What is a Reciprocal Insurance Exchange?

Written by Andy Webb, Esq.

Edited by Gary Reinhardt, Esq.

A reciprocal insurance exchange is “an unincorporated association in which members (as individuals, partnerships, trustees, or corporations) exchange contracts and pay premiums through an attorney-in-fact for the insurance of each other.”  Reciprocal Exchange: Legal Definition, Merriam-Webster.com, https://www.merriam-webster.com/legal/reciprocal%20 exchange (last visited March 6, 2019).  Historically, insurance exchanges were formed by individuals or corporations engaged in a similar line of business who together undertook to indemnify one another from certain kinds of risks by a mutual exchange of insurance contracts.  See Lee v. Interinsurance Exchange, 50 Cal. App. 4th 694.   Often times insurance exchanges were started to avoid questionable risk pools.  For example, USAA (a reciprocal insurance exchange with a military focus and over ten million customers) was founded by military officers who believed they were better drivers than average civilians.  See Andrew Verstein, Enterprise Without Entities, 116 Mich. L. Rev. 247, 267 (2017) (citing Paul T. Ringenbach, USAA: A Tradition of Service 1922-1997, at 20).  Today, policyholders in a reciprocal insurance exchange—often known as “subscribers”—act through a common attorney-in-fact and are simultaneously both insurers and insureds.  This method of providing insurance is different from mutual insurance companies because insurance exchanges do not have a corporate existence; instead, they are simply an unincorporated association of individuals who swap potential liabilities between themselves.  43 Am. Jur. 2d Insurance § 72 (2016).

Reciprocal Insurance Exchanges’ Unique Legal Position

Due to their unique structure, certain distinctive legal questions arise in litigation involving reciprocal insurance exchanges.  One of the most relevant of these questions is where are reciprocal exchanges “citizens” for the purpose of diversity jurisdiction in Federal Court?  28 U.S.C. § 1332 allows for jurisdiction over civil matters in the Federal courts system only when the matter in controversy exceeds $75,000 and the parties are “citizens” of different states, also known as diversity jurisdiction.  For the purposes of diversity jurisdiction, a corporation is a citizen of the State in which it is incorporated, as well as the State where the corporation has its principal place of business.  But when, as with a reciprocal insurance exchange, the entity in question is an unincorporated association “diversity jurisdiction in a suit by or against the entity depends on the citizenship of all its members.”  McKenzie v. Farmers Ins. Exchange, 2018 U.S. Dist. LEXIS 21974, *5 (S.D., 2018); see also Stagg v. Farmers Ins. Exch., 2016 U.S. Dist. LEXIS 57791 (Or. 2016).

Despite the fact that reciprocal insurance exchanges consider themselves unincorporated associations, Federal Courts are split as to whether to consider the exchanges unincorporated associations or whether to apply the traditional corporations citizenship test when determining diversity jurisdiction. Though there is a split amongst the Courts, the vast majority of Federal Courts examining the issue have found that reciprocal insurance exchanges, including large national based exchanges, are unincorporated associations and therefore, citizens of all states in which their subscribers reside.  See generally McKenzie, 2018 U.S. Dist. LEXIS 21974, *9-10.[1]

In coming to the conclusion that reciprocal insurance exchanges are unincorporated associations and share citizenship with their subscribers, Courts have looked to the specific structure and workings of the exchange.  For example, the Arizona District Court stressed that in determining a reciprocal insurance exchange’s citizenship, “the analysis should be case and fact specific” where “the courts examine the entity’s own definition of a ‘member.’”  James River Ins. Co. v. Cast & Assocs., 2012 U.S. Dist. LEXIS 49949 (Ariz., 2012).  The Maryland District Court, for example, looked at the traditional definition of a reciprocal insurance exchange and noted, “[i]n a reciprocal insurance exchange, there is no distinction between policyholders (or ‘customers’) and insurers (or ‘underwriters’)”, indeed “one of the key identifying components of a reciprocal insurance exchange is that all of the policyholders are also providers of insurance to each other.”  James G. Davis, Constr. Corp v. Erie Ins. Exch., 953 F. Supp. 2d 607, 611 (Md., 2013).  Whereas, in the 2018 McKenzie case, the South Dakota Circuit Court took an even deeper look into the workings of the particular insurance company in question, concluding the company was in fact a true reciprocal insurance exchange. The Court noted subscribers in that exchange could vote to determine the members of the Board of Governors, which had significant oversight powers within the exchange and was charged with overseeing the financial affairs of the exchange.  McKenzie, 2018 U.S. Dist. LEXIS 21974, *8-9.  Accordingly, the McKenzie Court found that the subscribers in that case were acting as a traditional unincorporated reciprocal insurance exchange and found the Court lacked diversity jurisdiction to adjudicate the issues in the case.

Despite the great weight of authority in favor of a reciprocal insurance exchange’s status as citizens of all states in which it has subscribers, recent opinions on the issue have warned reciprocal exchanges against “‘strategic[] and self-serving’” applications of these diversity jurisdiction principals.  McKenzie 2018 U.S. Dist. LXIS 21974, *11 (quoting Staggs, 2016 U.S. Dist. LEXIS 57791, *8, n. 3).  The McKenzie court identified multiple cases where the reciprocal insurance exchange in question argued for removal from State Court to Federal Court based on diversity jurisdiction and chastised the “Defendant‘s selective invocation of federal jurisdiction [as] a waste of its insureds[’] time and resources as well as that of the courts.” Id. at *13.  The Court went on to find “this apparent strategy more than ‘troubling,’ . . . and instead appears to be chicanery.”  Id.

Why Does All This Matter?

Often times in liability litigation or declaratory judgment actions, one party may have an advantage in litigating in either Federal or State Court.  With three of the nation’s largest twenty property/casualty insurance companies (USAA, Farmers, and Erie) classifying themselves as reciprocal insurance exchanges, you may come across many cases involving these or other reciprocal insurance exchanges.  It is important to recognize the jurisdictional limits these companies are under as a result of their structure and how that effects your litigation strategy.  Additionally, due to the split in authority and harsh critiques some of these insurers have seen for taking advantage of their unincorporated association status, you may be able to fight against this status for the advantage of your insured.

[1] The McKenzie Court cited to seven cases where reciprocal insurance exchanges were found to be citizens of the states of their subscribers and one case where the court held that opposite and distinguished the justification cited by the Garcia case.  Compare Privilege Underwriters Reciprocal Exch. v. Research Products Corp., 2017 U.S. Dist. LEXIS 21089,*10 (W.D. Ky., 2017); Staggs v. Farmers Ins. Exch., 2016 U.S. Dist. LEXIS 57791 (D. Or., 2016); Nevada Capital Ins. Co. v. Farmers Ins. Exch., 2014 U.S. Dist. LEXIS 169031, (D. Nev., 2014); James G. Davis, Constr. Corp. v. Erie Ins. Exch., 953 F. Supp. 2d 607 (D. Md. 2013); Hartfield v. Farmers Ins. Exch., 2013 U.S. Dist. LEXIS 3883 (E.D. Mich., 2013); James River Ins. Co. v. Cast & Assocs., Inc., 2012 U.S. Dist. LEXIS 49949 (D. Ariz., 2012); Farmers Ins. Exch. v. MTD Prods., 2011 U.S. Dist. LEXIS 135257 (N.D. Tex., 2011); Tyler v. Nightengale, 2007 U.S. Dist. LEXIS 89682 (D. Neb., 2007) with Garcia v. Farmers Ins. Exch., 121 F. Supp. 2d 667 (N.D. Ill., 2011).

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