. XPL clauses provide reinsurance coverage for XPL liability usually resulting from a binding judgment or arbitration award against the reinsured concerning a policy subject to the contract of reinsurance. ECO clauses provide reinsurance coverage for losses or liability incurred by the reinsured that are not within the scope of the policyholder’s insurance coverage (see Comment 3 above, which contains an example of such a clause). Details depend on the wording of the clauses. Annex F sets forth examples of such clauses.

C12     The mere existence of a “follow the fortunes/follow the settlements” clause in a contract of reinsurance is not sufficient to impose XPL/ECO liability on the reinsurer. For XPL/ECO liability to be covered, there must be agreement to assume these obligations in the contract of reinsurance or conduct of the reinsurer. The ECO and XPL clauses prevalent in the US (as discussed in Comments 23–26 below) are such agreements.

4.          Paragraphs (2) and (3): Definitions of XPL and ECO

C13     The definitions of XPL and ECO liability set forth in paragraphs (2) and (3) respectively are addressed in detail in Comment 1, Comment 2 and Comment 3 above, along with Illustrations. As discussed therein, the legal classification and doctrinal categorization of XPL and ECO liability may differ between jurisdictions, but such distinctions do not affect the treatment of XPL and ECO liability pursuant to the Principles.

5.          Paragraph (4): Exception to the default rule

C14     Paragraph (4) sets forth a limited exception to the general rule in paragraph (1). Although a reinsurer is not ordinarily responsible for a reinsured’s XPL or ECO liability, there may be situations in which the reinsurer’s own conduct sufficiently contributes to a reinsured’s XPL or ECO liability that it is reasonable to hold the reinsurer responsible.

C15     Depending on the facts of the situation and conduct of the reinsurer, a reinsurer’s XPL or ECO liability may be whole or partial. For example, if a reinsurer is entirely responsible for bad faith mistreatment of the policyholder, it may be deemed entirely responsible for a resulting ECO. If the wrongful conduct resulted from an equal collaboration of reinsured and reinsurer, they may each be deemed proportionately responsible. If the wrongful conduct was primarily at the instigation of the reinsured with the reinsurer contributing only modestly to the misconduct, paragraph (4), if applicable at all, would counsel for a reduced amount of ECO liability assigned to the reinsurer.

C16     The same analysis would apply to any XPL responsibility of the reinsurer. For example, if a reinsurer insists that a reinsured reject a reasonable settlement opportunity in a manner coercive of the reinsured, the reinsurer may be responsible for the entire XPL liability. If, however, the reinsured was primarily responsible for the unreasonable settlement conduct but the reinsurer contributed to the unreasonable conduct, the reinsurer may bear a portion of the XPL liability rather than the entire XPL liability.

Illustrations

I4.         Same facts as in Illustration 3 above involving pediatrician Dr. Shane Smith, but it is Reinsurer B, over the protest of Reinsured A, that insists on investigating policyholder Smith for child abuse and attempting to use this as a means of reducing or defeating coverage. The resulting ECO liability would, depending on particular factual nuances, fall largely or exclusively upon Reinsurer B. If Reinsured A did not engage in the misconduct toward the policyholder but failed to protest and acquiesced to the misconduct of Reinsurer B, an adjudicator could potentially still impose partial ECO liability upon Reinsured A.

I5.         Same facts as in Illustration 1 above involving the SmallCo cookie litigation. Reinsured A wants to accept the customer plaintiff’s USD 100,000 policy limits settlement offer in light of the clear liability and serious injury to the plaintiff but Reinsurer B objects, stating that it will not pay its share of the claim provided for in the contract of reinsurance and that it will refuse to honor other agreements with Reinsured A, as well as telling other reinsurers that Reinsured A is unreliable. Faced with such coercion, Reinsured A reasonably believes it cannot agree to settle. The resulting XPL liability should fall on Reinsurer B. If the unreasonable settlement decision were primarily taken by Reinsured A with only modest but atypical involvement of Reinsurer B, it may be assigned only a portion of the XPL liability.

C17     The Principles govern relations between reinsured and reinsurer. Paragraph (4) does not address situations in which a reinsured’s policyholder may have a direct claim against a reinsurer. Such claims are often labelled “cut-through” claims because they involve the reinsured’s policyholder piercing the veil of privity that ordinarily shields reinsurers from direct claims by an underlying policyholder of the reinsured. Such claims may be permitted by virtue of a “cut-through clause” in a contract of reinsurance that permits direct policyholder claims in cases of reinsured insolvency or other special circumstances. In addition, courts have on occasion found reinsurer conduct such as that set forth in paragraph (4) to constitute grounds for permitting cut-through or direct actions by a policyholder against an insurer in the absence of a cut-through clause. However, the Principles are not intended to address such situations of policyholder claims. Application of the Principles is confined to the rights and duties of reinsured and reinsurer vis-a-vis one another.

C18     As stated in paragraph (4), reinsurer liability for XPL or ECO claims requires not only particular conduct on the part of the reinsurer but also that it be “reasonable” under the circumstances to hold the reinsurer accountable. The Principles’ concept of reasonableness is that of the law generally and asks whether the hypothetical objectively reasonable person viewing the reinsurer’s conduct would conclude that the reinsurer was sufficiently involved in the conduct giving rise to XPL/ECO liability to hold the reinsurer to the liability imposed upon the reinsured.

C19     Where paragraph (4) applies, the amount or proportion of the reinsurer’s liability relative to the reinsured will depend on an overall evaluation of the circumstances. Relevant factors to be taken into account are the extent of the reinsurer’s involvement and culpability in causing XPL and ECO claims.

Illustrations

I6.         Reinsured A and Reinsurer B enter into a contract of reinsurance providing for proportional reinsurance in connection with Reinsured A’s book of automobile liability insurance. The contract contains no express provisions regarding XPL or ECO liability. A clearly at fault policyholder of Reinsured A kills a medical student, and Reinsured A refuses to accept the USD 250,000 policy limits settlement demand of the decedent’s estate. The matter proceeds to trial, resulting in a judgment (USD 1 million) against the policyholder that is much greater than the policy limits. Reinsured A’s rejection of the settlement offer was unreasonable. Ordinarily, Reinsurer B would have no responsibility for the XPL liability of Reinsured A.

I7.         Same facts as in the previous Illustration, except that Reinsured A wants to accept the plaintiff’s USD 250,000 policy limits settlement demand made well before trial, but Reinsurer B exercises its prerogative pursuant to the claims control clause of the contract of reinsurance and refuses to consent to the proposed settlement. To the extent that this results in XPL liability of Reinsured A, Reinsurer B is liable to indemnify Reinsured A.

I8.         Reinsured A is sued by a policyholder seeking payment of USD 2 million policy limits after the policyholder’s factory is totally destroyed in a fire. Reinsured A has concerns about the claim and consults Reinsurer B. Reinsurer B examines the file and concludes that the loss was probably the result of arson by the policyholder and instructs Reinsured A not to pay the claim and that if Reinsured A does so, Reinsurer B will refuse to pay its proportionate reinsurer’s share.

Reinsurer B, which claims great expertise in arson defences to property loss claims, provides co-counsel to Reinsured A in defending the claim and insists that Reinsured A make certain motions and conduct particular discovery designed to defeat the claim. Reinsured A concludes that the loss was not the result of arson, becomes uncomfortable with the aggressive nature of the defence, and seeks to settle the claim for an amount within the reinsured’s policy limits. Reinsurer B refuses to consent and again threatens Reinsured A with loss of reinsurance cover if Reinsured A deviates from the strategy and tactics outlined by Reinsurer B.

The case proceeds to trial, with the policyholder prevailing on its policy limits breach of contract claim, the state’s Unfair Claims Practices Act, and common law bad faith, including an award of punitive damages for a total judgment of USD 5 million against Reinsured A. Depending on the degree to which the actions of Reinsurer B produced the adverse result, it may be required to indemnify Reinsured A for some or all of the liability exceeding policy limits.

I9.         Reinsured A sells general liability insurance to a large pharmaceutical maker and enters into a contract of proportional facultative reinsurance with Reinsurer B. Hundreds of plaintiffs representing the estates of deceased users of the drug claim that the policyholder’s pain medication made users more likely to commit suicide. They are represented by a prominent plaintiff’s firm that proposes a group settlement that both satisfies applicable legal ethics standards and would resolve the claims for an amount well within the applicable policy limits.

Reinsured A regards the settlement as reasonable, as do the lawyers familiar with the situation. Reinsurer B invokes a consent clause in the contract of reinsurance and refuses to agree to the settlement, contending that the drug had no relation to the suicides and that trial will produce defence verdicts in almost all cases, resulting in reduced liability for the policyholder and lower payments by Reinsured A. Reinsured A, concerned about losing its reinsurance cover, follows Reinsurer B’s direction. The plaintiffs not only prevail at trial but also obtain very large judgments that exceed the amount of policy limits. Under the law of the jurisdiction in question, Reinsured A is liable for these amounts in excess of policy limits. Reinsurer B shall become liable to Reinsured A because Reinsurer B was intimately involved in the claims evaluation and settlement process and was the source of the refusal to accept the settlement proposal.

I10.      Reinsured A faces many claims arising out of the use of a dangerous industrial chemical used by Reinsured A’s policyholders, who operate industrial manufacturing facilities. Reinsured A notifies Reinsurer B and keeps Reinsurer B informed but Reinsurer B otherwise does not become involved with Reinsured A’s claims handling. The plaintiffs suing the manufacturers who used the toxic chemical obtain many large judgments at trial, which prompts Reinsured A to settle many of the remaining cases until its policy limits are exhausted, with hundreds of claims remaining pending. The remaining plaintiffs contend that Reinsurer B should provide insurance coverage for the manufacturers now that Reinsured A’s policy limits are exhausted. This contention is incorrect. As a reinsurer, Reinsurer B is not liable for any liability beyond that agreed to in the contract of reinsurance.

I11.      Same facts as in Illustration 10, except that Reinsured A and its manufacturer policyholders agree to settle the remaining cases under a cost-sharing arrangement that results in Reinsured A paying funds in excess of its policy limits. Reinsured A contends that this was wise because it avoided further large judgments and removed the risk that one or more policyholders might successfully sue Reinsured A for bad faith, unfair claims handling, or breach of fiduciary duty. Reinsured A demands that Reinsurer B pay a corresponding share of the amount in excess of policy limits. Reinsurer B is not obligated to pay indemnity funds beyond the limits of the contract of reinsurance.

However, absent specific contract language, Reinsurer B is obligated to pay its share of defence costs without regard to the contract limit on indemnity payments. See Global Reins Corp of Am v Century Indem Co, 91 NE3d 1186 (NY 2017).

I12.      Reinsured A, who has a contract of excess of loss reinsurance with Reinsurer B, issues a policy to a trucking fleet, with an attachment point of USD 1 million. One of the trucks in the fleet strikes a car on the side of the road where a flat tire is being changed, killing a family of six in which both parents were well-paid professionals. The estates of the decedents sue. As Reinsured A’s policy limits are only USD 1 million per person/USD 2 million per accident, it tenders the policy limits to Reinsurer B, which assumes control over the defence of the case and any settlement negotiations. Initial discovery suggests no comparative negligence by the decedents and that the trucking company policyholder has no viable defence to liability. Plaintiffs’ counsel offers to settle for the policy limits plus pre-judgment interest to date. Reinsurer B, now controlling the defence of the case, refuses and a USD 10 million judgment ensues. Reinsurer B is liable to the reinsured for the amount of the judgment in excess of USD 1 million. This Illustration is based in part on Peerless Ins Co v Inland Mutual Ins Co, 251 F2d 696 (4th Cir 1958) (applying West Virginia law) which allowed a direct claim by the policyholder against the reinsurer.

I13.      Reinsured A enters into a contract of reinsurance with Reinsurer B that reinsures Reinsured A’s employment practices liability policies. One of Reinsured A’s policyholders, a financial services firm, is sued by six women claiming sexual harassment. Reinsured A notifies Reinsurer B of the claims, which involve rather lurid allegations of misconduct by male employees of the policyholder. On its own initiative and with no knowledge or involvement of Reinsured A, Reinsurer B elects to retain aggressive private investigators to seek damaging information about the plaintiffs that can be used against them at trial or in attempting to intimidate them into a settlement. The private investigators violate various laws in the process of their investigation as well as the common law privacy rights of the plaintiffs, prompting criminal prosecution of the private investigators and civil suits against the private investigators by the plaintiffs. The court in the sexual harassment case rules that this information may be introduced at that trial, which results in a verdict against the policyholder financial firm well in excess of the amounts of Reinsured A’s policy limits. Reinsurer B is liable for this XPL amount as well as any ECO liability because it was Reinsurer B’s active misconduct that caused these liabilities and Reinsured A was not involved in the misconduct.

I14.      Policyholder X, a chemical manufacturer, is sued for polluting groundwater in the community where its primary processing facility is located. Policyholder X has a USD 10 million policy from Reinsured A which is subject to a reinsurance treaty with Reinsurer B. Reinsured A offers to settle the claim for policy limits but the plaintiffs suing Policyholder X refuse. Reinsurer B does not get involved in the settlement process of the liability claim of the plaintiffs. The plaintiffs prevail after trial, and a judgment is entered for USD 5 million in compensatory damages and USD 5 million in punitive damages. The insurance policy sold by Reinsured A contains no exclusion of coverage for punitive damages, and the jurisdiction in which the judgment is rendered does not forbid insurance coverage of punitive damages. Reinsured A is liable for the entire USD 10 million judgment, including punitive damages. Unless punitive damages coverage is expressly excluded in the contract of reinsurance, Reinsurer B cannot avoid covering the punitive damages portion of the judgment on the same basis that it is obligated to cover the compensatory damages component of the judgment. This situation does not create a case which would be subject to paragraph (4).

I15.      Same facts as in Illustration 14, except that the plaintiffs repeatedly offer to settle for less than USD 5 million, an amount reasonable in light of the facts of the case. Reinsured A repeatedly refuses. The trial results in a judgment against Policyholder X of USD 5 million in compensatory damages and USD 15 million in punitive damages. Reinsured A must cover the entire award and may not limit its liability to policy limits because Reinsured A engaged in unreasonable conduct that violated the rights of Policyholder X. Reinsurer B’s responsibility depends on the existence and language of any XPL or ECO clauses in the contract of reinsurance. Unless such a clause is in the contract of reinsurance, Reinsurer B is not responsible for any XPL or ECO liability of Reinsured A. In any event, no such liability arises under paragraph 4.

6.          Contractual provisions relating to XPL and ECO liability

a.          Claims Control Clauses

C20     In the US reinsurance market, claims control clauses may be found in contracts of reinsurance that do not expressly assume or disavow XPL and ECO coverage. Claims control clauses fall on a spectrum ranging from relatively weak commitments by the reinsured to provide information or confer to stronger clauses that effectively give the reinsurer a right of consent or veto power over the reinsured’s claims decisions or place the reinsurer in essentially full control of the claim. Although the language of a claims control clause is of course relevant to assessing the rights and duties of the parties, the actual conduct of a reinsurer is most relevant in determining whether the reinsurer has contributed sufficiently to an XPL or ECO liability to hold the reinsurer accountable for the liability pursuant towards the reinsured.

C21     Furthermore, as provided in paragraph (4), liability of the reinsurer may arise due to a reinsurer’s conduct in the absence of a claims control clause or express commitment to XPL or ECO coverage. Absent express agreement to the contrary in the contract of reinsurance, a reinsurer’s compliance with Article 2.4.3 regarding the follow-the-settlements and follow-the-fortunes doctrines does not trigger reinsurer XPL or ECO liability pursuant to Article 6.3.2.

C22     Some claims control clauses entitle reinsurers to be put on notice and to have the option to “associate themselves” with the defence of the claim or take over the defence at their own expense. If the option is taken up, reinsurers would have to pay the defence costs directly. In recognition of the increased risk that reinsurers assume through grants of XPL and ECO coverage, the claims control clause in such contracts commonly goes further than right-to-associate clauses by giving the reinsurer control over claims settlements. These provisions, sometimes termed “counsel and concurrence” or “concur and consent” clauses, not only give the reinsurer the right to be involved in the adjustment of a claim at the underlying insurance level but also obligate the reinsured to confer with and secure the agreement of the reinsurer to settle claims of certain types or amounts in order to be indemnified. When operating pursuant to such more expansive claims control clauses, there is greater risk that a reinsurer will be found to have exercised sufficient control over the claim to hold the reinsurer responsible (in whole or in part) for resulting XPL or ECO liability. However, the language and scope of the claims control clause, standing alone, is not determinative. The question of reinsurer responsibility for XPL or ECO liability primarily depends on the actual conduct of the reinsurer.

b.          Express coverage of XPL liabilities under XPL and ECO clauses

C23     Reinsureds and reinsurers have been aware of the possibility of XPL obligations for some time and have sought to create contractual solutions. Contracts of reinsurance have contained XPL clauses since the 1940s. They became more widespread in the US during the 1970s, at which point the XPL clause was revised and a new ECO clause was created. See generally Langen 586–95; Hammesfahr & Wright § 10.4. See also Employers Reins Corp v American Fidelity & Cas Co, 196 F Supp 553, 561 (WD Mo 1959) (referring to cases alleging bad faith damages against insurers as a “recent trend”); Staring & Hansell § 16:3[3]).

One purpose of these clauses was to permit cedents to aggressively handle claims without worrying about their reinsurance. In other words, if reinsurance coverage was not expressly provided by way of an ECO or XPL clause, a cedent might be tempted to settle a claim within the policy limits even if that claim might be defensible. Indeed, because the reinsurer would reap the reward of a cedent contesting a claim and reducing the ultimate loss, it made sense to have the reinsurer share in the risk of the cedent’s claims-handling actions and contribute to any losses that might result. (Jones & Addison-Smith 4)

C24     Reinsureds can secure XPL or ECO coverage by including clauses in their contract of reinsurance that specifically address these obligations. Most reinsureds insist on these provisions to address the risk that tort claims against their insureds will not be resolved within applicable policy limits following the reinsured’s unreasonable failure to achieve a settlement or bad faith or statutory misconduct liability that attaches to the reinsured’s conduct in handling the policyholder’s claim for coverage. Inclusion of XPL and ECO clauses removes the uncertainty as to whether such losses will be covered under the contract of reinsurance.

C25     ECO and XPL clauses vary but typically outline the contours of coverage by defining the losses to be covered, and frequently provide examples. Commonly, such clauses will obligate the reinsurer to protect the reinsured “in connection with ultimate net loss in excess of the limit of its original policy” (XPL) (see BRMA Contract Wording 15A) or “where the ultimate net loss includes any Extra Contractual Obligations” (ECO) (see BRMA Contract Wording 16A). XPL Clause BRMA Contract Wording 15A provides an example, as follows, stating that the contract of reinsurance will cover

loss in excess of the limit having been incurred because of failure by it to settle within the policy limit or by reason of alleged or actual negligence, fraud, or bad faith in rejecting an offer of settlement in the preparation of the defence or in the trial of any action against its insured or reinsured or in the preparation or prosecution of an appeal consequent upon such action.

Most ECO and XPL clauses also exempt from coverage losses that have been incurred due to fraud by the reinsured or collusion with claimants or counsel.

C26     Contracts of reinsurance involving life, health or disability insurance often provide for coverage of ECO claims but will seldom, if ever, contain an XPL clause. Unlike liability insurance, which typically involves defense of claims against the policyholder and the risk that the third-party claimant will obtain a judgment against the policyholder exceeding policy limits, life, health, and disability policies provide only first-party insurance coverage. Furthermore, claims are only against the insurer and made by the policyholder or beneficiaries. Therefore, there is never a legal exposure of the policyholder to a third-party claimant. Life, health, and disability insurers do not have a duty to defend or manage an insured’s lawsuit appropriately. Hence there is no risk of XPL liability. Life, health and disability insurers are, however, subject to duties of good faith and fair claims handling, the breach of which may create ECO liability.

Illustrations

I16.      An automobile liability policyholder is insured by Reinsured A, which in turn reinsures its automobile casualty risks through a reinsurance agreement with Reinsurer B in a contract that has a typical XPL clause. The policyholder runs a red light at high speed and kills a third-year medical student in good academic standing, whose spouse sues the policyholder in jurisdiction with no limit on wrongful death tort claims. The collision giving rise to the injuries is within the dates of coverage for the reinsured policy and constitutes a covered peril under the terms of the policy, which has policy limits of USD 250,000. The spouse makes no settlement offer or demand. The case is in a jurisdiction that does not require insurers to make affirmative efforts to settle within policy limits.

After trial, the spouse and the estate are awarded USD 5 million in compensatory damages and USD 1 million in punitive damages. The policyholder assigns his rights under the policy to the plaintiffs, who seek payment of the USD 6 million judgment on the ground that Reinsured A is responsible for the excess amount due to its failure to attempt to settle the claim within policy limits. Reinsured A believes that under applicable law, it is not responsible for the amount of the judgment exceeding the USD 250,000 policy limits. However, it decides to settle the claim for USD 3 million rather than risk being held liable for the entire USD 6 million plus pre-judgment interest, post-judgment interest and possible counsel fees. Absent specific contract language or special circumstances, a typical XPL clause will provide that Reinsurer B is liable for its apt share of the USD 3 million settlement if the settlement is reasonable under the circumstances.

I17.      Same facts as in Illustration 16, except that the plaintiff spouse and estate offer to settle for the auto policy limits of USD 250,000. Reinsured A refuses, which is an unreasonable failure to settle given that the average physician in the jurisdiction certainly will have lifetime earnings well beyond the policy limits and the policyholder has no defence to liability and is essentially 100 percent at fault. Due to the XPL coverage promised in the contract of reinsurance, Reinsurer B is liable to Reinsured A for its contractual share of the policy limits portion of the judgment and for any compensatory amounts in excess of policy limits or for punitive damages, even though it was the unreasonable settlement conduct on the part of Reinsured A that caused the XPL liability.

I18.      Same facts as in Illustration 16, except that the contract of reinsurance contains no XPL clause. The court awards compensatory damages of USD 2.5 million. Absent special circumstances not found in this Illustration, Reinsured A is solely liable for the amount of the judgment exceeding policy limits because it was the reinsured’s conduct that caused the XPL liability with no involvement by the reinsurer. Reinsurer B is liable only as provided in the contract of reinsurance – i.e. for USD 250,000.