Contract Finality—What a Concept!
January 2006
The reinsurance industry is unique among business
ventures for its history of handshake agreements and contract terms written
on the backs of cocktail napkins.
by Larry
P. Schiffer
LeBoeuf,
Lamb, Greene & MacRae LLP
In what other industry do businesses agree to deals without a signed, final
contract document, which clearly states all the terms and conditions of the
parties' agreement? Where in business do you ever see contracting parties begin
to perform under a contract months and, historically, years before the final
contract wording is executed? Welcome to reinsurance, where deals worth millions
of dollars happen often with no more than minimal terms and conditions actually
written down as agreed between the parties.
Historical Practice
In the London market, where reinsurance effectively began, the reinsured's
broker visited underwriters individually and provided them with the basic details
of the business to be reinsured. If the underwriter was interested, the underwriter
would "scratch" or sign the broker's placement slip, which was nothing more
than an outline of the basic terms and conditions of the reinsurance with a
place for each reinsurance underwriter to indicate the level of participation
the underwriter wished to assume (the "line"). The broker would go from underwriter
to underwriter until the slip was completed (the full percentage participation
sought by the reinsured was agreed to by various underwriters). Sometime later,
the lead underwriter and the broker, on behalf of the reinsured, would agree
to the final contract wording. In the meantime, premiums are paid, accounts
are rendered, and losses are paid all before a final contract is actually signed
by the parties. Sometimes the parties agree to end their relationship before
the final contract wording is even agreed.
Remarkably, this system has persisted nearly unchanged into modern times.
Even in markets outside London, including the United States, the practice of
contracting via a slip—exchanged by fax or later by e-mail—instead of a final
contract at inception is common practice. One can only suspect that this unique
practice arose because of the special relationship between market participants
and the reciprocal duty of utmost good faith. Or perhaps the speed by which
certain insurance covers were needed, especially for marine or construction
risks, required minimal evidence of coverage to be followed up by formal contract
wording.
Even more remarkable is the historical lackadaisical attitude toward ever
finalizing the contract wording by many in the reinsurance industry. While not
common today, it was not so long ago that parties to a reinsurance contract
would fail to finalize the contract wording even after years of dealings between
each other as reinsured and reinsurer.
The Obvious Problem
It should be obvious to the casual observer of the "agree now and contract
later" practice in the reinsurance industry that failing to agree to a complete
and certain contract wording before performance begins will likely cause problems
if a dispute arises. While the slip provides the basic terms and conditions
of the reinsurance contract, the devil is in the details. What does the phrase
"arbitration clause" mean in a slip? What kind of arbitration? What are the
qualifications of the arbitrators? How many arbitrators will decide the dispute?
Or what does "ultimate net loss" mean without a full definition? Does it include
allocated loss adjustment expenses or incurred but not reported losses? We can
go on and on with brief headings of agreement and references to so-called standard
clauses that beg for full elucidation.
A typical term in reinsurance slips is the phrase "to be agreed." This phrase
may be used for many important terms of the contract, including the dispute
resolution clause and many of the definitional clauses, not to mention the final
wording ("final contract wording to be agreed by lead underwriter"). Of course,
these "to be agreed" terms often are the basis for subsequent disputes between
the parties.
For years now, parties to reinsurance contracts and their counsel have been
fighting over the terms of slips after the parties' relationship has terminated
without both parties having signed the final contract wording. What controls
the relationship, the slip, or the unsigned wording? When the reinsurance relationship
breaks down, undefined terms, abbreviations, and minimalist language provide
fodder for disputes. While the parties may have thought they understood each
other when the slip was signed, it often turns out that there was no clear agreement
on the detail of the contract now in dispute. The failure to have a final and
certain contract before the contract term begins means that the parties really
have no idea what they truly agreed to in detail.
Evidence of the seriousness of this problem was highlighted by the failure
to have a property insurance contract in place for the World Trade Center. While
not a reinsurance problem, the placement of such a unique, layered property
cover followed the traditional pattern of having the insurers agree via slips
and temporary wordings before the final property insurance contracts were signed.
As we all know, while the cover was "in place" on July 1, the terrorist attacks
on September 11 occurred before there was universal agreement to the final contract
wording. The failure of a certain and uniform definition of "occurrence" cost
Mr. Silverstein hundreds of millions of dollars (so far).
What Is Being Done about Contract Finality?
The problem of entering into an agreement before final contracts are signed
has spurred various regulatory responses across the industry. On the financial
front, the National Association of Insurance Commissioners adopted a rule requiring
that final contract wordings be signed within 9 months of the contract's effective
date to allow for accounting treatment as prospective, as opposed to retroactive,
reinsurance. Even with the 9-month rule, many reinsurance contracts are still
not finalized in a timely manner. Moreover, the 9-month rule really only addresses
an accounting issue and does not lead to contract finality and certainty at
the time the contract goes into effect.
In the London Market, "Contract Certainty" is the latest buzzword. The London
Market has drafted a Contract Certainty Code of Practice, which was created
by its Market Reform Group. Under the Code of Practice, contract certainty must
become a reality by December 31, 2006. What that means is that reinsurance contracts
incepting January 1, 2007, in the London Market must be final and certain on
the effective date of the contract. Essentially, the idea of contract certainty
is that each party will know exactly what the product is that is being sold
at the time it is being sold, so it can be priced correctly and so the purchaser
knows exactly what it is buying without any later misunderstandings. Now, under
Contract Certainty, terms "to be agreed" have to be agreed by the inception
date of the reinsurance contract.
In the United States, contract finality or certainty has not yet been imposed
to the level of the London Market Code of Practice for Contract Certainty. The
9-month rule, which really comes out of Part 23 of SSAP 62, requires that the
reinsurance contract be finalized—reduced to written form and signed within
9 months after commencement of the policy period—but allows the contract to
incept before the contract is finalized. With the problems and lawsuits emanating
from the World Trade Center, the call for contract finality at the inception
date of contracting is growing louder.
Conclusion
Agreeing to terms and conditions of a business contract on the day of placement
of the contract is only a foreign concept in the world of insurance and reinsurance.
While contract finality on the date of inception will not eliminate disputes
between the parties, it will go a long way toward reducing disputes arising
out of "to be agreed" and other ambiguous or barely referenced contract terms.
Moreover, just because there is no current regulatory requirement in the United
States for a finalized contract at inception does not mean parties may not insist
on a finalized wording at placement. Tell your reinsurance broker that you want
the final contract wording agreed and signed no later than the effective date
of your reinsurance contract. You never know, maybe you will be the first to
have a final contract wording in place before the inception date of your contract.
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