For a variety of reasons, such as a desire to exit a non-core line of business or to redeploy capital, an insurer may decide to shed certain legacy exposures, rather than continue to manage related claims and carry the exposures on its balance sheet. A well-structured transfer of those legacy exposures, via a loss portfolio transfer (LPT) or adverse development cover (ADC), can allow the insurer to achieve those results, while also providing significant benefits to the acquiring party.
LPT and ADC transactions are inherently complex, however, and careful due diligence around a number of factors, including price, capital charges, accounting treatment, and actuarial analysis of reserves, is the norm. But in order to develop a more complete understanding of the risks and potential profitability of the transaction, the acquiring party would be wise to also undertake a thoughtful analysis of the terms of the actual insurance policies at issue and potential associated exposures. Various policy terms and coverage issues, including the following, can have a massive impact on the liabilities arising out of the legacy exposures.
- What standard is identified in the policies to determine if an injury or damage is expected or intended, and therefore outside of coverage? Is it an objective or subjective standard? For example, a policy that looks to the “the standpoint of the insured” may create substantially greater liability for the insurer than one that utilizes a reasonable person standard.
- What state’s law is likely to apply to coverage disputes? How do the policies address this issue? Insurance coverage jurisprudence can vary widely from state to state. A claim might be covered under one state’s law but not under the law of another state. Property damage resulting from faulty workmanship, for instance, is considered an occurrence under some states’ laws but not others. And some states view a series of sexual abuse incidents as a single occurrence, while others consider each instance to be an occurrence. These distinctions can significantly impact the amount of coverage that would be provided under the policies.
- Which trigger of coverage (i.e., exposure, continuous, manifestation, or injury-in-fact) and allocation method (pro-rata or all sums) are likely to be utilized for long-tail claims?
- Do the policies cover punitive damages?
- Are there legislative developments that could impact policy exposures, such as the new New York State Child Victims Act, which re-opens the statute of limitations for previously time-barred childhood sexual abuse survivor claims?
- How would the policies respond to claims arising out of other emerging exposures – such as new cyber and privacy regulations, technological developments, or climate change – that were not contemplated when the policies were issued?
- Do the policies address how and where coverage disputes will be handled? Do they require mediation and/or arbitration, perhaps in a foreign country?
- Are defense costs included within limits? If not, the insurer’s potential exposure could be well in excess of policy limits. The recent proliferation of litigation financing significantly compounds this risk, as well as funded plaintiffs, are better able to engage in protracted litigations.
- Are the policies written on a single-year or multi-year basis? If the latter, does an occurrence or accident trigger a single or multiple limits? Some policies apply a limit to each annual period within the multi-year policy period, while others apply a single limit to the entire multi-year policy period. For a three-year policy with a $5 million limit, for example, an annualized limit could lead to a $15 million covered claim obligation, whereas the limit for the same claim under a single limit policy would be capped at $5 million.
- Are multiple claims arising out of a single product treated as one aggregated occurrence or multiple occurrences?
- Do the policies contain a non-cumulation clause, which might reduce the insurer’s liability for claims that are covered in whole or in part by prior excess policies?
- Have coverage determinations been appropriately and consistently made? Is there a history of bad faith claims, and are there pending and/or potential bad faith exposures? What state’s law will apply to bad faith claims and to claim-handling practices? Bad faith claims and poor claim-handling practices can expose the insurer to significant extra-contractual liabilities and regulatory fines.
Depending on the category of risk being transferred (i.e., construction defect, industrial diseases, environmental, etc.), certain issues will be more important than others and additional issues likely will need to be considered. But in all cases, developing a good understanding of the risks associated with the specific policy terms and related coverage issues will enable the acquiring party to better structure and price the deal, increasing the likelihood of a profitable result.