January 28, 2014
A Dangerous Misunderstanding on the Reinsurance Broker’s Role
Many insurance companies act as if a reinsurance broker is a fiduciary working for them. This approach provides for a direct conflict of interest that the company ceding responsibility is often totally unaware of.
A recent court case (Workmen’s Auto Insurance Co. v. Guy Carpenter & Co., B211660 (c/w B213853)) specifically determined that the reinsurance broker does not owe a fiduciary duty to a reinsured company. The court rejected the company’s argument that the broker, as the company’s agent, had heightened duties including those of honesty, loyalty, integrity and faithful service, as well as a duty to make a full and fair disclosure of facts.
It was asserted that the broker breached its duty by failing to secure timely payments, failing to secure the best available terms of reinsurance and acting with the intent to injure the company by incurring inflated commissions. The court said the question was whether the broker was the company’s agent and, if so, whether that agency imposed fiduciary duties on the broker as a matter of law such that the broker can be held civilly liable for breaching those duties.
The court said that an “independent insurance broker is not an agent of the insurer, but rather is an agent of the insured.” But the court also said that a broker “cannot be sued for breach of fiduciary duty in a manner that conflicts with existing insurance law. In reaching this conclusion, we confess that agency law and insurance law are in conflict, resulting in a legal conundrum.”
The company suggested to the court that case law and statutory law involving insurance brokers should not be applied to reinsurance intermediary-brokers because they have far more complex and comprehensive relationships with their clients. The court responded that such an argument should have been brought up sooner and ultimately allowed the broker to prevail because of procedural rather than substantive issues.
Comparing the relationship of an insurance broker with an insured to the reinsurance broker’s relationship with a reinsured is amazingly naïve. Somehow, it escaped the court’s attention that the reinsurance transaction is not strictly regulated, and that applying the same rules to a relatively non-regulated transaction was inappropriate at best. Perhaps the court believed that insurance case law developed in a vacuum, and that it was not tempered by regulatory oversight and legislative consumerism.
Still, the author assumes that the court would apply its same “(il)-logic” to other reinsurance brokers.
The aha moment
The broker itself defines “broker” as a reinsurance intermediary that negotiates contracts on behalf of the reinsured. Yet the broker says it does not have the traditional duties imposed in the agency-principal relationship.
The attitude by the broker is, in my opinion, the single biggest takeaway for companies ceding management of their reinsurance. It is confirmation that is incorrect to believe that your broker owes you the duties of honesty, loyalty, integrity and faithful service as well as a duty to make a full and fair disclosure of facts, and that it is acceptable for brokers to generate inflated commissions. It is now been made clear that, when push comes to shove, the standards to which your reinsurance broker is held are not really a whole lot different than when you are buying a used car, where statements made concerning the sale are considered “puffing”; just an opinion or judgment that is not made as a representation of fact.
Companies that delegate reinsurance risk management to a broker may themselves be breaching fiduciary duties to stakeholders. That is, while the case concluded that the broker does not have a fiduciary duty to the reinsured, courts are quick to confirm that officers of the reinsured do have a fiduciary duty to the reinsured. Obviously, officers cannot meet their fiduciary duties by assigning those duties to someone whom the court has found to have no fiduciary obligation to the reinsured.
I do not fault the particular broker in its defense. The issue is not the particular broker in the case or brokers in general; the real issue is the willful ignorance of the reinsured. Not questioning the motives of the broker is naïve. Remember, the broker, like the used car salesman, makes his money based on how much comes out of your pocket in the sales transaction. Risk management requires truly understanding the environment in which you operate.
The above case is not unique in bringing to light the ignorance of courts concerning reinsurance. Judges have been known to throw up their hands when dealing with reinsurance and admit that they do not understand what is being presented. In the case of Indiana Lumbermans Mutual Insurance Co. v. Reinsurance Results, Inc., in the U.S. Court of Appeals for the Seventh Circuit, Case Number: 07-1823, the court stated:
“The lawyers’ oral arguments were excellent. But their briefs, although well written and professionally competent, were difficult for us judges to understand because of the density of the reinsurance jargon in them. There is nothing wrong with a specialized vocabulary – for use by specialists. Federal district and circuit judges, however, with the partial exception of the judges of the court of appeals for the Federal Circuit (which is semi-specialized), are generalists. We hear very few cases involving reinsurance, and cannot possibly achieve expertise in reinsurance practices except by the happenstance of having practiced in that area before becoming a judge, as none of us has.”
Ignorance is only part of the problem
The reinsured holds much power but is afraid of using it. The playing field is certainly not level to begin with, but all too often the ceding company’s management exacerbates this lopsided power arrangement. It is amazing how ceding company management knows instinctively that their clients have many alternatives, but somehow believe that they, as a client of the reinsurance broker, have no alternatives. Companies often do everything they can to protect the “long-term broker relationship.”
This demonstrates a complete lack of understanding by ceding company management of their own fiduciary duties. The fiduciary duties of officers of insurance companies are to the company stakeholders, not to the reinsurance brokers.
This lack of understanding should be of particular interest to regulators overseeing insurance. All states now have a statute or regulation pertaining to recognizing a company in “hazardous financial condition”; one telltale sign is the lack of competence and fitness of those in management. Breaching a fiduciary duty could indicate lack of fitness.
Most insurance companies are ultimately in business to make money and serve their clients. Mistakenly believing that you are in business to make friends and keep long-term broker relations will put you out of business. Reinsurance is a commodity. Thinking of it as anything else makes you an uninformed consumer.
Your reality – the Wild West
Your business (insurance) is a highly regulated one that owes a fiduciary duty to its clients. To stay in business, you must depend on reinsurance, offered by an entity (reinsurers) that is, for all intents and purposes, unregulated. Additionally, this commodity must be purchased in certain quantities or an agency (AM Best) that gauges how viable you are will let everyone know that you face questions. You may have to go through a salesman (broker) that the courts have determined owes you no fiduciary duties, and whose income is based on how much it can sell you. That is, there is no incentive for “your” agent to advise you of ways to reduce your costs. To people in other industries, it would appear that “your” agent actually doesn’t work for you.
If the commodity you purchased turns out not to be what it was said to be, then you must arbitrate the matter with the entity that offered it. Reinsurance arbitration has proven to be every bit as costly and time-consuming as litigation but offers none of the advantages or safety nets provided by the courts. In spite of naïve judges, the court system is a better option. Judges are naïve only because reinsurance transactions so seldom land in court. Courts are a vastly superior forum that offers reason, rules and stare decisis, where precedent is followed, records are published and the same issues do not have to be determined multiple times. In arbitration, if a decision is made that is unfavorable, you may not appeal the decision. If this same scenario has been arbitrated before, you will never know it, because there is neither precedent nor a record. The outcome will not be determined by legal construction of the commodity you purchased and a set of interpretive construction rules but by the “custom and practice” of the industry, which coincidentally is neither written down nor uniformly agreed upon or adhered to. Arbitration only provides an advantage for the unregulated party to the transaction; it in no way benefits the regulated party. If the commodity you purchased does not measure up to the set of standards your regulator imposes, your regulator will punish you, not the entity that produced the commodity. Additionally, your clients to whom you owe a fiduciary duty have no recourse against the producer of the defective commodity you purchased even if it caused you to go out of business.
Substitute ANY other industry for insurance, reinsurance and broker in this scenario and you will quickly discern the absolute draconian forum in which you must operate. Now you can see why I don’t believe that the ceding company has a reasonable basis to believe that deferring reinsurance oversight to the broker is appropriate.
The next time you sign your broker-of-record contract, try this experiment:
Ask to insert the clause – “the broker agrees and understands that it is acting as a fiduciary for the Company in all matters in which it services the Company, with all duties and standards imposed in a fiduciary capacity.” While the court was not willing to assign such duties, the broker is free to contractually assume them!