Exculpatory clauses appear in many contracts. They are often used to protect a contracting party from damages caused by its actions or the actions of others. For example, a hold harmless clause may protect one party from third-party suits caused by the alleged negligence of the other party.
Exculpatory clauses, like hold harmless or indemnification clauses, are somewhat unusual in a traditional reinsurance contract. But where the reinsurance contract is between a fronting company and a 100% reinsurer that is the real party in interest, the fronting cedent may want to insulate itself from any responsibility for the underlying claims by using an exculpatory clause.
A reinsurance contract in a fronting arrangement may contain a follow-the-settlements clause that unconditionally binds the 100% reinsurer to all claims settlements made by the fronting cedent. This is, in an of itself, a form of exculpatory clause. An errors and omissions clause is also another standard clause that is exculpatory by its nature.
We recently came across one situation where the fronting cedent sought to further insulate itself from responsibility for mistakes by requiring the reinsurer to indemnify and hold the fronting cedent harmless from any alleged or actual negligence, fraud or bad faith in settling underlying claims. In this case, the reinsurance contract contained a more robust errors and omissions clause that required the reinsurer to cover the fronting cedent for any errors found in its claim handling. Further, a hold harmless and indemnity clause made it clear that the reinsurer was required to indemnify the fronting cedent for all of the fronting cedent’s activities arising out of or related to the handling of any claim under the policies reinsured.
In this case, a dispute arose concerning the scope of these exculpatory clauses and whether they insulated the fronting cedent from any and all of its claims handling activities, no matter how egregious. The case was arbitrated and an arbitration panel majority found that the fronting cedent’s claims handling conduct was in many cases reflective of willful misconduct, refused to enforce the exculpatory clauses and awarded damages to the reinsurer for the mishandling of certain claims. The panel noted that behavior that amounts to willful or intentional misconduct has been found by the courts sufficient to overcome broad exculpatory clauses. The panel majority also found that the claims handling misconduct was in violation of the fronting cedent’s duty of utmost good faith (i.e., was not the behavior that the panel would expect from a reasonable cedent). Finally, the panel majority found that the fronting cedent’s conduct came up short under the honorable engagement language contained in the arbitration clause.
This result is interesting. It is true that exculpatory clauses may be rendered unenforceable under various state’s laws, public policy or common law when those clauses are not reasonable. Many of those cases, however, are situations where a party is trying to avoid liability for negligence in a consumer context and reaches too far. In the commercial context, between two sophisticated insurance companies, the avoidance of an exculpatory clause is usually much harder to obtain.
In the case described above, the panel majority looked to the honorable engagement clause and the duty of utmost good faith to assist it in judging whether the fronting cedent’s attempt to insulate itself from any and all activities in its claims handling would be upheld. The majority thought the cedent’s actions fell short and found willful misconduct.
Notably, it was the fronting cedent that handled the claims; not a third-party administrator chosen by the reinsurer. One can argue that the fronting cedent had no incentive to handle claims correctly as it had no skin in the game and was collecting 50% of the premiums for its trouble. There is something to be said for denying exculpation, even under the express and broad clauses here, when the claims handling was far more than sub-par and rose to a level of willful misconduct. Clearly, there is no place in reinsurance for a fronting cedent to abuse its position and purposefully mishandle claims.
To reach a finding of willful misconduct, the majority relied on the reinsurer’s expert’s detailed report and testimony on the deficiencies in the claims handling. The fronting cedent failed to put up its own expert in rebuttal. The dissent pointed out that the reinsurer never claimed that the fronting cedent acted fraudulently or committed willful misconduct, and had failed to meet its burden of proof. Whether the panel majority’s imputation of willful misconduct was challenged is unknown.
The overall point is that parties may contract for as much protection as they can by way of exculpation clauses. But if a court or arbitration panel finds that their behavior is such that enforcement of the exculpation clause should be denied, they may find themselves responsible for the losses.