The price of an insurance policy naturally includes a projection of future payouts under the policy plus a profit margin for the insurer. Rather than giving profit to an insurance company, sometimes corporate policyholders will elect to try to capture that profit by creating a “captive” insurance company. In this way, when the premium is paid to the captive insurance company, the “profit” component is retained on the corporation’s overall balance sheet. There are other reasons to establish a captive: a sense of greater control over the loss-adjustment process; greater certainty of performance; and opportunities for certain tax advantages (not so much from the deductibility of premium expenses as compared to the accrual of reserves but rather from obtaining investment income in a tax-advantaged manner on assets held by (or stuffed into) foreign-domiciled captives).
It is uncommon to find that a company only has a captive program: typically, there is commercial insurance market involvement through excess-layer insurance above the captive or through reinsurance of the captive. (Sometimes the reinsurance relationship is the converse where the insured has commercial insurance that is reinsured into the captive.) When a corporation taps reinsurance markets, what it wants most assuredly is the seamless flow of loss and coverage through the captive to the reinsurer once the retention is exceeded. In this regard, a recent High Court decision in London is important to note, because the decision creates a gap in this flow stemming from of all things a difference in “choice of law” as between the captive-issued policy and the reinsurance policy backing it.
In CGU Int’l Ins. PLC v. AstraZeneca Ins. Co. Ltd.,  EWHC 2755 (Dec. 1, 2005), Mr. Justice Cresswell held that a captive insurer might not obtain recovery due to a disjunction between the interpretation of the identical words between English and US state law. In CGU, the captive faced a loss from an affiliate; that affiliate submitted a claim for coverage that the captive evaluated at arms’ length and paid. The reinsurers had been apprised of the claim and the possibility of settlement in advance, and they did not dispute that all procedural duties pertaining to the perfecting of the reinsurance claim had been satisfied by the captive/cedent.
It was common ground as between the captive and its reinsurers that, had the claim not been paid, the affiliate would have sued the captive for coverage in state court in the US and that the US court, properly applying its own choice-of-law rules, would have applied US state law to the loss in question. Faced with that inevitability, the captive paid the claim guided by that state’s law and turned to its reinsurers for indemnification.
The reinsurers denied recovery for most of the claim by advancing the curious argument that assuming ex hypothesi that the captive’s payment was validly compelled with respect to the US state law the scope of coverage under English law for the same loss was narrower. In other words, the reinsurers argued that one must take the identical words and identical loss and run them through English law, even though the underlying loss would have been litigated and resolved under US law.
The CGU court construed the placing slip – providing coverage “as original” – to mean, as a practical matter, that one takes the words from the original contract being reinsured and retypes them into a new document containing the identical words. Instead of confirming an intention that there be no gap between the terms afforded under the original policy and the reinsurance, “as original” in fact will create a disjunction to the extent the original policy will be construed under a different set of laws from those applying to the retyped policy. As the court states: “Where the reinsurance incorporates the terms of the underlying, the coverage terms of the underlying insurance are treated as incorporated in a contract which is expressly governed by English law. That incorporation took place at the outset, and the coverage terms bore, from the outset, the meaning attached to them applying English rules of construction.” Id. at .
In CGU, therefore, the result of the court’s ruling is to put the captive in the following position: having a full obligation to perform vis-à-vis its own insured guided by the applicable US state’s law and having its reinsurance recovery decided by a different jurisdiction’s law with a more parsimonious view of the coverage afforded under the identical words. While recognizing implicitly that the captive’s payment of its insured was compelled (and so was not an ex gratia payment or voluntary), the High Court ruled that unacceptable commercial uncertainty otherwise would result were the reinsurers bound to pay according to the legal obligations of the cedent/captive. Id. at , .
One lesson of the CGU case is that, when placing reinsurance in the London market for a worldwide program, the company needs to be prepared to incur a substantial additional retention stemming from the disjunction in the coverage afforded under the local law governing a dispute with one of the captive’s insureds and the same words as construed with an English-law gloss. Placing coverage “as original” will not ensure that coverage flows seamlessly – to the contrary, “as original” will create a disjunction in a worldwide policy.
Accordingly, captives placing reinsurance through the London market in particular need to make express the hitherto assumed expectation that the reinsurance will be back-to-back to the captive’s coverage. The captive needs either (i) to issue a policy with the same choice of law (and preferably choice of forum) as that governing its reinsurance or (ii) to craft language in its reinsurance contracts that compels the reinsurers to follow the coverage as it will be construed under the law governing a claim under the captive-issued policy.