COMMUTATIONS IN REINSURANCE The ARC Commutations Manual (Second Edition) WSIL 248 - Commutations in Reinsurance 2nd Ed.indd 13/26/2009 11:45:15 AM v CONTENTS About the Contributors Foreword The Association of Run-off Companies 1 Introduction to Commutations 2 Issues to be Considered 3 Legal Aspects 4 The Accounting of Commutations 5 Insolvent Companies 6 The Actuarial Evaluation 7 The ins.sure Commutation Facility (LPC) 8 Commutation Checklist 9 Database of Commutation Contacts Appendices This manual has been designed to be an everyday tool for its users as they plan, perform and record commutations. A number of organisations from separate sectors of the industry have come together to prepare it, to give as wide a view as possible of the current accepted best practice and procedures. However, the science of commutations is new and fast-developing, and we realise that we need to keep abreast of modifications as they occur. To help us do this we would welcome suggestions from readers updating or enlarging on any of the topics in this manual. Send your comments to Leslie-Ann Giovnilli at secretary@aroc.org.uk At this time there is no legal precedents concerning the recoverability against outwards reinsurers of certain elements of inwards commutations, but it should be noted that UK and European law are changing all the time. Also an increasing number of liquidations/ schemes in the (re)insurance market may effect the current ease with which commutations are performed. WSIL 248 - Commutations in Reinsurance 2nd Ed.indd 53/26/2009 11:45:16 AM COMMUTATIONS IN REINSURANCE 1819 2.8 Other types of FS clause may impose qualifications or provisos. These must be given full weight. Thus, the Court of Appeal has clarified that a reinsurance treaty containing a provision making it a condition precedent to the reinsurer’s liability: “... that settlement by the reassured shall be in accordance with the terms and conditions of the original policies or contracts” requires the reinsured to demonstrate actual liability to the assured.4 2.9 Similarly, an FS clause in the following form is common in treaty reinsurance: “All loss settlements by the reassured including compromise settlements ... shall be binding upon the reinsurers providing such settlements are within the terms and conditions of the original policies ...and within the terms and conditions of this reinsurance.” The House of Lords has made clear5 that such a clause will allow a reinsurer to challenge the settlement by its reinsured of the underlying claim on the grounds that the loss does not fall: (a) within the scope of the original contracts written by the reinsured; and (a) within the scope of the reinsurance. Inspection 2.10 Quite apart from the scope of the obligation of a reinsured under an FS clause to prove its loss. A reinsurer considering a commutation will often wish to satisfy itself that the liabilities which it is being asked to commute are properly due. To do that, it may in some cases wish to inspect its reinsured’s relevant records.6 2.11 Reinsurance contracts generally contain inspection clauses allowing a reinsurer to inspect its reinsured’s books and records. If that is the case, then the reinsurer will be entitled to exercise its contractual rights of inspection within the scope of the inspection clause. (4) Commercial Union -v- NRG Victory [1998] 2 All ER 434 (5) Hill -v- Mercantile & General Reinsurance Co plc LI996] 1 WLR 1239 (HL) (6) For more detailed information regarding inspections of records refer to ARC’s Inspection of Records (Witherbys 2001) WSIL 248 - Commutations in Reinsurance 2nd Ed.indd 183/26/2009 11:45:18 AM 1819 LEGAL ASPECTS 2.12 Where there is no express contractual inspection provision, a right of inspection will usually be implied by law7. As is the case with an express provision, it cannot be used by a reinsurer to engage on a purely speculative “fishing” exercise and it will normally be limited to a right to inspect records and accounting documents relating to the contract in question and no others. 2.13 Whether or not there is an express or implied inspection provision, in the context of a commutation negotiation, a reinsurer is unlikely to wish to commute unless it can conduct an inspection to satisfy itself that the business, which has been ceded by its reinsured, is of the correct categories and has been handled correctly. As a matter of practicality, it is therefore sensible to allow an inspection to take place. IBNR and Outstanding Loss Reserves 2.14 It should be easier for a reinsurer to verify the paid claims than the outstanding loss reserves and IBNR of its reinsured. The reinsured may offer an actuarial assessment of its outstanding loss reserves and IBNR and a reinsurer may even engage its own actuary and/or inspection agent to review such an assessment. Either way, both parties should be absolutely clear on the exposure which they are either relinquishing or taking back, especially in the case of long-tail liability treaties where the future may be highly uncertain. In particular, the IBNR element should be carefully scrutinised to ensure that the commutation price falls within an acceptable range given the potential exposure gained or lost as the case may be. 2.15 In the absence of express provision in the reinsurance agreement, a reinsurer’s only contractual obligation is to pay ascertained or agreed claims (i.e. claims which have at least been quantified and agreed by the reinsured even if the reinsured has not paid). It is not contractually obliged to make payments to its reinsured in respect of outstanding losses and still less in respect of IBNR. Its retrocessionaire may therefore decline to indemnify it in respect of any commutation made by the reinsurer to its cedant in respect of outstanding loss reserves and IBNR. 2.16 The question whether a reinsurer is obliged to indemnify its reinsured for the reinsured’s commutations of its inward claims based on actuarial valuations has been addressed only once by the English Courts8. The reinsured had obtained approval from the Bermuda Court of actuarial (7) Phoenix -v- Halvanon [1987] 2 WLR 512 (8) Re a Company No.0013734 of 1991 [1992] 2 Lloyd’s Rep 415 WSIL 248 - Commutations in Reinsurance 2nd Ed.indd 193/26/2009 11:45:18 AM