Simon Kilgour and Tim Harmer examine inspection problems and how to tackle them
Inspections are the process by which reinsurers extract information from their cedants to ensure that they have written business and settled claims in accordance with the terms of their reinsurance. The right to inspect will usually be written into the reinsurance contract and, even if it is not, the reinsurer will have a limited right to inspect implied by law. The reinsurer is merely exercising its contractual rights in carrying out an inspection. However, inspections often prove contentious because many reinsurers use them to gain information to build a legal case against their cedants, in an attempt to discount their liabilities.For companies in run-off, the inspection process can be a serious drain on resources and reinsurers may exploit this. However, inspections can also be a useful tactic to delay payment of sums owed to cedants and can be exploited by the reinsurer in run-off where cash flow considerations mean that this is a real benefit. Whether in the role of the reinsurer carrying out the inspection, or as the cedant being inspected, it is important to understand the legal and practical implications of the reinsurer's right to inspect.
Inspection rightsUnder English law, the reinsurer's right to inspect is founded on the principle expressed by Hobhouse J in his judgment in Phoenix General Insurance Co of Greece SA v Halvanon Insurance Co Ltd (1985) that every cedant has an implied duty to "obtain, file or otherwise keep in a proper manner, all accounting, claims and other documents and records and make them reasonably available to a reinsurer". This is generally interpreted as meaning that the reinsurer, in any form of obligatory treaty reinsurance arrangement, may require the cedant to provide reasonable access to its books and records.The reinsurer may enforce this right whether or not the reinsurance contract incorporates an inspection clause.However, where the reinsurer carries out an inspection relying on this implied right it will be argued that it is only entitled to inspect those classes of documents which it is established that the cedant has a duty to maintain. That is, documents which relate directly to details of risks, claims and premium. Inevitably, this will give rise to arguments about the extent to which the cedant is required to give access to its records.It is, therefore, in the interests of the reinsurer to ensure that its contractual right to inspect is expressed in the reinsurance contract fully, clearly and in terms as wide as possible so that all records held by the cedant relating to the reinsurance fall within the scope of the inspection. It is similarly in the interests of the cedant to ensure that the right to inspect is expressed in the terms of the contract, but in terms that clearly define and restrict those documents to which the reinsurer will be given access, and provide that the reinsurer can only enforce its right to inspect at reasonable notice and/or at specified times.The terms of any inspection clause which are ultimately agreed will be a matter of commercial negotiation and are likely to reflect the commercial strength of the parties. A cedant or reinsurer in run-off will have to live with whatever terms have been agreed. However, even where the inspection clause is very wide in its scope, enforcement of it will be subject to a reasonableness requirement. It has been established under English law that the courts will not allow inspections to go ahead if they are deemed excessive, oppressive or otherwise in bad faith (Re A Company No.008725 of 1991, ex parte). This should be borne in mind by a cedant in run-off where the reinsurer's inspection team is exerting unreasonable pressure on the cedant to co-operate notwithstanding the cedant's limited resources.In one reported case, the English courts interfered to prevent a reinsurer carrying out an inspection which amounted to no more than a "fishing expedition" to obtain evidence entitling the reinsurer to avoid its obligations under the reinsurance contract (SA d'Intermediaires Luxembourgeios v Farex Gie  LRLR 116]. However, in reality it is difficult to establish that an inspection is being carried out other than in good faith, and many inspections will proceed where the reinsurer's sole intention is to obtain such evidence. Cedants must, therefore, ensure that they have procedures in place which will prevent such 'bad faith' inspections producing evidence other than that to which the reinsurer is strictly entitled and which prevent the reinsurer from exercising its inspection rights unreasonably or oppressively.
Importance of preparationFor the cedant in run-off, the inspection process can place a very high burden on its limited resources and this may be exploited by a reinsurer's inspection team. Where litigation is contemplated, the inspection team is likely to have been briefed by a legal team about those types of documents and records which may provide evidence entitling the reinsurer to avoid the reinsurance or otherwise not pay claims. Experienced inspection teams - and there is a growing number of companies which provide this resource to reinsurers - will seek to obtain information and documents to which they may not be strictly entitled and to gain informal access to staff who may make unguarded and damaging comments.One tactic to ensure that the inspection team has its access to documents and staff properly policed is to agree an inspection 'protocol' in advance.This will formalise the means by which the inspection team requests information and documents, and ensure that there is a proper record of all documents and data provided. Any questions will be required to be put in writing and responded to in writing. This prevents the inspection team from gaining access to documents to which it is not entitled and from having informal access to staff. Where the cedant is unsure whether the reinsurer is entitled to documents, it may refer the inspection team's requests to its lawyers.The protocol will also ensure that the inspection team is not able to place unreasonable demands on the cedant.For reinsurers, preparation is just as essential. An inspection team should be aware of what it expects to achieve and prepare an inspection plan. Electronic data can be requested in advance and will direct the inspection team to areas of concern. A file selection process may also be carried out in advance. In the London market, many files will not be retained by the cedant and will need to be requested from brokers. It is important to agree that the cedant will make all reasonable attempts to obtain these files ahead of the inspection.It is important for the cedant to consider what the reinsurer's motive might be for carrying out the inspection. In many cases, the inspection is part of the usual business relationship and is often a sensible way of ensuring that a cedant is underwriting and handling claims in the manner expected of it. However, where a cedant in run-off is being inspected there will be no ongoing commercial relationship. A cedant in run-off should always be aware that an inspection is likely to be used as a means to attack the cedant and limit the reinsurer's liability to pay claims.Often, the reinsurer will attempt to delay payment of claims until it has carried out an inspection. But under English law, the reinsurer will rarely have the grounds to do this. Only if the inspection clause is clearly expressed in the reinsurance contract to be a condition precedent to the reinsurer's liability will the reinsurer be able to rely on the cedant's failure to comply with it to delay payment of claims.For the cedant in run-off, cash flow and obtaining funds from reinsurers is of paramount importance, and a request for inspection prior to payment of all outstanding balances should be resisted. Litigation may ultimately prove necessary to enforce payment but, whilst the cedant in run-off may not have any concerns about protecting ongoing commercial relationships, the litigation process may be a drain on limited resources and hence the cedant should also consider commercial options. For example, the cedant may agree to allow the reinsurer to carry out its inspection in return for a full or partial payment under a reservation of rights. It should also be borne in mind that the English courts have shown themselves unwilling to allow summary judgment applications by cedants where there have been previous requests to inspect on the basis of justifiable concerns which have been refused by the cedant without good reason (Pacific and General Insurance Co Ltd v Baltica Insurance Co (UK) Ltd  LRLR 8].From the reinsurer's point of view, if litigation is contemplated, it is important to ensure that by carrying out the inspection the reinsurer's rights are not waived and that it is not deemed to have affirmed the contract.If a reinsurer obtains information which entitles it to avoid the contract, the reinsurer will be taken to have affirmed the contract if it does anything subsequent to obtaining that information which can be taken as being inconsistent with the avoidance. Enforcement of an inspection clause in a reinsurance contract has been held by the courts to be an act waiving the reinsurer's right to avoid the contract. It is therefore essential that any inspection request is made under a full and clear reservation of rights. However, reinsurers cannot unilaterally reserve their position indefinitely and once in possession of information entitling them to avoid the reinsurance must act on it within a reasonable time. To further protect the reinsurer's position, it may be advisable to formalise the terms on which the inspection is carried out by means of a non-waiver agreement such that the cedant agrees that the inspection will not be deemed a waiver of the right to avoid the contract or to otherwise dispute liability.
After the inspectionFor the reinsurer, it is important that if the inspection does reveal any grounds on which it may be entitled to avoid the contract, it acts on this information within a reasonable time. The cedant can assist its position by negotiating a time following the carrying out of the inspection within which any payment of sums due must be made. Also, the cedant may build into the protocol a requirement that the inspection team reports its findings and concerns to the cedant immediately following the audit.It will be important for the cedant to obtain finality and not to be in a position where the reinsurer continues to request further information following the audit. The reinsurer should not be allowed to embark on an open-ended fishing expedition whilst delaying payment - if it does, a cedant may choose to enforce its own right to recover under the reinsurance.Inspections are not always a weapon, but for a cedant in run-off they may be best perceived as such. Preparation is therefore essential, together with awareness of the tactics that can be deployed by reinsurers and their inspection teams.Simon Kilgour is a partner and Tim Harmer a solicitor in the reinsurance group of City law firm Reynolds Porter Chamberlain.