Reinsurance is a specific form of insurance utilized by insurance companies to help spread the burden of indemnification and defense. Generally, a reinsurance company will contract with an insurance company to cover a specified portion of the insurance company’s obligations to its policyholder(s) in the event of a valid claim.
The California Insurance Code defines “reinsurance” as a contract by which an insurer procures a third person to insure him against loss or liability by reason of such original insurance.
Under such a reinsurance contract, the primary insurer will “cede” a portion of the premiums [paid by its policyholder(s)] to the reinsurer so that it will cover a portion of any losses suffered on those policies. In other words, the policyholder pays a premium to their insurer, who, in turn, pays a reinsurer a percentage of that initial premium as consideration for reinsuring a specified portion of the original risk. Thereafter, if a policyholder suffers a loss, the original insurer will compensate the particular policyholder, and the reinsurer, in turn, indemnifies the insurer.
In short, reinsurance is a method of apportioning risk between an original insurer and a reinsurer. The ceding insurer’s (i.e., the original insurer) portion of the risk is typically known as the “retention share.” The retention of some risk by the ceding insurer generally encourages it to underwrite property, as it remains liable for at least a portion of any payout made to a policyholder. For example, assume that the original insurer issues a $1 million liability policy to the insured policyholder for a $10,000 premium. Thereafter, the insurer enters into a reinsurance contract with a reinsurer that agrees to assume any liability over $100,000 pursuant to the insurer’s policy in exchange for a $2,500 reinsurance premium. The $100,000 is the insurer’s “retention share.”
Here, the insurer will have to pay the reinsurer $2,500 of every $10,000 premium payment it receives. Should the policyholder suffer an injury, (or other damage/harm), and submits a covered claim (or if he or she submits a claim which is denied and thereafter files a lawsuit and recovers the amount owed through litigation), the insurer will be responsible to the policyholder for the entire loss up to $1 million.
However, the insurer will then have a claim against the reinsurer for any amount paid out over $100,000 (i.e., the retention share).
The purpose and advantages of reinsurance are quite clear. Reinsurance affords the original insurer sufficient risk distribution by transferring a portion of the risk assumed, (in insuring policyholders), to a secondary insurer. As such, reinsurance allows the ceding original insurer to reduce its statutory reserve requirements, enabling it to write more policies, (under California law, insurance companies must meet certain financial standards in order to do business – the reserve requirements set forth the assets that an insurer must have available to pay all claims, losses, and other expenses).
While reinsurance allows the original insurer to distribute its risk, reinsurance does not change the insurer’s relationship with its policyholder, (i.e., the insured). Rather, the original insured still remains liable for defending, settling, and paying covered claims against the policyholder. As mentioned in the example above, the original insurer must cover the full amount of any such claim. However, the insurer can then pursue reimbursement from the reinsurer for the reinsured portion of the claim, (i.e., any amounts exceeding the retention share).
In summary, the original insurer separates the reinsurer and the insured policyholder, as the reinsurance contract is separate and distinct from the original insurance contract. As such, the insured policyholder is not a party to the reinsurance contract. This means that the insured policyholder typically has no rights against the reinsurer, or to the proceeds of the reinsurance. Similarly, the insured has no standing to sue as a third party beneficiary to a reinsurance contract because such a contract is not “expressly” for his or her benefit.
Where the original insurer becomes insolvent, the insured policyholder may find himself or herself in a difficult position. Because the reinsurance contract is not for the insured policyholder’s benefit, the insured cannot compel the reinsurer to perform the insurer’s duties to indemnify and defend the insured.
Attorney Stanley P. Lieber has handled numerous insurance claims involving reinsurance and has been in practice since 1973. Call or email us for a free consultation.