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How reinsurers will respond when cedents pay their insureds for COVID-related business interruptions remains an open question, legal and insurance professionals suggested recently, adding more wrinkles to an already complex claims situation.

Illustrating some of the specific reinsurance coverage questions that are arising from COVID-19 business shutdowns, Ernesto Palomo, a partner in Locke Lord’s Business Litigation and Arbitration group, presented several scenarios during the Casualty Actuarial Society Seminar on Reinsurance earlier this month. In each hypothetical scenario, he assumed that primary insurers paid business interruption claims under policies that did not have virus exclusions, and ceded losses to their reinsurers under reinsurance contracts with “follow-the-fortunes” language.

“Is the reinsurer bound?” he asked repeatedly, polling a virtual audience.

While a high percentage of actuaries casting their votes said the reinsurers were bound to reinsure claims under one scenario, there were real differences of opinion in two others—one in which the primary carrier paid the claim to maintain a key client relationship, and another where the reinsurance contract included a pandemic exclusion.

Before laying out the specifics of each of the hypotheticals, Palomo said there are three factors that determine whether a claim paid by a ceding company is going to be covered by a reinsurance agreement: the terms of the reinsurance contract; the terms of the underlying policy; applicable laws. Focusing on the reinsurance agreement, the lawyer highlighted two typical provisions: follow-the-fortunes and follow-the-settlements clauses.

Boiling down the language of a follow-the-fortunes clause in simple words, Palomo said it means that “the cedent and the reinsurer generally must share the same fate” —good or bad— “as long as the ceding company did not act in bad faith, or as long as they didn’t do anything to expand their liability” in paying a claim. “The reinsurer must accept whatever misfortunes give rise to the claims under the cedent’s original policies,” he said, noting that the notion of fortuity is at the core of the follow-the-fortunes doctrine. (Editor’s Note: Fortuity is often defined as meaning that risks insured are neither expected nor intended.)

The follow-the-settlements concept is “essentially the follow-the-fortunes provision in the context of settlements,” Palomo said as the typical language was written out on a slide presented during the virtual session. “Reinsurers agree to follow all settlements (excluding without prejudice and ex gratia payments) made by original insurers arising out of and in connection with the original insurance,” the slide said, while Palomo explained that the clause is intended to prevent a reinsurer from “second-guessing or attempting to relitigate arguably covered claim payments made by the ceding company.”

“The doctrine essentially holds that a reinsurer is bound by the cedent’s decisions regarding claims handling and payment of settlement claims, so long as the cedent acted in a business-like manner and that its decision was reasonable and made in good faith,” he said. That means “a reinsurer cannot relitigate a cedent’s good faith decision to waive defenses to which it may have been entitled,” he added.

In summary, the two clauses together “bind the reinsurer to all good-faith decisions by the ceding company, including underwriting, litigation, settlements, unless either 1) the cedent engaged in fraud, collusion or bad faith, 2) the losses are not covered under either their reinsurance contract or the underlying policy.”

Going on to present three hypothetical COVID-19 business interruption claims scenarios, Palomo first imagined that a primary carrier wrote a policy which didn’t contain a virus exclusion but that, in settling the claim, the carrier “determined that the virus was present on or near the covered premises and caused ‘physical loss or damage.'” That condition needed to be met for the insurer to cover loss of business income from an insured’s suspension of operations under the terms of the underlying policy. Assuming the presence of a follow-the-fortunes clause in the reinsurance contract, Palomo asked the actuaries to weigh in as to whether the reinsurer is on the hook as well.

This was the only example of three he presented in which an overwhelming majority of the actuaries listening to the talk (91 percent) said that the reinsurer would be bound in this scenario.

“The follow-the-fortunes doctrine doesn’t override the other terms and conditions of the reinsurance contract.”

Ernesto Palomo, Locke Lorde

Palomo wasn’t so sure. “In my view, there’s no right or wrong answer,” he said, noting that more facts would be needed to get to an appropriate determination. “The answer may turn on what did the cedent do to investigate and determine that there was virus on the covered property or in it. Was there any evidence that the virus was present on the property, or did the cedent merely cave to avoid fighting the issue? Is there any case law in the jurisdiction that suggests that a virus can cause physical damage within the meaning of the insurance policy?”

“Obviously, reinsurers [are] going to want to review the cedent’s files to make sure that the settlement was reached in a proper and businesslike manner,” he said.

Changing the hypothetical so that the insurer, still issuing policies without virus exclusions, actually just decided to pay the claim, relinquishing its coverage defenses in response to pressure from state insurance department regulators and because of the carrier’s desire to maintain its relationship with a valued insured, Palomo asked again whether the reinsurer was bound to follow the fortunes.

Although 56 percent of the actuaries responding to an online poll said they believed the reinsurer would be bound in this situation, “based on the loaded facts,” Palomo agreed with the other 44 percent. “This seems like an ex-gratia payment,” he said. Some reinsurance agreements provide coverage for ex-gratia payments, he said, noting that if that had been true in the scenario presented, then the reinsurer would likely be bound.

Offering details of a final hypothetical, Palomo asked seminar attendees to imagine that New York state enacts legislation voiding all virus exclusions and requiring retroactive coverage of all business interruption losses from COVID-19. In this case, the insurer pays a claim and cedes losses under a reinsurance contract that has both a follow-the-fortunes clause and a pandemic exclusion. Here, just under half the attendees thought the reinsurer would be bound to provide reinsurance coverage, but Palomo said the presence of the pandemic exclusion in the reinsurance agreement is the controlling factor. “It doesn’t matter how honorably the cedent acted or what really happened to them, the reinsurer would likely be entitled to enforce the terms of its contract to deny the claim.”

“The follow-the-fortunes doctrine doesn’t override the other terms and conditions of the reinsurance contract,” he said, suggesting that the result would only be different if the legislation also applied to reinsurance contracts.

“None of the proposed legislation that I have seen would seem to apply to reinsurers,” he added.

One actuary protested during the question-and-answer portion of the session: “If pandemic exclusions are overturned by states, why would there be a difference between an insurer’s exclusion and a reinsurer’s exclusion on the same risk?”

Palomo repeated his assessment that if the legislation doesn’t say it applies specifically to reinsurers, the reinsurer “would have a decent argument” that it doesn’t have to follow. He also said that reinsurers would likely fare better than insurers on any constitutional challenges they might bring if faced with such legislation.

He noted that courts examining the question of whether it’s unfair to rewrite or interfere with direct insurance contracts would “potentially conclude that the insurance industry is so heavily regulated that there’s no expectation that the legislature would not rewrite the contract in this fashion [if] it would be good for society.” But reinsurers are generally subject to less regulation. So, if reinsurers were to challenge that legislation on constitutional grounds, Palomo believes they “would have a better chance of prevailing” in arguing that they relied on the contract language and that the state should not interfere with vested rights under their contracts.

Earlier in the session, Palomo reviewed some of the insurance policy language being battled over in courts and talked specifically about the legislative attempts to retroactively rewrite coverage into primary policies. He noted that there is a provision found in many insurance policies called a “conformity to state law” provision that is getting some attention in arguments for coverage of COVID business interruption claims. The typical “conformity” provision essentially says that if something in the policy conflicts with state law, then the state law will apply. Palomo continued that if a state were to enact a law forcing insurers to pay business interruption losses, the “conformity” provision will likely be used against insurer arguments that such a state law is unconstitutional.

“Policyholders will argue that there’s nothing unconstitutional about enforcing an insurer’s promise to abide by state law,” he said.

What Reinsurers Are Saying

How are scenarios like the ones Palomo presented playing out in the real world?

At least one reinsurance executive, Juan Andrade, the chief executive officer of Everest Re, said determination of reinsurance payouts are specific to the facts of each reinsurance arrangement. “It is important to note that as a reinsurer, we have contractual terms and conditions, such as retentions, limits, event definitions, hours clauses and other coverage provisions that will apply to this ongoing event. Thus, we do not simply follow the fortunes. It will be very fact-specific,” he said during a first-quarter 2020 earning conference call in early May, as he described estimate of incurred-but-not-reported losses for the company’s reinsurance book.

It is important to note that as a reinsurer, we have contractual terms and conditions, such as retentions, limits, event definitions, hours clauses and other coverage provisions that will apply to this ongoing event. Thus, we do not simply follow the fortunes. It will be very fact-specific.”

Juan Andrade, Everest Re

RenaissanceRe CEO Kevin O’Donnell, also describing his company’s loss estimates, said, “We rely on our cedents when they tell us there is minimal exposure” to business interruption, outside of the instances where “certain insurers have provided a limited number of manuscripted communicable disease extensions.”

For insurers that haven’t sold specific extensions, “we rely on our cedents’ interpretation of their contracts and the discussions they are having with their insureds about the coverage they provided. We are not really involved in that dialogue because that’s between the insured and the insurer. What we’re involved with is how does our treaty protect the cedent,” O’Donnell continued. “And we’re relying on their advice that they don’t believe they have BI [business interruption] exposure from COVID-19 under the policies they have sold.”

Like Andrade, O’Donnell said reinsurance contract wording is key. “There are coverages that are excluded [in] the governing documents between us and an insured compared to an insured and an insurer…We’ll be disciplined in making sure that losses ceded to us [are] in compliance with our governing documents,” he said.

Aggregation of Losses

What a typical aggregation of losses clause says:

The term “loss occurrence” shall mean the sum of all individual losses directly occasioned by any one disaster, accident or loss or series of disasters, accidents or losses arising out of one event which occurs within the area of one state of the United States or province of Canada and states or provinces contiguous thereto and to one another. However, the duration and extent of any one “loss occurrence” shall be limited to all individual losses sustained by the Companies occurring during any period of 168 consecutive hours arising out of and directly occasioned by the same event…”

One other specific reinsurance clause that Palomo highlighted during the CAS meeting is the aggregation clause typically found in excess-of-loss treaties that allows a ceding insurer to combine multiple loss occurrences so that only one retention needs to be satisfied—as long as the loss occurrences are linked to some common event or cause. He illustrated the concept with the sample language (shown in the accompanying textbox) allowing the cedent to combine claims arising out of one event that occurs in one state or in neighboring states and within a 168-day time frame.

“We saw in the context of asbestos, pollution and health hazard claims that insureds and cedents employed many creative arguments to describe a covered event. In the [COVID] situation, I would predict certainly that cedents are going to use stay-at-home orders as the event that will allow the cedent to combine losses out of one event,” he said.

Going on to offer an example of an insurer attempting to present claims for insureds in Illinois and California as one occurrence on the basis of stay-at-home orders from governors of those states, he suggested that such an aggregation won’t fly with reinsurers. “Those states are not next to each other,” which was a requirement in the language of the clause he read to the group. The cedent “probably could combine all Illinois losses as one event or all California losses could be combined as one event, but not both,” he said.

“To be perfectly honest, it’s unclear how a pandemic can fit into an hours clause.”

Kevin O’Donnell, RenaissanceRe

An actuary attending the session asked Palomo whether cedents can get around hours clauses in reinsurance contracts. (An hours clause limits the time that loss arising from a specific peril, such as a hurricane or windstorm, can be aggregated into one occurrence if the loss was sustained during a long-lasting event—typically to 72 or 168 hours, according to a description on the Locke Lorde website.) Palomo responded: “I haven’t seen any of these claims presented to the reinsurers yet, and I agree with you that that’s going to be a significant issue in terms of whether this is going to be covered or not. It’s really going to be a case-by-case determination as to whether the reinsurer will be able to deny them because they didn’t satisfy the hours clause.”

Similar questions came up during reinsurer’s earnings conference calls for the first quarter. O’Donnell said that “the hours clause is an imperfect way to measure when something like a hurricane starts and stops so that a primary company can aggregate losses in a consistent way for cessions to a property-cat [treaty]. To be perfectly honest, it’s unclear how a pandemic can fit into an hours clause,” he said.

He added, “When we think about how to approach a claim, we always approach it constructively—but we approach it on a bespoke basis with each cedent…”

“You have to consider the entire agreement, and the hours clause is one complicated element,” he said.

An analyst asked Everest Re’s Andrade whether a second COVID-19 wave later this year would constitute a second event, and wanted to know when the reinsurer would “close the book on the losses associated with [the] first lockdown.”

“This is where you come back to my comments that this is not a follow-the-fortunes event for Everest,” Andrade said. “When you start looking at event definitions, including hours clauses, limiting duration of an event, outlining the radius or the contiguous environment that’s involved, this is where all of that is going to come into play for us,” he said.

John Doucette, CEO of the Reinsurance Division at Everest, attempted to quell analyst’s fears about multiple rounds of losses hitting the reinsurer’s books. “It’s important to point out that not only is the event going on, but we have rolling inception dates that are happening all the time,” said Doucette, pointing to April 1, May 1, June 1 and July 1 renewal dates. That means “we are pursuing terms and conditions that help narrow or exclude pandemic risk” on all these dates, he said, suggesting a ripple effect. “That will help mitigate, limit or exclude the potential losses going forward. And we’re certainly not alone doing that. While we are leading the charge, many other reinsurers are doing it as well, and I think that will help narrow whatever the scope of this turns out to be,” he said.