Most people are surprised to learn that insurance companies and sureties purchase insurance otherwise known as reinsurance. In 2004, a general contractor client was sued by a surety under a general indemnity agreement or GIA for losses allegedly incurred under a series of Payment and Performance Bonds or P&P Bonds. Everything about the lawsuit was highly unusual! First, the contractor had no knowledge of the GIA as it had been executed years ago by a predecessor owner group. Second, the contractor had no knowledge of P&P Bonds as they had been issued by the Surety on behalf of a third party controlled by the predecessor owner group. Third, the predecessor owner group and all other signatories to the GIA were defunct leaving the contractor as the only financially solvent source from which the Surety could seek recovery. Fourth, the new owner group was facing more than $10M of claims for costs it did not incur, relative to P&P Bonds it knew nothing about, under a GIA it had neither executed, much less had any knowledge. [See, "Why Signatories Should Fear Indemnity Obligations Under Construction Surety Bonds", Posted May 3. 2023].
The contractor was facing bankruptcy until we discovered the Surety was seeking a “double recovery” through the lawsuit. It turned out, the Surety had already recovered 100% of its alleged losses sought to be recovered from the contractor under a Treaty of reinsurance. Like most everyone else, our client did not know that sureties and insurers often purchase insurance for the risks they assume – called reinsurance. By way of reinsurance, a Surety or “ceding company” can transfer or “cede” some or all of the risks for which it has assumed under P&P Bonds to a reinsurer or “assuming company”. In addition to helping hedge against major losses, sureties and insurers purchase reinsurance so they can spread risk, underwrite more bonds or policies, increase loss reserves, and generate more income and profits.
There are two types of reinsurance used with respect to P&P Bonds – Facultative and Treaty reinsurance. Facultative reinsurance occurs where a Surety “cedes” a single risk or a defined package of risks and the reinsurer performs its own risk assessment or underwriting of the P&P Bonds. Treaty reinsurance occurs where a Surety “cedes” all risks within a specific class of P&P Bonds, the “ceding company” performs all underwriting, and the reinsurer indemnifies the ceding company against all defined risks and losses.
Treaty reinsurance is further broken down into two types of treaties – proportional or “pro-rata” and non-proportional or “excess of loss”. Under a proportional treaty, the Surety and the reinsurer share both the premium and the potential losses based upon a defined pro-rata basis. Under a non-proportional treaty, the Surety retains the risk of loss up to a defined loss limit or “ceding company” retention, the reinsurer assumes the risk of loss over and above the “ceding company” retention up to a fixed upper loss limit, after which the Surety once again assumes all further risk of loss.
The reinsurance program adopted by a Surety can be complex and esoteric. Many programs consist of both Facultative and Treaty reinsurance, with layers of both proportional and non-proportional treaties covering different risk levels.
Our general contractor client discovered that the Surety seeking to recover $10M in the Lawsuit had already recovered its entire loss under Treaty reinsurance. The reinsurance was written under a non-proportional treaty, by a reinsurer who had ceased doing business. However, even if the reinsurer was still operational, the Treaty did not obligate the Surety to repay the reinsurer for the loss. Either way the Surety had no obligation to seek recovery, much less turn over any recovery to the reinsurer. Since the Surety was seeking a “double recovery” the lawsuit was settled by a “nuisance payment” by our client.
The lessons to be learned are simple. If you assume the obligations of an existing company, make certain you fully understand such obligations and whether there are any outstanding GIA's. And if you are facing exposure to a surety under a GIA, make sure to investigate whether and to what extent the Surety has been compensated by reinsurance for the alleged losses sought to be recovered.