We are often asked to speculate on the future of audit and inspections. We believe that the answer can be found in the lessons not learned by our predecessors as well as those lessons that are not being learned by our peers.
There is an old adage that seems to have been designed for the reinsurance arena: you can't teach an old dog new tricks. (Erase dog and insert broker, underwriter and, or contract department.) There are so many things that can and do go wrong in reinsurance contracts, yet the wording never seems to change. It is very likely that 80-90% of the contract language remains unchanged from 30, 40 or 50 years ago. Having said this, changes are easy to make and more than likely the underwriters would be willing to make these changes if they knew the problems existed or looked in the rear view mirror to see how problems manifested in the past.
The story goes that back in the old days, brokerage houses had books of contract wording clauses which were to be used for the easy creation of new contracts. An underwriter would pick the standard clauses which he wanted to use, and these clauses would be cut and pasted and photocopied together to give the appearance of an original document. Today, I understand the same thing happens, although instead of actually cutting and pasting, it is all done with the click of a mouse button.
As a reinsurance auditor, I have been involved in numerous arbitrations and litigations which could have very easily been avoided or diminished if companies would just follow the wording as it was intended, never mind the fact that these contracts should be adhered to as written. Beyond the basics of following the wording, contracts could be altered in such a way as to alleviate doubt as to meaning, as well as to recourse should a contract condition be violated.
The easiest place to start is at the beginning with the business covered section, which can be found in most reinsurance contracts. Throughout the years companies on both sides of a reinsurance transaction have gone out of their way to specifically limit the business covered by a given reinsurance contract. The following is an extreme example but perhaps not as far from the truth as you might think.
ABC Insurance Company writes various food service businesses and wants to purchase reinsurance from XYZ Reinsurer, for the policies purchased by hot dog vendors. For some reason, ABC's ceded reinsurance department forgets to get program specifics from the assumed business department and the next thing you know, the hot dog street vendor excess of loss program is now ceding railroad primary workers' compensation losses to the reinsurers. Obviously XYZ is not happy because they had no intention of writing railroad business. ABC feels that these losses are allowed because, after all, the contract states: “This contract covers all business classified by the company as hot dog vendor policies.” The rationale that ABC gives is that one small subsidiary of the railroad sells hot dogs on one of the train lines and therefore the insured can be classified by the company as a hot dog vendor. After all, the wording does state “classified by the company as”, which some ceding companies see as a licence to cede business that may not be reinsured elsewhere. The language in one part of a contract should not be allowed to override the intent of the contract, which was obviously to cover actual hot dog vendors, not railroad workers' compensation claims.
Access to records
Another area of the contract that often needs more attention is the access to records clause. These clauses are usually pretty basic and state merely that the company will allow the reinsurer or its representatives access to the records which pertain to the reinsurance contract in question. There are several problems with this clause which, for obvious reasons, don't come to light until a reinsurer decides to inspect the records of the contract. The first thing that usually happens is the ceding company will state that a reinsurer is not allowed to inspect the contract until all of its balances are paid in full. Nowhere in the access to records clause is a reference to balances or the payment of balances. Yet countless hours and legal expense will be spent negotiating and fighting over this initial obstacle. On that subject, if contracts included penalties which could be enforced where due and owing balances become overdue, then disputes could be headed off and addressed or at least handled in a timely fashion and not years later, which is what we see in too many cases.
The next problem that arises is exactly which records will the reinsurers be given access to. Most ceding companies limit access to only those records which they feel are relevant to the reinsurer. However, there may be other records available that would prove that contract violations or improprieties exist that the reinsurer will never be allowed to see. For instance, if the contract states that the ceding company will maintain a certain portion of the business net for its own account, the reinsurer should be allowed to view the records that prove that the net retention was maintained. These documents may include a ceded policy register or a digest of other ceded programs. Many cedants will maintain that these documents are proprietary, not relevant or are outside the scope of the contract.
Then there is the topic of confidentiality agreements. Nowhere in any contract we have ever seen is there a stipulation that the access to records clause is contingent upon a confidentiality agreement being in place prior to access to records being given. Even when a confidentiality agreement is in place, some companies still do not provide all of the pertinent documents. In other situations, companies are allowed to view the documents in the ceding company's offices, but when copies are requested by the reinsurer or its consultants, the requests are denied, or the language of the document is redacted, rendering the document useless.
The final area of discussion is the information that is given to the reinsurers prior to risk acceptance. This information is typically the placing submission or renewal information. Although ceding companies supply this information to the reinsurers, the reinsurers, it would seem, are not really supposed to rely on this information for underwriting purposes. In fact, in a number of arbitrations I have been involved in, the ceding companies response to an issue developed from the placing information was: “That wasn't in the contract.” In others, the same cedants will attempt to rely on the placing/renewal information over the actual contract.
The are two easy solutions to all of the above issues, as well as many issues not raised here. One is to put the information in the contract. Not only should the intent be specifically laid out, but the recourse for failure to follow the contract should be included as well. The other key to ensuring contract adherence is the use of audits and inspections.
From the reinsurer's perspective, these should include pre-quote audits as well as interim spot checks of the business being assumed. These spot checks could include brief visits to the cedant's offices, or periodic in-depth reviews of the information provided by the ceding company. From the ceding company side of the equation, efforts should be made to ensure that accounts are rendered and that payments are received within the stated guidelines of the contract. Also, the ceding company should make every effort to respond to questions that are raised by the reinsurers in a timely fashion. Merely not answering the question does not let the ceding company off the hook. Answering and addressing problems up front can be an easy way to avoid arbitration.
If the business covered section above would have been more specific, so that it only included companies whose principal operation - that is, more than 75% of revenue - is hot dog sales as a vendor to the public, many problems would have been avoided. The ceding company would have known that railroad business was not acceptable and either would not have written the business in the first place or not ceded it to this reinsurance program. The assuming company would not have had to fight and incur expenses to get credits for losses that never should have been ceded to them in the first place.
The access to records clause could very easily be amended to state that the reinsurer will be granted access to a specific group of records and only under specific conditions. This could include a pre-requisite that all balances have been settled by the reinsurer. It could also mention the necessity for a confidentiality agreement, which seems to be almost an initial requirement for auditing these days, but for some reason is not usually included in a contract. As mentioned above, even when a confidentiality agreement is in place, documents or copies of them are not always supplied. These problems should be addressed in the contract to avoid complications later on.
As for placing information, it is a wonder that ceding companies and brokers go through the hassle of producing the information and then supplying it to the many reinsurers they are asking to be on the contract. If the placing information is not reliable, why do reinsurers use it for underwriting purposes? Reliance on the underwriting information is the only information that reinsurers have to go by and, as such, the adherence to this information should be its own clause in a reinsurance wording. Items like projected premium volume, while understood to be an estimate, should have contractual guidelines to be followed. For instance, if the placing information states that the ceding company estimates premium volume of $10 million dollars, the contract should call for an acceptable variance, perhaps a 10% swing in either direction. If this variance is exceeded, penalties could be enforced such as a reduced ceding commission or a reduced share of the contract, perhaps in proportion to the variance from projected.
In the opening paragraph I let underwriters off the hook. In most of the cases I have been involved in, the underwriter is long gone by the time the inspection takes place. The reinsurance has been placed, the underwriters moved on to a different account, and the claims and accounting personnel are the ones trying to figure out what happened. I would be surprised if these same people who were left holding the bag went back to the underwriters and told them what the problems were and how they could be corrected.
When ceding companies or reinsurers reach an impasse on a given issue, the easiest solution would be for the contract wording to be able to stand alone. Showing the penalty for failure to adhere to the contract directly in the document will not only (hopefully) reduce contract violations, but will entice the reinsurer to more closely monitor the business that it assumes.
Jack Ignatowitz is the director of the audit and consulting arm of CNA Global Resource Managers.