Extra-Contractual Obligations (ECO) Clause

Extra-Contractual Obligations Clause

Investopedia / Theresa Chiechi

What Is an Extra-Contractual Obligations (ECO) Clause?

An extra-contractual obligations (ECO) clause in a reinsurance contract requires a reinsurer to pay for expenses imposed upon the ceding insurer by regulatory, judicial, or governmental organizations. An extra-contractual obligation (ECO) clause specifically applies to losses that are outside of the insurance policies covered under a reinsurance treaty.

Understanding Extra-Contractual Obligations (ECO) Clauses

Extra-contractual damages are awarded in "bad faith" claims against insurance companies. They are a form of punitive damages, intended to punish extreme insurer conduct. Extra-contractual obligations differ from excess of policy limits (XPL) losses.

Excess of policy limits losses refer to those that result from an insurer mishandling an insurance claim, and finding itself liable for the losses above the policy limit. Extra-contractual obligations are not the result of mishandling a claim, and instead are the result of negligence, bad faith, or deceptive practices. For example, an insurer may be found to have engaged in deceptive sales practices, and be sued by a policyholder for misrepresenting what perils are covered by the policy.

Insurance companies are required to indemnify policyholders against claims made against them. In some cases, the insurer will fail in its contractual obligation and will act in bad faith, or may be considered negligent in its handling of a claim. If a court finds that the insurer has behaved poorly, it may impose a penalty. If the insurer has a contract with a reinsurer, the reinsurer may be held liable for these penalties, which are referred to as extra-contractual obligations.

Insurance companies will typically use reinsurance treaties to mitigate some of the risks associated with the policies that they underwrite. Depending on the reinsurance treaty language, reinsurers may be responsible not only for losses associated with the policies covered under the contract, but also for fines that the insurer may have levied against it for negligence by the courts. The reinsurance treaty will indicate if the reinsurer is responsible for extra-contractual fees, and if it is to be held responsible, under what situations it would have to pay for any fines.

Extra-Contractual Obligations Clause Example

While reinsurance agreements will be tailored to the particular policy or indemnity sought, the clauses included will have similar boilerplate language, such as the following:

This Reinsurance Agreement shall protect the Company as provided in Article 1 Business Covered where the Loss includes any Extra Contractual Obligations. The date on which any Extra Contractual Obligation Loss is incurred by the Company shall be deemed, in all circumstances, to be the date of the original Loss. However, this Article shall not apply where the Loss has been incurred due to fraud by a member of the Board of Directors or a corporate officer of the Company...