Self-Motivation or Regulation

There's a movement in the Reinsurance Industry to have contracts signed at inception. Can we do it?

Introduction

Historically, the Sellers and Buyers of reinsurance have been notoriously lax in getting "actual contracts" negotiated, drafted and signed. We all know the heralded stories of "handshake deals" and "cover notes written on napkins"; everyone knew each other and deals were done as a gentlemen's agreement. The deal was priority, the contract was not. With the growth of the reinsurance community and the involvement of larger sums of money, this remiss practice led to "regulatory involvement' in 1994 when the Plenary Committee of the National Association of Insurance Commissioners (NAIC) adopted amendments to Chapter 22 of the NAIC Accounting Practices and Procedures Manual establishing what has become known as the "Ninth Month Rule".

Ninth Month Rule

In the early 1990's there was regulatory concern that parties to a reinsurance agreement may reconstruct essential coverage terms of a previously negotiated reinsurance deal after the losses have occurred in order to take reinsurance credit for a transaction that involves no transfer of insurance risk.

Thus, on September 18, 1994 amendments were adopted which revised Chapter 22 of the NAIC Accounting Practices and Procedures Manual. The Manual is used by most states to establish statutory accounting practices for insurers. Specifically, Chapter 22 governs how reinsurance transactions will be accounted for in the financial statements of insurance and reinsurance companies.

One of the amendments prescribed a special accounting treatment for reinsurance transactions where the contract associated with said transaction has not been signed within nine months of the inception date of the transaction (i.e. the "Nine Month Rule"). Thus, if a contract is not signed within the specified nine months the underlying transaction will receive retrospective accounting treatment which would significantly impact the financial statement of the insurer.

Silverstein and Spitzer

Following the events of September 11, 2001 (in particular, the Silverstein case) and the investigations of the industry by the Attorney General of New York, it is not hard to imagine that regulators may once again take a look at how the industry executes its contracts. Is this what we want as an industry?

Ronald Reagan once said "the nine most terrifying words in the English Language are: 'I'm from the government and I'm here to help.'" Well... I won't go so far as to say regulators are terrifying, but if we are not proactive enough to help ourselves, we can be sure that we'll be faced with further regulations.

The issue in the Silverstein case had to do with the definition of "occurrence" or rather the lack thereof. This issue arose because the parties failed to reach agreed upon contract wording before the loss occurred. While this example is in the context of an insurance binder, the same problems emerge in regard to reinsurance placement slips. In any case, this exposed to the public and highlighted to regulators a less than sophisticated business practice that occurs in both the insurance and reinsurance industries. (i.e. incomplete terms at inception). It should not have been surprising; many examples of this type of issue have been happening for years.

New York Attorney General Eliot Spitzer's investigation threw the spotlight on a heretofore little known industry and the lack of disclosure that was exposed has no doubt cast a shadow on the image of our industry with consumers and regulators. The fact that, as an industry practice, contracts are not signed until almost nine months after the inception date only darkens that shadow of suspicion.

These events have rightfully awakened some in the industry to push for contracts to be signed by inception with full disclosure of all contract terms and conditions.

London Market and Contract Certainty

In London, the Financial Services Authority (FSA) ("an independent non-governmental body, given statutory powers by the Financial Services Ad Markets Act 2000"; according to its website) has set a challenge for the UK insurance industry to achieve "contract certainty" by the end of 2006. Should the industry fail to meet this deadline the FSA has indicated that regulatory intervention will result with possible "operational risk charges, other capital charges and specific rules."

Nick Prettejohn, CEO of Lloyds, in a speech to the Insurance Insider Breakfast Briefing stated that there are commercial and regulatory reasons for a move towards contract certainty which he defined as "not only contract delivery" (i.e. having a contract produced or drafted prior to inception) but as a "complete and final agreement of all terms between the insured and insurers before inception". Prettejohn explained that contract certainty is essential in order to minimize risk because without it underwriters have uncertainty about their exposure: "uncertainty over exposure for underwriters leads not only to reserving risk but also to an inability to properly understand business performance and therefore pricing. Inability to calculate exposure properly leads to capital misallocation." Thus, he states, there is a "commercial case" for contract certainty.

Prettejohn further explained that if insurance/reinsurance companies fail to achieve contract certainty and thus cannot fully assess their exposure then the rationale for regulatory interest (FSA) is obvious.

Prettejohn concludes that, "We have no choice in the drive to contract certainty; we simply have to make it happen. The commercial and regulatory rationale cannot be denied. As such, I would prefer that as far as Lloyd's is concerned, we do not have to exercise any mandate or sanction to enforce compliance. A voluntary market solution is distinctly preferable and it is certainly to be preferred to FSA enforcement."

The London Market is on its way to meeting their goal. Where are we and can we strive toward the same goal without regulatory intervention?

Slip vs. Contract

Much of what Nick Prettejohn says also applies to the US Reinsurance Market. In order to have "contract certainty" (to borrow that phrase from our UK colleagues) there must be a complete and final agreement of all terms and conditions between the ceding company and the reinsurers before, or immediately following, inception.

Just out of law school I started my first "reinsurance job" barely having any idea of what "reinsurance" was. On my first day my new boss pointed out a pile of contracts that I could work on that "just came in". Upon my review I noticed that these contracts that had "just come in" in September of 1988 had inception dates of January 1, 1977. Granted they were property cat covers, but just the same, it offended the sensibilities of a recent law school grad. What type of industry does business without a complete and signed contract? I wondered what I had gotten myself into.

Needless to say those "sensibilities" relaxed as I continued my reinsurance career and realized the reality that contracts were, in fact, signed at or before inception. They were called "placement slips" or "cover notes", and though bare-boned they were still legally binding contracts. A more "complete" contract would be negotiated, drafted and signed at a later date, sometimes much later, as my anecdote indicates.

Any writing is enough to form a contract if it shows the intention of the parties to make an offer and acceptance. Thus, when a slip shows a promise by the insurance company to offer or cede premium and risk in exchange for a promise by the reinsurer to accept the premium and risk, you have a valid contract. Whether a slip contains enough information to answer all issues arising about the interpretation of the formed contract may be questionable. Any issues not fully vetted would be left for the parties to come to terms with in their business dealings or if they are unable to do so then to be decided by an arbitrator or judge.

With the advent of the Nine Month Rule, many reinsurers and brokers complained that it would be impossible to get contracts completed within such a time frame, (history shows this to be wrong, but it was the prevailing thought at the time). This new compressed time period pushed the brokers (and the direct markets) to include not just the usual laundry list of clauses in the slip, but to actually attach examples of clauses that were expected to be in the contract. This of course, has taken us a long way from the bare-boned cover note to something which had some substance to it. However, in light of the current market place we need to go farther.

I would argue that for purposes of "contract certainty" we need to push forward with a completed actual "contract" and not just a "complete slip" at inception. Since the use of a slip seems to imply that the terms and conditions are not yet completely set. Further to those persons not "in the business", consumers and shareholders for example, it may seem like an actual contract has not been agreed to and it is just business as usual.

Contract Certainty

The problems with obtaining contract certainty are many. Having to negotiate contract provisions other than the strictly financial terms of a placement can lengthen and intensify the negotiation/placement process and put further pressure on an already hectic and harried renewal period. If it takes more time to negotiate the placement slip, it could possibly lead some brokers to fail to fully place coverage by the inception date, thus doing a disservice to their clients. Note that particularly in the "broker market", because coverage is placed by "subscription", you may not obtain agreements by all reinsurers at an early enough date to have the contract in place by inception. Very often the dynamics of negotiation take discussions right up to the inception date. In this case, considering that an underwriter's authorization is at least partially based on the contract provisions, the underwriter would not be able to have a contract "in hand" at inception that reflects what has been currently negotiated.

Some have suggested "standardized wordings". In that regard, maybe it would facilitate a quicker review of the wording because of familiarity. However, as a practical matter each cover is different; from the rate charged to the business covered, and thus "standardized wording" will not work in all situations. There is also the question as to whose "standardized wordings". What the ceding company would tend to want as "standard" may tend to be what the reinsurance market would like least and vice versa. Any "industry standard" may run afoul of anti-trust considerations. In any case it is important to note that the placement of reinsurance is a negotiated process and the type of wording that the underwriter may be willing to accept on one piece of business, he or she may not be willing to accept on another. Thus if the contract is to truly reflect this and be a negotiated product then underwriting submissions must in turn be submitted earlier for a complete review even if "standard wording". If it is not a truly negotiated process, then ultimately these "standard" contracts will be looked at as contracts of adhesion. Thus, while standardization may help it is not a panacea to the issue of contract certainty.

How then can the Reinsurance Industry accommodate this change? Greater regulations are certainly one answer. However, the insurance industry is already heavily regulated and I would guess that most would agree that more regulations and the bureaucracy that accompanies them would not be welcome. What is needed is a change in the way we do our business, a paradigm shift. If we are going to make it work, this shift needs to be supported by everyone - brokers, underwriters and ceding companies. But such a shift in behavior can only come about through leadership at the senior management and board level, given the resistance of human nature to change. But the change is coming one way or another and it behooves us as an industry to move forward on our own volition.

It is important to note the resistance to the Nine Month Rule in the early 1990's. Underwriters and contract writers said it couldn't be done; the industry would be hard pressed to produce and sign a contract within nine months. Well, it was done, and currently virtually all contract documentation is negotiated, drafted and signed within nine months of the inception date. This was, of course, accomplished because it had to be, despite the perceived difficulty, because the accounting penalties for not doing so were too significant. However, it was accomplished with a great deal of anguish (at least on the part of reinsurers and brokers) and fear of costing accounting penalties to client ceding companies.

At a time when our industry is faced with the possibility of further regulations and probably further angst in complying with whatever regulations may be imposed, it would seem preferable, as an industry, to voluntarily adopt changes rather than to have regulations with penal provisions thrust upon us.

Random Thoughts

o Contracts can be negotiated, agreed to and signed before inception if the wordings are received by the reinsurers much earlier in the placement process (September-October) and possibly assigning a deadline for subscription prior to the actual inception date. However, this would entail that the brokers obtain all placement/renewal information and agreement to contract terms from their clients at a very early date.

o A cultural shift may cause change in our business structure, how we do business and the workload cycle (i.e. amount of personnel needed). Brokers may consider convincing their clients to stagger inception dates throughout the year rather than just 1/1 and 7/1.

o Consideration needs to be given to version identification when changes are made due to negotiations. (Are we looking at the latest document?)

o Any movement towards contracts being signed by/at inception would be remiss if it didn't address contract ambiguity

Acknowledgments

This article would not have been written but for my participation in a conference involving some of the best contract experts in our industry: Pam Parkos of BRMA, Kevin McCune of Willis Re and Rich Lagani of AIG. I was humbled to be asked to join them on the panel discussing this very topic. Further, I wish to extend my gratitude to Jon Colello and Eileen Villeroel of AXIS Re whose comments and assistance on this article were invaluable. Lastly, but not least, I thank Ron Moore of AXIS for giving me the opportunity to write this article for "Declarations".

Disclaimer

The information contained in this commentary is without any form of warranty expressed or implied. Any use of the information contained within this article is solely at your own risk. All opinions in this commentary are personally those of the author and do not represent the views of AXIS Reinsurance Company or any other company or person.

Mark Reynolds is Vice President and Senior US Reinsurance Counsel of AXIS Reinsurance Company. Mark joined AXIS Re in 2004 and serves as manager of the Contract Department and legal counsel to the underwriting staff. Mark also provides reinsurance contract support to AXIS? sister companies globally. AXIS Re is located in New York, New York and is a member of the AXIS Holding Group which is headquartered in Hamilton, Bermuda.