To Commute or Not To Commute, that Is the Question
July 2003
The reinsurer's obligation to cede and pay
claims continues many years after the termination of the contract, unless it
is commuted. A commutation allows the reinsured to receive cash now to invest
for the payment of future claims, and the reinsurer's commitment ends. Regardless
the reason for the commutation, and there are many, care must be taken in drafting
the agreement to avoid future disputes.
by Larry
P. Schiffer
LeBoeuf,
Lamb, Greene & MacRae, L.L.P.
Depending on the business reinsured, a reinsurance relationship may last
long after the reinsurance contract has terminated. In long-tail lines of business,
it may take 20 or more years for all underlying claims to be reported and resolved.
If that business was reinsured, particularly through a quota share treaty, the
reinsurance relationship will last until the final claim is paid and the final
reinsurance claim is submitted by the reinsured to the reinsurer.
Although the reinsurance contract itself may have only existed for a year
or two, the obligation to cede and pay claims will continue for many years after
the termination of the reinsurance contract. An alternative does exist to this
often long-drawn out reinsurance relationship. That alternative is the commutation.
What Is a Commutation?
A commutation is a settlement agreement reached between a reinsured and a
reinsurer by which the reinsurance obligation is terminated by an agreement
by the reinsurer to pay funds at present value that are not yet due under the
reinsurance agreement. Similar to a policy buy-back with an insured, a commutation
allows the reinsured to receive cash now to invest for the payment of claims
that will come due in the future. The reinsurer’s obligations for future payments
are terminated and the reinsurance contract is finally terminated in its fullest
sense.
A commutation also may be a term of the existing reinsurance contract. Particularly
in life reinsurance, accident, and health reinsurance, and workers compensation
carve-out reinsurance agreements, sunset and commutation clauses often exist.
These provisions contractually conclude the reinsurance relationship or provide
the opportunity for the reinsurer to terminate the relationship after a certain
number of years based on an agreed upon formula or other negotiated provisions.
While problems do arise if these preexisting clauses are not drafted properly,
the real issues arise with commutation agreements negotiated outside of the
terms of the underlying reinsurance agreement.
Why Commute?
The reasons for commutations differ from company to company and from line
of business to line of business. A reinsured may want to commute because it
is no longer in that line of business or it wants to maximize its reserves for
transfer or sale to another entity. A reinsured also may want to commute to
avoid the credit risk associated with its reinsurer, particularly if its reinsurer
has suffered recent downgrades and its long-term viability is questionable.
A reinsured may believe that its claims department will do a better job at settling
the underlying claims than the reinsurer believes so that it would rather take
a present value payment from the reinsurer now and eliminate the need to report
to the reinsurer on future claims. If the reinsurance agreement was placed through
an intermediary that no longer exists or is no longer capable of handling the
reinsurance claims function, a commutation may be in order for the reinsured
to avoid assuming the expense of reinsurance collections.
A reinsurer may want to commute to terminate a relationship with a reinsured
that is in run-off or one with which it no longer does business. If a reinsured
has solvency issues, a reinsurer may want to commute to avoid having to deal
with a state guarantee fund or liquidator. Commuting with a potentially impaired
company raises other issues such as voidable preferences if the reinsured becomes
insolvent shortly after the commutation agreement is negotiated. Of course,
a reinsurer would rather have a deal done with funds paid to a reinsured then
have to deal with a liquidator in the future. The flip side is that a reinsurer
does not want to find itself subject to reinsurance collection efforts from
a liquidator after it commuted in good faith with a reinsured.
A reinsurer may also want to commute where it is concerned that the reinsured
has a radically different viewpoint about the future emergence and payment patterns
of the underlying claims. If the reinsurer believes that its actuaries have
it right, a properly structured commutation may save the reinsurer future expenses.
Evaluating a Commutation
The negotiation of a commutation requires a detailed financial and actuarial
analysis of the book of business being commuted. Each party must have a clear
understanding of the number and nature of the policies issued, the value and
credibility of the reserves established by the reinsured, and, most importantly,
the value of the losses anticipated to arise in the future, otherwise known
as incurred but not reported (IBNR) losses. Each party performs its own evaluations,
but both sides must have general agreement on the policies actually issued,
the claim payments made to date, and the existing case reserves. While the parties
may differ on the IBNR, each side’s evaluation of the IBNR will have to be within
a reasonable range of each other for agreement on a commutation payment to occur.
Present value calculations and investment income assumptions are also a crucial
part of the commutation process. The reinsured will want to receive from the
reinsurer a payment that it believes will pay all future losses and expenses
based on the payout pattern for the losses and the investment income anticipated
on the commutation payment amount and its current reserves. The reinsurer will
want to pay an amount at as deep a discount as possible so that its present
value payment today will enhance its bottom line by lowering its reserves for
losses and future payment obligations. Slight differences in interest rate assumptions
may make very large differences in the economic results of a commutation.
For the reinsured, the risk is greatest because the reinsured will have to
pay the claims as they come due without recourse to the commuted reinsurance
agreement. If the reinsured guesses wrong, it will have lost the original value
of the reinsurance and the value of the commutation agreement.
The Commutation Agreement
Like any contract, careful drafting of a commutation agreement will avoid
future disputes. There have been a number of cases in the past few years where
parties thought they commuted all the business only to learn that other contracts
existed that were not included in the commutation agreement. Other disputes
have occurred where a company commutes the business it underwrote and ceded
to the reinsurer, only to learn that the reinsurer considered business written
by a managing general agent or pool manager for the reinsured to come within
the commutation. Careful drafting avoids these problems.
As in any agreement, it is crucial to properly describe and identify the
exact business that is the subject of the agreement. Sometimes a reinsurer will
agree to commute all business with a reinsured. This often happens when the
reinsured is in run-off or has otherwise stopped writing business. If the reinsurer
and the reinsured had a long-standing relationship, there may be literally hundreds
of reinsurance agreements that might be subject to the commutation agreement.
The importance of specifically identifying each contract commuted cannot be
over emphasized.
Some commutation agreements will include an appendix listing all contracts
commuted. Others will also include a clause that purports to incorporate all
reinsurance contracts between the parties, whether listed on the appendix or
not. Obviously, it is to the reinsurer’s advantage to have as broad a clause
as possible if the goal is to commute every possible agreement that may exist
with the reinsured. If the reinsured does not intend to commute a certain category
or class of agreement with the reinsurer, then those specific contracts or categories
of contracts must be specifically excluded from the commutation agreement. Confusion
or ambiguity on this point is a guarantee for a future dispute.
The clear identification of the parties subject to the commutation agreement
is another critical point to a successful commutation agreement. Because of
the holding company structure of many, if not most, insurance and reinsurance
companies today, it is necessary to identify the correct parties to any commutation
agreement.
Very often, reinsurance agreements will define the reinsured as a number
of affiliated companies, including any companies that it manages or which may
come under its control during the term of the reinsurance agreement. This is
particularly important if the business being reinsured is business underwritten
by an underwriting manager, managing general agent, or a pool manager that writes
for multiple companies. The older, long-tail business that parties seek to commute
often has these types of relationships. Proper and unambiguous identification
of the parties to the commutation is critical to avoiding future disputes.
Conclusion
Commutations are a routine occurrence in reinsurance. Commutations allow
both the reinsured and reinsurer to truncate an old reinsurance relationship
to the economic advantage of both parties. Care must be taken in drafting commutation
agreements to avoid disputes in the future by making sure that all the commuted
business is clearly identified and that the proper parties are named.
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