Captive Insurance Arrangements

Companies that use captive insurance companies to manage risk are increasingly being victimized by excess insurance companies and reinsurers that participate in their insurance programs. Excess insurers and reinsurers know when they are insuring or reinsuring a risk that uses a captive insurer for claims handling and decision-making, yet when a large claim must be paid, they may feign surprise and seek to use the captive's relationship with the policyholder as a way to resist paying claims by casting suspicion on the captive's claims decisions. Captives and their owners can proactively avoid some of these common pitfalls.

Background

In a common captive insurance structure, a large company will create an insurance company subsidiary that collects premiums from the parent and other subsidiaries, sells them insurance, investigates and resolves claims, and perhaps handles other risk management functions. The captive will absorb the typical claims, but the corporate family will be protected from the largest losses by high-level excess insurance for the captive insurer itself, or reinsurance. This type of program may help to manage and spread a company's risks in an economically favorable fashion, with enhanced risk management oversight over developing problems and claims control. Through the underwriting process, excess insurers or reinsurers will know when they are writing insurance in excess of a captive's policy.

Excess insurers and reinsurers will also know that because captive insurance companies are owned by or related to many or all of the companies they insure, captive insurance claims handling is not as highly adversarial as the practices used by some traditional insurers. Like other insurers, captives will investigate and seek to pay only covered or potentially covered claims, but they may not engage in the full-blown claims battle that has become all too common in the traditional insurance marketplace. They will work to manage claims for the corporate family and fairly apply their policy's terms.

By its nature as a tool used to manage risk, a captive is simply not designed to resist paying covered claims suffered by its parent. Unfortunately, however, more reinsurers and excess carriers are boldly resisting paying high-stakes claims involving captives, often challenging the independence or good faith of the captive in its investigation of a claim ' even if the captive handles and pays a matter using a third-party administrator and independent forensic accountants.

Unfair Strategies

This type of tactic is unfair, given the voluntary decision to underwrite policies in which payment obligations may hinge on a captive insurer's judgment, and should be resisted. As significant claims are investigated and contested, the company and its captive must not lose sight of the purpose and role of the captive in a larger insurance program. The strategies used by traditional insurers to investigate and settle claims for the lowest cost possible are often out of place in the captive context, and so it is not “unbusinesslike” when a captive acts in good faith toward its insureds. For example, being related to many of their policyholders, a captive should not be expected to ignore constructions of policy language that favor the policyholder, overlook allegations in a complaint that potentially trigger coverage, or fail to pay undisputed amounts to gain leverage in negotiating disputed amounts.

Like all insurers, captives have a duty to pay claims in good faith after an appropriate investigation, but their closeness to their policyholders makes it natural for captives to take the obligation more seriously. Reinsurers should respect this. Insurance law across the country generally states that if the policy language is ambiguous or unclear, the interpretation favoring the policyholder should be followed. Doing so should not be an excuse for refusing to follow the captive's settlement decisions. Similarly, although two insurance adjusters might interpret and apply categories of loss differently when calculating damages, if both are reasonable, the captive should not be faulted for applying the method that leads to the smaller figure. Numerous state insurance statutes also prescribe the proper claims techniques for insurers, generally in language protective of policyholders, and captives should be comfortable following them. Yet, there are an increasing number of instances where this is not always true.

Conflicts

The different purposes of captive insurers and traditional insurers lead to conflicts. Often, an excess insurer or reinsurer will resist liability payments or first party claims that have already been investigated and approved by a captive or its agent. This can arise from a simple disagreement about the scope of coverage, interpretation of ambiguous terms, or methods of calculating damages. Whatever the reason, the traditional insurance company or reinsurer will at times refuse to pay without either a large negotiated discount or an order from a court or arbitral tribunal forcing them to pay in full. Obtaining such an order can be expensive and time-consuming, and may require resort to a foreign forum such as London or Bermuda, where the reinsurer or excess carrier may have “home court” advantage.

Unless there is evidence of real collusion, or perhaps payment on a claim that cannot reasonably be interpreted as covered, a reinsurer would ordinarily be obligated to follow the captive's decision and pay under the reinsurance contract if the claim exceeds its retention. Under the longstanding reinsurance doctrine of “follow the fortunes” or “follow the settlements,” courts have long accepted that a reinsurer may not ordinarily second-guess or relitigate a ceding insurer's settlement decisions. Although the principle is not without its limits, it remains vital enough that it can prove an effective means to resolve many disputes with reinsurers. Mere disagreements combined with “suspicions” arising from the fact of the captive's relationship with the insured should never suffice. In short, choosing not to follow the fortunes requires reinsurers to satisfy a very high burden.

This reality provides room for creativity in responding to reinsurer challenges of legitimate claims decisions. Sometimes a credible threat to follow through on a follow the fortunes recovery strategy, or efforts to initiate one, can have enough force to spur a settlement. If a captive and reinsurer disagree, but the captive's view is reasonable, the reinsurer may complain and initiate arbitration, but its arguments to avoid coverage may be severely limited. Where a negotiated settlement with the reinsurer is impossible, the captive's agreement to withhold payment to its insured on a disputed claim (thus avoiding an arbitration limited to application of follow the fortunes doctrine), might be enough to lead reinsurers agree on a consolidated arbitration in a more neutral forum in which the reinsurers and the policyholder directly contest coverage or the amount of damages.

Dispute Resolution?

Although dispute resolution may at times require litigation or arbitration, captives can also do much to avoid future disputes. Corporate policyholders might address the use of their captives with excess insurers or reinsurers proactively in underwriting and add policy language to try to stem off challenges based on the captive's perceived bias. A coverage review might reveal a gap in coverage that can result from differences in exclusions or other policy language or confusion in the treatment of defense costs insured by the captive. To better avoid unwarranted accusations of bias or collusion, captives might consider modifying claims handling procedures, such as identifying separate managers or employees to represent the captive and the policyholder during underwriting processes versus claims negotiations and decision-making, and keeping only one “hat” on the head of each individual involved.

In common practice, a corporate risk manager may serve also as the chief officer of the corporate captive, but it can be useful to divide management of the captive from claims responsibility. Use of a dedicated captive staff or agreed-upon third-party administrator or captive manager can help prove a decision was made at arms-length following recommendations of experienced, independent claims personnel.

These and other strategies can help to avoid and fend off the worst attacks challenging captives' claims decisions. Captives are created by their owners for a purpose, and they should not be shy to defend their reasonable decisions merely because a traditional insurer, formed for a different purpose, might reach a different decision.

John N. Ellison and Luke E. Debevec are partners in the Philadelphia office of Reed Smith LLP who represent policyholders and their captives in a variety of matters, including seeking to recover insurance and reinsurance payments for challenged claims. The views expressed in this article are those of the authors, and not necessarily those of their firm or their clients.

Companies that use captive insurance companies to manage risk are increasingly being victimized by excess insurance companies and reinsurers that participate in their insurance programs. Excess insurers and reinsurers know when they are insuring or reinsuring a risk that uses a captive insurer for claims handling and decision-making, yet when a large claim must be paid, they may feign surprise and seek to use the captive's relationship with the policyholder as a way to resist paying claims by casting suspicion on the captive's claims decisions. Captives and their owners can proactively avoid some of these common pitfalls.

Background

In a common captive insurance structure, a large company will create an insurance company subsidiary that collects premiums from the parent and other subsidiaries, sells them insurance, investigates and resolves claims, and perhaps handles other risk management functions. The captive will absorb the typical claims, but the corporate family will be protected from the largest losses by high-level excess insurance for the captive insurer itself, or reinsurance. This type of program may help to manage and spread a company's risks in an economically favorable fashion, with enhanced risk management oversight over developing problems and claims control. Through the underwriting process, excess insurers or reinsurers will know when they are writing insurance in excess of a captive's policy.

Excess insurers and reinsurers will also know that because captive insurance companies are owned by or related to many or all of the companies they insure, captive insurance claims handling is not as highly adversarial as the practices used by some traditional insurers. Like other insurers, captives will investigate and seek to pay only covered or potentially covered claims, but they may not engage in the full-blown claims battle that has become all too common in the traditional insurance marketplace. They will work to manage claims for the corporate family and fairly apply their policy's terms.

By its nature as a tool used to manage risk, a captive is simply not designed to resist paying covered claims suffered by its parent. Unfortunately, however, more reinsurers and excess carriers are boldly resisting paying high-stakes claims involving captives, often challenging the independence or good faith of the captive in its investigation of a claim ' even if the captive handles and pays a matter using a third-party administrator and independent forensic accountants.

Unfair Strategies

This type of tactic is unfair, given the voluntary decision to underwrite policies in which payment obligations may hinge on a captive insurer's judgment, and should be resisted. As significant claims are investigated and contested, the company and its captive must not lose sight of the purpose and role of the captive in a larger insurance program. The strategies used by traditional insurers to investigate and settle claims for the lowest cost possible are often out of place in the captive context, and so it is not “unbusinesslike” when a captive acts in good faith toward its insureds. For example, being related to many of their policyholders, a captive should not be expected to ignore constructions of policy language that favor the policyholder, overlook allegations in a complaint that potentially trigger coverage, or fail to pay undisputed amounts to gain leverage in negotiating disputed amounts.

Like all insurers, captives have a duty to pay claims in good faith after an appropriate investigation, but their closeness to their policyholders makes it natural for captives to take the obligation more seriously. Reinsurers should respect this. Insurance law across the country generally states that if the policy language is ambiguous or unclear, the interpretation favoring the policyholder should be followed. Doing so should not be an excuse for refusing to follow the captive's settlement decisions. Similarly, although two insurance adjusters might interpret and apply categories of loss differently when calculating damages, if both are reasonable, the captive should not be faulted for applying the method that leads to the smaller figure. Numerous state insurance statutes also prescribe the proper claims techniques for insurers, generally in language protective of policyholders, and captives should be comfortable following them. Yet, there are an increasing number of instances where this is not always true.

Conflicts

The different purposes of captive insurers and traditional insurers lead to conflicts. Often, an excess insurer or reinsurer will resist liability payments or first party claims that have already been investigated and approved by a captive or its agent. This can arise from a simple disagreement about the scope of coverage, interpretation of ambiguous terms, or methods of calculating damages. Whatever the reason, the traditional insurance company or reinsurer will at times refuse to pay without either a large negotiated discount or an order from a court or arbitral tribunal forcing them to pay in full. Obtaining such an order can be expensive and time-consuming, and may require resort to a foreign forum such as London or Bermuda, where the reinsurer or excess carrier may have “home court” advantage.

Unless there is evidence of real collusion, or perhaps payment on a claim that cannot reasonably be interpreted as covered, a reinsurer would ordinarily be obligated to follow the captive's decision and pay under the reinsurance contract if the claim exceeds its retention. Under the longstanding reinsurance doctrine of “follow the fortunes” or “follow the settlements,” courts have long accepted that a reinsurer may not ordinarily second-guess or relitigate a ceding insurer's settlement decisions. Although the principle is not without its limits, it remains vital enough that it can prove an effective means to resolve many disputes with reinsurers. Mere disagreements combined with “suspicions” arising from the fact of the captive's relationship with the insured should never suffice. In short, choosing not to follow the fortunes requires reinsurers to satisfy a very high burden.

This reality provides room for creativity in responding to reinsurer challenges of legitimate claims decisions. Sometimes a credible threat to follow through on a follow the fortunes recovery strategy, or efforts to initiate one, can have enough force to spur a settlement. If a captive and reinsurer disagree, but the captive's view is reasonable, the reinsurer may complain and initiate arbitration, but its arguments to avoid coverage may be severely limited. Where a negotiated settlement with the reinsurer is impossible, the captive's agreement to withhold payment to its insured on a disputed claim (thus avoiding an arbitration limited to application of follow the fortunes doctrine), might be enough to lead reinsurers agree on a consolidated arbitration in a more neutral forum in which the reinsurers and the policyholder directly contest coverage or the amount of damages.

Dispute Resolution?

Although dispute resolution may at times require litigation or arbitration, captives can also do much to avoid future disputes. Corporate policyholders might address the use of their captives with excess insurers or reinsurers proactively in underwriting and add policy language to try to stem off challenges based on the captive's perceived bias. A coverage review might reveal a gap in coverage that can result from differences in exclusions or other policy language or confusion in the treatment of defense costs insured by the captive. To better avoid unwarranted accusations of bias or collusion, captives might consider modifying claims handling procedures, such as identifying separate managers or employees to represent the captive and the policyholder during underwriting processes versus claims negotiations and decision-making, and keeping only one “hat” on the head of each individual involved.

In common practice, a corporate risk manager may serve also as the chief officer of the corporate captive, but it can be useful to divide management of the captive from claims responsibility. Use of a dedicated captive staff or agreed-upon third-party administrator or captive manager can help prove a decision was made at arms-length following recommendations of experienced, independent claims personnel.

These and other strategies can help to avoid and fend off the worst attacks challenging captives' claims decisions. Captives are created by their owners for a purpose, and they should not be shy to defend their reasonable decisions merely because a traditional insurer, formed for a different purpose, might reach a different decision.

John N. Ellison and Luke E. Debevec are partners in the Philadelphia office of Reed Smith LLP who represent policyholders and their captives in a variety of matters, including seeking to recover insurance and reinsurance payments for challenged claims. The views expressed in this article are those of the authors, and not necessarily those of their firm or their clients.