Should I Stay or Should I Go Now?

March 2005

Provisional notices of cancellation in continuous reinsurance contracts are the typical method used when deciding whether the contract should continue past its anniversary date. However, the time periods are strict, and failure to give notice means that the contract will continue for another year. The provisional notice of cancellation combined with a reservation of the right to withdraw the notice provides greater flexibility, allowing the parties to make a reasoned decision based on the best available information.

by Larry P. Schiffer
LeBoeuf, Lamb, Greene & MacRae, L.L.P.

Where a reinsurance contract has a fixed term, concluding the contractual relationship is simple. Unless the parties negotiate an extension, the contract expires as stated in its termination clause (yes, there are run-off issues, but let's not complicate things). The parties may rewrite the contract anew, but the old contract still expires by its terms. Notice of termination is not necessary in most cases because the reinsurance contract's termination clause is self-executing.

But when the reinsurance contract is written on a continuous basis, notice of termination must be made within the time set forth in the termination clause or the contract will continue for another term. Both reinsureds and reinsurers are often in a quandary over whether to provide notice of termination or to allow the contract to continue. To make the decision process easier, a practice has developed whereby one or both parties will send a provisional notice of cancellation (often called a "PNOC"). The provisional notice gives the parties a chance to assess the relationship, receive the annual update information for the treaty, and then decide whether they should continue the contract. If the decision is made to continue, the PNOC is withdrawn and the contract continues without interruption beyond the anniversary date.

The Continuous Contract

Reinsurance contracts are written on a continuous basis to take advantage of the long-term nature of the reinsurance partnership. Books of business take years to develop, and policy issuing companies often want the same reinsurance support year after year for consistency. A reinsurer that acts as a long-term partner with a policy issuing company will become more familiar with the book of business and will be able to offer its expertise on how to make the business more profitable for all. Moreover, as the reinsured's needs change on the reinsured book of business, the long-term reinsurers will have less of a learning curve in deciding whether to accept the modifications suggested by the reinsured.

Continuous contracts may be written as quota share or excess-of-loss treaties. It may be for reinsurance or for retrocessional contracts. They often cover most lines of business, including property, liability, and life insurance. The underlying business may range from ground up limits to catastrophe covers. Essentially, any reinsurance contract can be written as a continuous contract.

The Termination Clause

The essence of the continuous reinsurance contract is that the contract will remain in force unless notice of termination is given by a date certain. The relevant language is usually found in the "Term" or "Term and Cancellation" clause of the reinsurance contract. As usual, some clauses are more elaborate than others. A simple version of the clause is as follows.

• This contract is for an unlimited period beginning July 1, 2004 and may be cancelled at June 30th of any year by either party giving to the other not less than ninety (90) days prior notice in writing.

A more elaborate version of the clause is as follows.

• This Agreement shall take effect at June 30, 2004 and is of unlimited duration, but may be terminated as of January 1 of any year by either party giving to the other not less than 90 days prior written notice. The Reinsurer shall continue to participate in all reinsurances coming within the terms of this Agreement as respects policies issued by the Company during the period of 90 days.
• If any law or regulation of the Federal or State or Local Government of any jurisdiction in which the Company is doing business shall render illegal the arrangements made in this Agreement, this Agreement can be terminated immediately insofar as it applies to such jurisdiction by the Company giving notice to the Reinsurer to such effect.
• In the event of cancellation of this Agreement, the Company shall have the option of:

1. continuing cessions in respect of all business in force at the date of cancellation until the first anniversary date of each risk following the effective date of cancellation (but in no event shall the Reinsurer's liability continue for more than twelve months from the effective date of cancellation of this Agreement), or

2. relieving the Reinsurer of all liability as respects business in force at date of cancellation. However, the Reinsurer's liability under policies providing aggregate limits, and in respect of occupational disease and/or continuous injury claims under Workers' Compensation Specific Excess policies shall continue until the first normal anniversary date of each policy following cancellation date (but in no event shall the Reinsurer's liability continue for more than twelve months from the effective date of cancellation of this Agreement).

• The Reinsurer shall refund to the Company the applicable unearned premium (less commission as specified in Article 8) in accordance with the option exercised by the Company as above.

More recently, termination clauses have included provisions allowing for cancellation automatically upon the insolvency of the reinsured or the reinsurer or the entry of an order of receivership by any court or regulatory authority.

The Provisional Notice of Cancellation

As discussed above, the provisional notice of cancellation (PNOC) is the typical way parties to continuous reinsurance contracts handle the anniversary date of the contract. Reinsureds and reinsurers each have different reasons to consider issuing a PNOC, but fundamentally each may wish to be in a position to withdraw from the contract if it makes economic sense to do so.

From the reinsured's perspective, a PNOC may be appropriate if the underlying book of business is highly leveraged through reinsurance and the reinsured has some concern that its reinsurance support may be difficult to maintain. Also, where the business is produced by a managing agent or through a pooling agreement, the reinsured may wish to issue a PNOC while it assesses the profitability of the program.

In a book of long-tail business, the early years of the reinsurance arrangement may not tell the full story of how losses will emerge. If a reinsured sees unusual loss development in the first years of a program, it may use a PNOC as part of its exit strategy. A PNOC may also be used where the terms and conditions of the underlying business or the reinsurance contract itself are being changed. The PNOC gives both the reinsured and the reinsurer the opportunity to review and decide whether they wish to continue on the revised basis. Finally, where the reinsured or its reinsurance intermediary wish to upgrade the quality of the reinsurers on a program, the reinsured will use the PNOC device to renegotiate the contract and strengthen its reinsurance support.

From the reinsurer's perspective, a PNOC is commonly used to give the reinsurer sufficient time to review the annual statistics on the underlying business prior to the anniversary date of the reinsurance contract. Typically, a continuous contract must be canceled within 90 days of the anniversary date. On a new program, that gives the reinsurers at best 6 months of statistical data, which is not nearly enough to make a rational decision on whether to continue with the program. By issuing a PNOC, the reinsurer assures itself of obtaining at least three quarters worth of data from the reinsured and obtaining the reinsured's annual update on the program issued in advance of the anniversary date. While an additional quarter of data does not seem like much, it still gives the reinsurer a larger statistical base to judge the performance of the reinsurance arrangement.

In some life reinsurance arrangements, a provisional termination notice is given to allow the reinsurer to decide whether to stay on the treaty if the economic experience of the underlying products or assets (interest driven) improves sufficiently. If the assets generate sufficient revenue, then the provisional notice is withdrawn.

When issuing a PNOC, the party issuing notice has a choice whether to reserve the right to withdraw the notice or whether to leave it to the other party to offer renewal terms. If the reinsurer issues a PNOC and reserves the right to withdraw the notice, it usually is doing so merely to have sufficient time to receive the reinsured's annual update and evaluate the experience on the reinsurance contract. If satisfied, it simply withdraws the PNOC and the contract continues past the anniversary date. If, however, the reinsurer issues a PNOC without reserving the right to withdraw the notice, it then becomes the reinsured's option whether to invite the reinsurer to renew. In either case, if the reinsurer has an interest in receiving the annual update on the underlying business, it should express an affirmative desire to receive that information in the PNOC. Otherwise, the information may not be forthcoming.

Conclusion

In a continuous reinsurance contract, a provisional notice of cancellation is the typical method used by the parties to give them the opportunity to answer the question of whether they should continue on the contract past its anniversary date. The time periods are strict in a continuous contract and failure to give notice means that the contract will continue for another year. The provisional notice of cancellation combined with a reservation of the right to withdraw the notice gives the parties the flexibility to make a reasoned decision based on the best available information.

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