Reinsurers are increasingly finding themselves the target of class action lawsuits

Over the years, reinsurers have become well acquainted with US-style class actions, and they have developed strategies and abilities to manage and, if possible, avoid the enormous exposures these lawsuits can engender.

As the targets of class action lawsuits have evolved from cedants' insureds to cedants themselves, and now to reinsurers, however, the reinsurance sector finds itself increasingly exposed to massive class action expenses and losses, for which it has not had the opportunity to prepare. Furthermore, although class-style litigation at one time was considered to be limited almost exclusively to the US, it has crept into other legal systems, creating global exposures for reinsurers that previously were unprecedented.

The reinsurance sector responded to the onslaught of 'traditional' class action claims against cedants' policyholders in various ways. For example, reinsurers increased prices significantly for certain categories of risks, outright refused to accept other types of risks, increased attachment points, and/or decreased aggregate limits. Some reinsurers also offered limited types of cover, such as normal excess-of-loss covers with higher retention amounts, for particular classes of risk. The reinsurance sector adopted new and different contract wordings to attempt to mitigate exposure to various perceived class action risks. None of these efforts, however, prepared reinsurers in any meaningful manner for the latest wave of class action lawsuits directly impacting the industry.

New breed

Fuelled in part by skyrocketing class action exposures in the US, as well as continually increasing asbestos exposures globally, many insurers in recent years have dramatically increased their reserves. These reserve increases have spurred the filing of shareholder securities class action lawsuits in which insurers and reinsurers find themselves and their executives as named defendants. Furthermore, many insurance companies in recent years have become publicly traded companies, or part of publicly traded companies, on US stock exchanges, and matters pertaining to their stock prices and initial public offerings (IPOs) have created, in the minds of a group of plaintiffs' class action attorneys, fodder for the US class action mill.

Although shareholder class action proceedings directly against insurers and reinsurers are not entirely new (TIG Holdings Inc and TIG Reinsurance Co were named as defendants in a class action securities fraud case filed a few years ago), these actions seemingly are being pursued more frequently and more vigorously of late.

Fraud security cases

In just the past few months, a number of securities fraud class actions have been filed that directly impact the reinsurance sector. Late last year, in Boyd v PMA Capital Corp, PMA shareholders filed a class action complaint after PMA's stock price plunged, alleging that the defendants caused the company's stock to reach an artificially high price by issuing a series of material misrepresentations to the market, in violation of Rule 10b-5 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Specifically, the complaint alleged that PMA reported strong financial results and adequate loss reserves, but that the apparently strong financial results were based on improper reserving practices for claims arising from its reinsurance operations and for loss adjustment expenses.

Also late last year, a class action lawsuit was filed on behalf of purchasers of the publicly traded securities of XL Capital Ltd. Plaintiffs allege in their complaint that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5. In particular, the complaint alleges that defendants failed to disclose and advise that XL Capital maintained inadequate loss reserves for its subsidiary, NAC Re; that XL did not, contrary to its express representations, establish adequate loss reserves to cover claims by NAC Re 'policyholders'; that certain reserve increases announced for NAC Re were materially insufficient; and that XL Capital's earnings and assets were materially overstated due to the alleged understatement of loss reserves. The lawsuit seemingly was prompted by XL Capital's announcement that its third quarter results would be lower than anticipated due to higher than expected losses in its North American reinsurance operations, primarily from new casualty claims for the 1997 to 2000 underwriting years, and a subsequent 7.5% per share drop in share price.

Last year also saw the commencement of a consolidated securities fraud class action against Annuity and Life Re (Holdings) Ltd and its corporate officers, based upon an alleged fall in the company's stock price from nearly $37 per share to about $2.25 per share. The plaintiffs in that action allege that Annuity & Life Re deceived investors regarding the risks of reinsuring a $1.6bn book of annuity policies and misstated information in its SEC filings concerning management fees, surrender rates, methods of accounting for liabilities and the assumptions concerning the amortisation schedule of capitalised commission costs. Plaintiffs further alleged that the defendants "were motivated to perpetuate the fraud in order to maintain ANR's financial ratings and to satisfy conditions on existing contracts, attract new business and post required letters of credit as collateral for its reinsurance agreements." (Am Compl P269) (Schnall v Annuity & Life Re (Holdings) Ltd, No 3:02 CV 2133 (GLG), D Conn; 2004 US Dist LEXIS 1601 (Feb 4, 2004)). In a judicial opinion entered earlier this year, the judge presiding over the case denied a motion to dismiss claims filed against the CEO of Annuity & Life Re, Frederick S Hammer. In denying Hammer's motion to dismiss, the court observed that the plaintiffs alleged that the executive careers of the officers were 'at stake', and that plaintiffs' allegations concerning the timing of the company's filing of restated financial statements adequately pled recklessness sufficient to sustain a cause of action against him. Such a ruling is not shocking, as insurance executives have witnessed for years the manner in which the class action plaintiffs' bar utilises restated financials as weapons against corporations and their officers. Until recently, however, reinsurance executives had not been the targets of these allegations.

Exacerbating the situation for the reinsurance sector is the fact that shareholder class action litigation has emigrated beyond the US. Although the ultimate viability of the claims asserted remain questionable, approximately 1,200 former shareholders of HIH Insurance Ltd in Australia have been allowed to pursue an action alleging that HIH directors, auditors and reinsurers misled shareholders by overstating asset values, understating provisions for claims, and entering into sham reinsurance contracts, all intended to deceive the shareholders into believing that HIH was in financial good health when, in fact, it was on the brink of insolvency. In another Australian class action, 33,000 former shareholders have sought to recover hundreds of millions of dollars from an insurer arising in large part from losses incurred by its reinsurance businesses that suffered catastrophe losses. Other, similar lawsuits have been initiated in Australia, seemingly following the US trend. Although industry observers do not perceive the threat of true class action litigation emigrating to Europe and Asia as significant at this time, the same facts that give rise to shareholder class actions directly against reinsurers are likely to enhance ratings agencies' scrutiny of reinsurers and to increased governmental supervision of reinsurers and their finances as, for example, the German government recently proposed supervisory provisions.

Consolidated actions

Shareholder class actions are not the only consolidated lawsuits being pursued against reinsurers. A recently consolidated class action, brought by thousands of professional malpractice policyholders, alleges that American National Lawyers Insurance Reciprocal (ANLIR) and its reinsurer, Reciprocal of America (ROA), conspired with ROA's reinsurer, General Reinsurance Corp, to misrepresent the financial health of ROA and ANLIR, and that the officers of ROA and ANLIR 'orchestrated' the alleged scheme. The suit accuses the defendants of fraudulent misrepresentation, conspiracy, breach of contract, unjust enrichment, suppression, negligence, wantonness and racketeering under civil RICO statute. These actions stem from ROA's alleged overly aggressive practice in the 1990s of selling insurance policies at discounted rates to raise investment cash. The plaintiffs argue that, as the stock market's downturn approached, malpractice damage awards escalated sharply, causing ROA's downfall and ultimate placement into receivership.

Plaintiffs further allege that ROA did not possess sufficient assets to come out of receivership because Gen Re renegotiated its contracts, effectively releasing it from approximately 90% of its obligations. The suit alleges that Gen Re left ROA in "significant financial trouble and liable for claims well in excess of what was being represented to state insurance departments and rating services. However, to auditors and regulators, the company appeared solvent because of Gen Re's bogus treaties." The plaintiffs thus object to the so-called 'side agreement' between ROA and Gen Re, which, they assert, was not publicly disclosed and left the policyholders with no financial recourse or backing upon ROA's demise. The class plaintiffs also cite as improper the reinsurance commissions paid to Gen Re, which they characterise as "illegal and fraudulent payoffs". These consolidated class actions are still in their incipiency, and it is far too soon to predict their ultimate outcome. However, such policyholder actions are particularly disturbing as they attempt to blame reinsurers and longstanding reinsurance practices for the demise of a carrier, and to effectively rewrite reinsurers' negotiated contract terms.

Wide-ranging impact

Whether the recent spate of class actions targeting the reinsurance sector ultimately will result in determinations of liability or payouts remains to be seen. However, the impact of these suits, even if they prove to be unsuccessful on the merits, promises to be wide-ranging. Obviously, the cost of defending such lawsuits can be staggering. Even more significantly, however, the rise of these class actions arguably has created an impression of inadequate corporate governance, financial reporting and auditing in the reinsurance industry that is likely to spur governmental and regulatory scrutiny from which reinsurers heretofore had been relatively free. These lawsuits additionally have drawn attention to an industry that previously had been rather outside the public eye. Moreover, an industry that historically has conducted its affairs in accordance with its own traditions and practices as opposed to the mores of 'big business' now finds itself being viewed in the same way as any other sizable corporate citizen and potentially subject to many of the same liabilities.

Michael L Morkin is a partner in the Chicago office of law firm Baker & McKenzie, concentrating in the resolution of reinsurance and other international disputes. Ronald L Ohren is also a partner in the Chicago office of Baker & McKenzie, concentrating in the resolution of coverage and reinsurance disputes. Donna J Williams is an associate in the Chicago office of Baker & McKenzie.