By Larry Walters, Aon

The mark of a mature and successful captive is the “stand alone” nature of its operation, both regarding the exposure that it underwrites, and its ability to spread risk through reinsurance. This article illustrates two distinctly different ways that a captive might address these objectives.

Reinsurance Relationships

Two captive insurance companies were domiciled in the Cayman Islands – Integrity Insurance Company and Haphazard Insurance Company*. These captives were similar in many ways:

1. Each captive was owned by a parent company headquartered in the US; each parent faced significant product liability exposure.

2. Each captive issued a policy that covered the product liability risk of the parent company in the layer $5M xs $1M.

3. Each captive purchased reinsurance for the $5M xs $1M layer from a US based reinsurer, which was a part of a larger group of companies, one of which (coincidentally) offered umbrella liability coverage. (The reinsurer and the umbrella liability carrier were both distinct legal entities, but part of the same common ownership.)

4. Each parent company in the US purchased umbrella coverage for the layer $5M xs $5M xs $1M from the umbrella liability carrier listed in “3.”

In 2005 a group of 100 plaintiffs filed a law suit in the US against 20 defendants (including the policyholders that Integrity and Haphazard insured) based on allegations of strict liability and negligence that resulted in lung, pulmonary and other latent injury claims. In 2012, after significant discovery and the dismissal of most of the defendants, the jury awarded a verdict. For purposes of our discussion, the verdict was $6M against the policyholder of Integrity, and $6M against the policyholder of Haphazard.

Integrity

Integrity operated as an independent insurance entity, insisting on an “arm’s length” relationship with the policyholder (its owner), and its reinsurer. The chief risk officer, Bill Smith, was intimately familiar with both the terms of the policy that Integrity issues to the policyholder, and the terms of the Reinsurance Agreement by which the reinsurer provided $5M of support to Integrity. When the suit was filed in 2005, the policyholder placed its insurance carriers on notice, to include a formal written notification on a policyholder letterhead to Integrity. Integrity in turn complied with the terms in the Reinsurance Agreement to include the obligation to:

“… notify the Reinsurer promptly of any event which might result in a claim against the
Reinsurer…

… allow the Reinsurer to inspect all books, records and papers …

… cooperate in every respect in the defense and control of any claim…”

Integrity reported the loss to its reinsurer using standard protocols (and professional courtesies) that made contract identification easier for the reinsurer, such as Reference Numbers and relevant dates. While the claim was pending, Integrity sent a letter to its reinsurer on six separate occasions, providing coverage, liability and damage information, as well as advice regarding an upcoming trial, the potential verdict, and a negotiation strategy. The updates allowed the reinsurer to establish an appropriate and timely reserve. Subsequently, Integrity provided to the reinsurer 1) a copy of the signed Release, including the date certain of the settlement payment, and 2) a Proof of Loss. The reinsurer responded promptly to the Proof of Loss and wired its $5M to Integrity, in satisfaction of the contractual obligation (and an element of professional courtesy) in the reinsurance agreement:

“…upon receipt by the Reinsurer of satisfactory evidence of payment for which reinsurance is provided, the Reinsurer will promptly reimburse the Company for its share of the loss…”

The cooperation of the reinsurer in providing a payment simultaneously with the settlement of the claim was an enormous cash flow benefit to Integrity. (Bill Smith thought: “Reinsurance – that’s the way it should work.”)

The President of the parent company (policyholder) wrote Bill Smith a congratulatory note: “Regarding that unfortunate product law suit that we successfully resolved, and the involvement of Integrity ‐ nice work. Thanks.”

Haphazard

The claim for Haphazard took a different turn. The parent of Haphazard treated the captive as a self insurance vehicle, part of “one big happy family.” This shortcoming was at the core of a less than accurate understanding of the relationship of the various parties, specifically the obligations of Haphazard to its reinsurer.

Bob Jones, the chief risk officer, was satisfied that Haphazard covered the product exposure, and that secure reinsurance of Haphazard was in place. To save expense dollars (as was the practice for years), the in‐house claims staff at the parent company in the US notified the umbrella carrier (in the layer $5M xs $5M xs $1M) of the claim in a June 15, 2005 letter and also copied the company that reinsured Haphazard. However, during the pendency of the claim, no one noticed that Haphazard 1) failed to notify the reinsurer under the proper Reinsurance Agreement, or 2) that the reinsurer did not acknowledge to Haphazard that it (the reinsurer) had received notice, or was monitoring the claim.

When the claim was resolved in 2012, the umbrella carrier stood ready to indemnify its policyholder for the exposure in excess of $6M. However, when Haphazard approached its reinsurer and stated that Haphazard intended to pay its $5M limit of liability on the claim, the reinsurer wrote back:

“What claim?”

As the investigation revealed, the reinsurer had no record of the June 15, 2005 letter that the in-house claim staff generated. Further, even if the letter were located, the reinsurer maintained that it was not proper notice of the claim because 1) it was not notice by its ceding carrier – Haphazard, and 2) it failed to identify the Reinsurance Agreement under which claim was presented. Even though the multimillion dollar claim had been notified to Haphazard seven years earlier, the investigation revealed no proper notice to the reinsurer. The reinsurer denied the claim to Haphazard based on late notice.

Haphazard hired a coverage law firm in New York that began discovery in the US and in the Cayman Islands. The Reinsurance Agreement allowed for London based arbitration. At the instruction of Haphazard, the New York law firm began the arbitration process in London.

Three years later, the reinsurer paid $4.2M of the $5M obligation, a settlement achieved because of two arguing points:

1. Haphazard representatives maintained that there was no prejudice to the reinsurer because of the “delayed” report.

2. The reinsurance agreement contained a “Correction of Errors” provision that encourages the parties to return to a pre-error position if an error is discovered, and then corrected as soon as possible.

The legal expenses of Haphazard totaled $450K. (High quality lawyers operating in three different jurisdictions are expensive.) Also, there was significant disruption to the cash flow position of Haphazard because of the delayed and incomplete recovery.

The President of the parent company (policyholder) wrote Bob Jones “Regarding that product law suit that we settled, and the Arbitration that Haphazard filed, what went wrong?” Bob Jones answered that the issue began with the treatment of Haphazard as part of our “big happy family.” It was not the type of response that he wanted to make. He subsequently took early retirement.

The Take Away

A successful captive will:

• Treat all corporate relationships on a professional basis;

• Meticulously comply with all reporting provisions in a Reinsurance Agreement; and

• Never surprise the reinsurer.

* This article uses fictitious names and has no relationship with existing persons or firms in the
Cayman Islands.