Richard Leedham looks at the problems surrounding reinsurance recoverables.
Picture the scene: we are in the boardroom of Utopian Insurance Co in London. Its Finance Director and Head of Reinsurance are finalising management accounts for the first six months of 2003. The Finance Director glances at a spreadsheet of reinsurance recoveries, protecting Utopian's inwards book, and notes that the company's accountants have listed them at full value in the management accounts. He has a brief discussion with the Head of Reinsurance that a number of the companies which reinsure Utopian have recently been downgraded by the ratings agencies. He makes a mental note to keep this in mind during a forthcoming regular meeting with the Financial Services Authority (FSA), but as all the companies appear to be solvent he cannot see this even being discussed with the regulator. The Finance Director signs the management accounts and sets his mind to the various inwards claims that are currently occupying the company.
It is not too far-fetched to assume that this is a common scenario, playing out across the boardrooms and offices of London market insurance companies in terms of how they treat their reinsurance asset. Whilst changes are on the way, current UK accounting regulation allows for reinsurance recoverables to be listed in balance sheets at their full value. Similarly, as regards FSA returns, whilst these are more prescriptive, in general terms, the FSA does not apply discounts to the reinsurance asset when considering an insurance company's solvency. As a result of this trusting, if not naïve, attitude towards the reinsurance asset and given the combination of different events currently confronting the market, many ceding companies are sitting on a time bomb.
Like many difficult issues facing the reinsurance market, the problems stem from an inability of the market to adapt to changing times. Two or three decades ago it was expected that reinsurers would simply pay claims on demand. There were, of course, contested claims from time to time, but the focus of insurance companies was on the inwards book, on writing premium income and managing inwards claims. Reinsurance was seen as a dull, if vital, administrative necessity.
The reinsurance market has undergone a sea change over the last 30 years. Whether it is a result of a more litigious society or simple commercial realities, reinsurers now routinely take defences that they would not have done before.
There are two main reasons for this. First, many reinsurers simply cannot afford to pay the claims now presented to them. This may be because they are fringe market players which wrote for premium income in the 1960s and 1970s and deliberately now delay or avoid payment of claims. Increasingly, however, they are companies that through no fault of their own face financial difficulties; many are considering or have gone into run-off or even more advanced stages of liquidation. What is clear is that the reinsurance market has a liquidity problem. The general trend over the last 20 or 30 years has been exacerbated by the large number of huge catastrophes in the late 1980s and early 1990s, and most recently by 9/11. This has, in turn, lead to wholesale security downgrades by ratings agencies (the de facto regulators of the industry). Just as night follows day, if a company has a liquidity problem, it will seek to delay and find reasons for not paying claims.
The second principal factor is rooted in the impact of litigation and arbitration on the reinsurance market. Whilst it is a generalisation, it is fair to say that the trend in English reinsurance law has been to favour the reinsurer over the cedant. For example, jurisprudence surrounding the follow settlements clause, originally introduced into wordings to try to ensure that a settlement, fairly reached by the cedant, should be paid, effectively on demand, by the reinsurer, now entitles excess of loss reinsurers to put the cedant to proof that all inwards losses fall within the terms of the relevant contracts (Hill v M&G). Over the years, English courts have rejected claims that compromise settlements and defence costs are automatically recoverable (Commercial Union v NRG and Black Sea & Baltic v Baker respectively), and have questioned the recoverability of asbestos payments made under the Wellington agreement (Hiscox v Outhwaite) (see related article p61). In short, there are a plethora of defences available to a reinsurer which, genuinely or otherwise, wishes to challenge a cedant's settlement.
The string of recent cases on the meaning of 'event' (Caudle v Sharp, Axa v Field, Cox v Bankside - managing agent's/underwriters' E&O; Mann v Lexington - Indonesian riots; Kuwait Airlines v Kuwait Insurance, Scott v Copenhagen Re - 1990/91 invasion of Iraq; Lloyds TSB v Lloyds Insurance - pension mis-selling - a selection of cases, all since 1995), have as a general trend not allowed the widest basis of aggregation sought by insureds/cedants, generally to the benefit of reinsurers.
Aside from anything else, the vast number of cases, often taken to the appellate courts, demonstrates how litigious the reinsurance market has become and how hard it is to make recoveries.
A combination of these two principal trends has led a variety of companies - not simply the traditional 'don't pay, won't pay' reinsurers - to withhold settlement, take legal points, and require cedants to act as 'prudent un-reinsureds' in the defence of claims, at a time when those very same reinsurers' ratings are falling. Yet at the same time, the insurance market continues to value reinsurance recoveries at their full book value and takes few proactive steps to make the recoveries. The market literally cannot continue in this way, firstly as changes are underway to the way in which reinsurance assets are treated, and secondly as insurers do need to take steps to protect their own position.
On the regulatory front, the EU is currently considering a draft reinsurance directive that would require EU reinsurers (and therefore ceding companies which also write reinsurance) to increase their solvency margins substantially. Entitled 'SolvencyII', the directive would mean that a reinsurer's solvency could be set at up to 150% of the direct insurance level in an attempt to bring solvency requirements of banks and insurance companies into line. This would see a move away from the current UK regime of companies performing their own risk-based analysis as regards solvency towards meeting the set criteria.
On the accounting front, the International Accounting Standards Board (IASB) is taking steps towards the creation of a new accounting environment for insurance companies. Exposure Draft ED5 Insurance Contracts was published at the end of July 2003 which, if implemented, would effectively mean that companies could not list reinsurance recoverables at full value, but instead would be required to attribute a market value to them, taking into account some of the solvency and recoverability issues set out above.
Both sets of regulations are some years away from implementation and are being challenged by various insurance bodies, but the message is clear - the reinsurance asset will be looked at in the future in a more critical fashion by both regulators and auditors.
Options for cedants
Set against this background, what can cedant companies do to protect their position? Steps can be taken internally to first analyse, then evaluate the strength of the reinsurance asset. This should be done not simply by looking at the relevant ratings of the company, but actively managing claims. Guidance here can be taken from those companies that advise the run-off market, which often as a first step consider the liquidity and solvency of the company's reinsurers with an open, rather than Utopian, mind. One exercise that can be carried out is to look at the age of the debt. It is a truism that if nothing is done to recover the debt, then that debt will eventually become time barred, offering reinsurers a cast iron defence to any claim. There is a fallacy in the insurance and reinsurance market that a regular chaser letter, typically from the broker, will suffice to protect the position. Under English law reinsurance recoveries become time barred six years from the date in which the cedant company agreed its own inwards liability which triggered its ability to claim on its reinsurance. At the very least, insurance companies should be addressing this issue by way of an internal audit and then actively, and if necessary aggressively, pursuing that debt.
In terms of that pursuit, unless a standstill can be agreed with a reinsurer or the reinsurer is prepared to formally admit the debt, it is only possible to stop time running by commencing legal proceedings, by issuing a claim form or serving Notice of Arbitration. Many companies baulk at that concept, on the basis that it may be all well and good for the run-off market, where relationships have deteriorated, but would never do in the ongoing live market, where relationships with brokers and reinsurers alike are key to the ongoing business of the ceding company.
This view is not only outdated, but dangerously wrong. First, it is wrong to assume that in the run-off market 'anything goes'. There are relationships that need to be preserved there in terms of recovering asset, just as there are in the ongoing market. For example, Spectrum, which manages six of the Crowe syndicates in run-off, states that whilst they have liability of over $1.1bn, they have $500m worth of reinsurance recoverables. Blithely commencing arbitration and litigation in respect of sums of that order, which will be spread around the globe and administered by a network of brokers and run-off agents, would be madness.
Second, whilst acknowledging that relationships are important, a dose of reality needs to be applied. If a reinsurer is deliberately withholding funds or delaying payment, and there is a belief that the broker is not acting as expeditiously as it should on behalf of the ceding company, what really is the strength of the relationship that a company seeks to preserve by not taking legal action? Reinsurers live in a commercial world, where they are prepared to take time bar and other defences to protect their own solvency. Ceding companies should do the same, and if they do may, if anything, gain grudging respect from their counterparties, rather than mock outrage.
A further tip is not to be afraid of pursuing the legal route, and if necessary viewing this as a long-term strategy. Not every case of unpaid reinsurance recovery ends in litigation. There are sophisticated service providers in the market, be they lawyers, accountants, run-off managers or other specialists, which can bring their skills to bear to free up the reinsurance asset. However, there does come a time when the threat of legal action is necessary. The aim is to sort the genuine defences from the merely speculative.
Our experience is that using the legal arguments set out above, reinsurers will put a variety of hurdles in the way of a ceding company, not least requesting inspections and putting the cedant to proof of each and every claim. However, with the right information, advice and research, and it has to be said, a stomach for the fight, a cedant should hope to recover assets where they exist. This latter point is key, as there is no point pursuing a reinsurer that simply does not have any money. However, if assets can be identified (and there are options available to obtain and enforce judgments and seize assets in the UK and worldwide), a cedant should expect to recover its reinsurance if it has dealt with its inwards claims properly. Whilst a reinsurer may argue time bar, a cedant can respond by, if available, replacing time barred claims with newer fresher claims, and can insist on interest being paid to it. In our experience, many of the generic issues raised by reinsurers (for example, event-based defences on asbestos claims, Wellington arguments, defence costs, etc) fall away once the ceding company can demonstrate proof of its own inwards liability.
Finally, although there is a growing feeling that the UK arbitration process is failing the insurance and reinsurance industry, the English courts provide a first-class alternative. If parties have agreed to arbitrate their disputes then arbitration route is the only practical course. Where they have not, however, or are prepared to argue to litigate, the courts should be considered. Judges and the use of court rooms are free, and unlike arbitration, court decisions create binding precedent. Judges are available to hear emergency applications, and under English civil procedure rules will proactively manage disputes. Many of the judges in the Commercial Court were previously commercial silks who 'cut their teeth' on the reinsurance disputes in the 1980s and 1990s, and are aware of the commercial realities facing the reinsurance world.
The message to the insurance market is loud and clear: ignore your reinsurance asset at your peril. Use the options available to you to make sure it is a true recoverable.
By Richard Leedham
Richard Leedham is a partner in the reinsurance group of London law firm Addleshaw Goddard.