Letters of credit take on increased significance and pose some new problems to reinsurers in run-off, says Steven Anderson.

The announcement appears in the morning newspapers: “The management of Reinsurance Unlimited have put the company into run-off”. Putting down the newspaper article, ReU's director of claims is less surprised than the rest of market, but is still taking on board the changes that the morning's announcement are having on the company's claims operation.

Very soon, it becomes apparent that one place the claims department's world has changed is with regard to ReU's letter of credit (LOC) position. LOCs posted over the years to secure the company's share of reserves for unearned premium, reported losses and incurred but not reported loss (IBNR) take on a heightened significance, and pose some new problems.

Last week, the bank issuing ReU's LOCs required less than full security for outstanding LOCs. This week, those relaxed funding requirements are likely to be the first casualty of the reinsurer's change in status. The bank will now require it to back its obligations fully with cash or highly liquid (read, low interest) securities, with consequent impact on its cash position and investment income.

ReU's relationship with brokers has changed as well, with implications for its LOC program. Pre-run-off, the brokers did a reasonable job of working with ceding companies to adjust LOCs up or down to track changes in the reserves that the LOCs secured. Now in run-off, the reinsurer will find it must rely mainly on its own efforts, including direct negotiations with ceding companies, to see that overfunded LOCs are reduced.

Most changed are ReU's relationships with its cedents. Where once the ceding companies saw its reinsurance as a resource for their growth, the reinsurer's run-off announcement has rendered the relationship one dimensional. To its reinsureds, ReU has now become solely a debtor. Exacerbating that change in status is the ceding companies' concern for the security of that debtor, a concern born from a history of watching other run-offs, announced with confident predictions of ample surplus, turn into insolvent schemes of arrangement.

Two consequences are likely. First, the ceding companies will be reluctant to reduce ReU's LOCs securing claims that have been paid or otherwise reduced. Proceeding on a bird-in-the-hand mentality, the ceding companies will not want to agree a reduction in an existing LOC until they become confident that the reinsurer is paying losses as they fall due and is also adding to its other LOCs as the reserves they secure are increased or new losses advised. If ReU does settle losses and post or increase LOCs when called upon, it will see an accelerated growth in its overall LOC position. The second consequence is more dire. Aware that ReU's shares of some reserves are already unsecured, and faced with the prospect of that trend continuing, some ceding companies will make pre-emptive strikes, draw down all LOCs, and hold the funds drawn as security for all of the reinsurer's obligations.

ReU's claims director knows that there have been unjustified drawings before and following management's announcement of the run-off. He feels confident, too, that a substantial part of the company's outstanding LOCs are overfunded. But what are the company's rights with regard to those overfunded LOCs and LOCs drawn without justification - and what are the remedies by which it can enforce any such rights?

The common perception is that providing an LOC is tantamount to giving the reinsured the key to the reinsurer's bank account to the extent of the LOC's face amount, that the term of that charge is effectively forever because of the LOC's “evergreen” clause, and that the reinsurer is virtually powerless to prevent or correct abuse by a beneficiary. The first element of that perception is partly true; the second and third are mistaken. In fact, the reinsurer can recover wrongful drawings and can unwind the company's LOC position to the extent of overfunded accounts, with a net recovery to the reinsurer's treasury.

To understand ReU's rights and remedies, the claims director must understand the basic triangular relationship among (1) the reinsurer posting the LOC, (2) the bank issuing the LOC and (3) the reinsured/beneficiary.

Beginning with the triangle's first leg, the LOC is the issuing bank's promise to the cedent/beneficiary to pay any amount up to the face value of the LOC. LOCs used in reinsurance transactions are “clean” and “irrevocable”. A clean LOC can be drawn by the beneficiary on a bare draft without documentation supporting the beneficiary's contractual right to the funds. The irrevocable feature, central to the LOC's commercial utility, means that the issuing bank cannot withdraw its promise during the LOC's stated term. Augmenting the LOC's irrevocability is its “evergreen” clause. This clause varies in its mechanics, but its purpose is to compel renewal of the LOC at the end of its stated term, ordinarily one year. This objective is typically accomplished by a provision stating that the LOC will be renewed automatically at each expiration unless the issuing bank gives notice in advance that renewal will not be made, and providing further that, if such notice is given, the beneficiary may thereupon draw the full face value of the LOC.

Turning to the next leg of the triangle, the relationship between the issuing bank and the reinsurer putting up the LOC is governed by a reimbursement agreement. Not surprisingly, the issuing bank - having committed its credit unqualifiedly, irrevocably and seemingly in perpetuity - requires a lock on the reinsurer's funds at least as great. The consequence is that a not insignificant part of the reinsurer's assets is tied up as security for the LOC programme, typically in liquid, low yielding investments. Upon receipt of a demand on the LOC, the issuing bank simply helps itself to an equivalent amount from the reinsurer's funds that it holds. So much for the unpleasant facts. The good news resides in the third leg of the triangle. It is here, in the relationship between the ceding company and the reinsurer posting the LOC, that the latter's right and remedies lie. In that leg, a distinction exists between what the cedent can do with ReU's LOCs and what it may do. The distinction between “can” and “may” has real significance in the reinsurance LOC transaction.

The relationship between the reinsurer and reinsured, as it affects LOCs, is set by two documents - the reinsurance contract and the LOC trust agreement. For purposes of defining what the reinsured may, and may not, do with the LOC, the trust agreement is the more important of the two.

Most London market reinsurers of North American risks are participants in the Citibank LOC scheme. Each LOC issued under the scheme is the subject of a specific trust agreement between the cedant and the reinsurer's scheme counsel, Mendes & Mount. The trust agreement is entered into contemporaneously with the posting of the LOC to which it pertains and is updated periodically by revisions of the agreement's “exhibit A”. Following a standard form, the exhibit A of each trust agreement identifies the particular claims or contracts that the LOC secures.An example of how an exhibit A to one of ReU's trust agreements could look.

EXHIBIT “A”
Reinsurers' shares of losses reported
and outstanding including allocated
loss expenses as at 31 December, 1999

Policy No. USX 1234 AA
1st Casualty XL
Bad & Worse, LLP
D/L: 8/1/83

Reinsurers % borne Amount advance
ReU 2.377% $234.67
Policy No. USX 1234 AB
1st Casualty XL
Dark & Stormy, Ltd.
D/L:7/1/82

Reinsurers % borne Amount advance
ReU 2.377% $101.24
Policy No. USX 1234 AD
1st Casualty XL
Careless & Actionable, Inc.
D/L: 6/1/82

Reinsurers % borne Amount advance
ReU 2.377% $22,888.25
Grand total $23,794.74

Reinsurers' shares of unearned premiums as at - nil -

Reinsurers' shares of losses and allocated loss expenses paid by the ceding company, but not recovered from the reinsurers - nil -

Reinsurers' shares of losses incurred
but not reported - nil -

The text of the trust agreement then defines, with reference to the exhibit A, the circumstances in which the ceding company may draw on the LOC and the uses to which the drawn funds may be put. The agreement permits the ceding company to retain the drawn funds for three purposes only:
• to reimburse itself for paid losses and allocated loss expenses presently due from the reinsurer, as those loss items are defined in the agreement's exhibit A;
• to reimburse itself for unearned premium previously remitted to the reinsurer, as reflected in the agreement's exhibit A;
• if the reinsurer has given notice of non-renewal of the LOC, to fund a separate, interest-bearing bank account in trust for the two uses identified above or for return to the reinsurer to the extent that the amount drawn exceeds the obligations of the reinsurer, as those obligation are identified in the trust agreement's exhibit A.

The trust agreement further requires the ceding company to return to the reinsurer any overdrawing in one of two ways. The ceding company must either “immediately” reinstate the LOC for the full amount of the overdraft, or it must refund the overdrawn amount, with interest, to the reinsurer.

Most significantly, the trust agreement forbids two “self-help” remedies that are all too frequently employed by ceding companies dealing with reinsurers in run-off: pre-emptive draw-downs and resisting reduction of overfunded LOCs with a view to using the proceeds at some later time to settle different losses not secured with an LOC.

Those self-help initiatives are based on two fallacies, both of which spring from the ceding company's confusing what it has the power to do, ie what it can do, with what the trust agreement permits it to do. The first fallacy lies in the ceding company's assumption that, because the LOC gives it the power to draw funds without providing supporting documentation (ie because the LOC is “clean”), the ceding company may apply the drawing, now or later, to another debt of the reinsurer. In fact, to the extent that the ceding company has drawn on an LOC without justification, it holds the overdrawn funds in trust. The ceding company's application of those trust funds to another debt owed it by the reinsurer is a breach of trust and exposes the ceding company to damages.

This brings us to the answer to the remedies question posed above and to the second fallacy of the ceding company embarked on a self-help programme. The second fallacy is that the ceding company, in helping itself to its reinsurer's LOC funds, runs no greater risk than being returned to where it was before its pre-emptive strike. In fact, an LOC beneficiary that knowingly or recklessly makes a wrongful drawing is exposed not only to a claim for reimbursement and interest, but also a claim for punitive damages. In one prominent US case, punitive damages awarded for a reckless drawing on an LOC were ten times the amount of the drawing. In the author's experience, the in terrorem effect of punitive damages on top of damages and interest is virtually always sufficient to negotiate recovery of the wrongfully drawn LOC funds.

Returning to ReU's claims department, we find the claims director pensive but smiling. In run-off, the claims director is top dog. With an understanding of his company's rights and remedies, the tools are available to turn the LOC problems into opportunities.

Steven Anderson is with Barger & Wolen, New York.