Insurance companies purchase reinsurance for various reasons, including to reduce their net exposure to loss arising from the insurance policies they have issued to policyholders. Common sense dictates that a reinsurance contract protecting a ceding insurer will align with the underlying risk and the underlying policy wording to create a seamless recovery against the reinsurance contract when losses arise on those underlying reinsured policies.
Usually, that is the way it works. Liability policies are reinsured by reinsurance contracts with liability wording, property policies are reinsured by reinsurance contracts with property wording, and life insurance policies are reinsured by reinsurance contracts with life insurance wording. But sometimes, there is a misalignment between the underlying reinsured policy and the reinsurance contract. When that happens, there can be regulatory, financial, claims, and dispute consequences.
Contract Drafting
Look, we are all busy. Sometimes, it is easier to grab a form off the proverbial shelf, mark it up, and be done with the process. In the old days, this was called a "cut-and-paste job." Most insurance/reinsurance companies and brokers have libraries of carefully drafted models to choose from when drafting a new reinsurance contract, so what could go wrong? With the advent of artificial intelligence (AI), this grab will become easier, but will it resolve the issue?
My contract drafting mantra is, "Mean what you say, and say what you mean." While this might not necessarily apply directly to misalignment in contract wording, the overall sentiment is similar. The reinsurance contract needs to reflect the terms and conditions that fit with the terms and conditions of the underlying ceded insurance policies and the risks reinsured. This means that simply grabbing a form off the shelf and mindlessly marking it up with the basic economic terms and conditions and the corporate parties' names is not enough. It is critical that the reinsurance contract reflect the risks and terms of the ceded insurance contracts to avoid a misalignment.
What Could Go Wrong?
Using a property excess of loss reinsurance contract and trying to apply it to a portfolio of ceded underlying automobile liability policies will not work. As we know, in a liability policy scenario, the ceding insurer generally will have the right and obligation to defend and indemnify the underlying insured from claims brought against the insured by third parties. The reinsurance contract will need terms and conditions that address the reinsurer's obligation to indemnify the ceding insurer for a share of the expenses incurred by the ceding insurer in investigating, adjusting, defending, and settling the underlying claim.
Property reinsurance wording likely will not have the appropriate provisions to address this because first-party property policies do not defend and indemnify against third-party lawsuits, and property reinsurance contracts generally will not address that subject. If the wording is misaligned because property reinsurance wording is used instead of liability wording, the ceding insurer may have a dispute on its hands if the reinsurer stands on the misaligned wording.
Worse is applying property and casualty reinsurance contract wording to a life reinsurance contract. There are significant differences between how property and casualty insurance policies operate when compared to life insurance policies, and obviously, the reinsurance contract needs to reflect those differences. For example, you might have a commutation clause in a reinsurance contract covering workers compensation policies, but in a life reinsurance contract, it would more likely be a recapture clause, not a commutation clause.
Now, this all sounds very basic, but the fact is that misalignments happen because the wrong model wording or model clauses are applied without proper review and consideration. The point being made is that just grabbing wording off the shelf (or asking AI to grab it for you from the database) or cutting and pasting from the last reinsurance contract that was drafted is only the beginning of the contract drafting exercise, not the end. Contract wording needs to align with the underlying policies and risks being reinsured, and the appropriate attention to detail needs to be applied to avoid a misalignment.
Esoteric Policies
The great thing about the insurance industry is that it develops new products for new exposures and risks. Unfortunately, sometimes, when contract wording is being drafted for those new products, not enough attention is paid to the differences between more traditional and well-known products. When reinsurance is then layered on top of developing a new direct insurance product, even more misalignment is possible.
Take, for example, a new product that provides insurance against a loan default. Is this a liability policy, a property policy, or something else? Likely, a product like this will be written offshore or in the excess and surplus lines market where form filing and approval by regulators is less likely to happen, and statutory and regulatory guidance on policy terms and conditions is minimal, if there is any at all.
Staying with the example, if there is a loan default, and the insurance company has to pay the loss, the insurer may seek a recovery against collateral if any has been required, or it may seek a recovery against a responsible third party. In doing so, it will incur expenses associated with either type of recovery.
When ceding the loss to its reinsurer, the ceding insurer will want to recover the reinsured portion of the indemnity loss but also recover a share of the expenses associated with the recovery. If the reinsurance contract is not written to reflect the loan risk and likely scenarios upon a loss, the ceding insurer may find it difficult to recover its costs.
For example, if the reinsurance contract has provisions stating that if the costs are within the limits of the underlying policy, then the ceding insurer's costs are within the limits of the reinsurance contract. However, if the costs are in addition to the limits of the underlying policy, costs are proportionally in addition to the limits of the reinsurance contract. If the underlying policy protecting against a loan default has no provisions expressly providing that costs are inclusive or exclusive of the policy limits—because it is not a liability policy in the traditional sense—then the ceding insurer may have a big problem recovering its costs because of this misalignment of the policy wording to the reinsurance contract.
This problem can be a big issue in drafting reinsurance contracts for cyber policies, especially cyber policies that have both first-party and third-party coverages. A traditional property or liability reinsurance contract wording might be a starting point for a cyber reinsurance contract, but a cookie-cutter approach will not work because of the complexities of cyber risk and the hybrid nature of the coverage.
Standard or Organizational Terms
In the London market and elsewhere, there are standard clauses that are used in both insurance and reinsurance contracts. Those clauses are often referred to by number and are incorporated by reference in the insurance and/or reinsurance contracts. Lloyd's Market Association clauses are an example. Often, those standard terms are modified by the specific contract in additional terms and conditions. This can be quite confusing when referring back and forth to wording manuals and lists.
Incorporating numbered forms by reference and amending some of those forms within the policy can easily lead to misalignment with the associated reinsurance contract, which may also be using numbered forms incorporated by reference. Special care is required to follow the applicable terms and conditions in the policy and to make sure the reinsurance contract is in proper alignment with the numbered clauses or their modified versions.
When Disputes Arise
Most reinsurance contracts have arbitration clauses. This means that if a reinsurer refuses to pay based on a misalignment in the contract wording, it is likely that the dispute will be resolved by a panel of industry arbitrators. Subject to the terms in the arbitration clause, it is more likely that an arbitration panel will consider the misalignment in its deliberations and will not merely hold the parties to the words of the contract if the wording makes no practical sense.
The likelihood of this scenario is enhanced if the arbitration clause has "honorable engagement" or similar language that directs the arbitration panel to decide the dispute based on industry practice rather than interpret the reinsurance contract as strictly a legal document. Experienced arbitrators may recognize the misalignment and may interpret the reinsurance contract in such a way that conforms with proper business practices. Of course, arbitrators may also recognize that the parties are experienced commercial entities with a team of contract drafters and lawyers and may hold the parties to their misaligned bargain. Obviously, the better practice is to avoid misalignment and thereby avoid a dispute over contract wording.
Conclusion
The key to avoiding unnecessary disputes is to draft reinsurance contracts that align with the underlying policies and risks being reinsured. Blindly using model contracts or standardized clauses without conforming them to the substance of what is being reinsured can lead to a misalignment between the reinsurance wording and underlying policy wording being reinsured. No good can come of this—only disputes.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
Insurance companies purchase reinsurance for various reasons, including to reduce their net exposure to loss arising from the insurance policies they have issued to policyholders. Common sense dictates that a reinsurance contract protecting a ceding insurer will align with the underlying risk and the underlying policy wording to create a seamless recovery against the reinsurance contract when losses arise on those underlying reinsured policies.
Usually, that is the way it works. Liability policies are reinsured by reinsurance contracts with liability wording, property policies are reinsured by reinsurance contracts with property wording, and life insurance policies are reinsured by reinsurance contracts with life insurance wording. But sometimes, there is a misalignment between the underlying reinsured policy and the reinsurance contract. When that happens, there can be regulatory, financial, claims, and dispute consequences.
Contract Drafting
Look, we are all busy. Sometimes, it is easier to grab a form off the proverbial shelf, mark it up, and be done with the process. In the old days, this was called a "cut-and-paste job." Most insurance/reinsurance companies and brokers have libraries of carefully drafted models to choose from when drafting a new reinsurance contract, so what could go wrong? With the advent of artificial intelligence (AI), this grab will become easier, but will it resolve the issue?
My contract drafting mantra is, "Mean what you say, and say what you mean." While this might not necessarily apply directly to misalignment in contract wording, the overall sentiment is similar. The reinsurance contract needs to reflect the terms and conditions that fit with the terms and conditions of the underlying ceded insurance policies and the risks reinsured. This means that simply grabbing a form off the shelf and mindlessly marking it up with the basic economic terms and conditions and the corporate parties' names is not enough. It is critical that the reinsurance contract reflect the risks and terms of the ceded insurance contracts to avoid a misalignment.
What Could Go Wrong?
Using a property excess of loss reinsurance contract and trying to apply it to a portfolio of ceded underlying automobile liability policies will not work. As we know, in a liability policy scenario, the ceding insurer generally will have the right and obligation to defend and indemnify the underlying insured from claims brought against the insured by third parties. The reinsurance contract will need terms and conditions that address the reinsurer's obligation to indemnify the ceding insurer for a share of the expenses incurred by the ceding insurer in investigating, adjusting, defending, and settling the underlying claim.
Property reinsurance wording likely will not have the appropriate provisions to address this because first-party property policies do not defend and indemnify against third-party lawsuits, and property reinsurance contracts generally will not address that subject. If the wording is misaligned because property reinsurance wording is used instead of liability wording, the ceding insurer may have a dispute on its hands if the reinsurer stands on the misaligned wording.
Worse is applying property and casualty reinsurance contract wording to a life reinsurance contract. There are significant differences between how property and casualty insurance policies operate when compared to life insurance policies, and obviously, the reinsurance contract needs to reflect those differences. For example, you might have a commutation clause in a reinsurance contract covering workers compensation policies, but in a life reinsurance contract, it would more likely be a recapture clause, not a commutation clause.
Now, this all sounds very basic, but the fact is that misalignments happen because the wrong model wording or model clauses are applied without proper review and consideration. The point being made is that just grabbing wording off the shelf (or asking AI to grab it for you from the database) or cutting and pasting from the last reinsurance contract that was drafted is only the beginning of the contract drafting exercise, not the end. Contract wording needs to align with the underlying policies and risks being reinsured, and the appropriate attention to detail needs to be applied to avoid a misalignment.
Esoteric Policies
The great thing about the insurance industry is that it develops new products for new exposures and risks. Unfortunately, sometimes, when contract wording is being drafted for those new products, not enough attention is paid to the differences between more traditional and well-known products. When reinsurance is then layered on top of developing a new direct insurance product, even more misalignment is possible.
Take, for example, a new product that provides insurance against a loan default. Is this a liability policy, a property policy, or something else? Likely, a product like this will be written offshore or in the excess and surplus lines market where form filing and approval by regulators is less likely to happen, and statutory and regulatory guidance on policy terms and conditions is minimal, if there is any at all.
Staying with the example, if there is a loan default, and the insurance company has to pay the loss, the insurer may seek a recovery against collateral if any has been required, or it may seek a recovery against a responsible third party. In doing so, it will incur expenses associated with either type of recovery.
When ceding the loss to its reinsurer, the ceding insurer will want to recover the reinsured portion of the indemnity loss but also recover a share of the expenses associated with the recovery. If the reinsurance contract is not written to reflect the loan risk and likely scenarios upon a loss, the ceding insurer may find it difficult to recover its costs.
For example, if the reinsurance contract has provisions stating that if the costs are within the limits of the underlying policy, then the ceding insurer's costs are within the limits of the reinsurance contract. However, if the costs are in addition to the limits of the underlying policy, costs are proportionally in addition to the limits of the reinsurance contract. If the underlying policy protecting against a loan default has no provisions expressly providing that costs are inclusive or exclusive of the policy limits—because it is not a liability policy in the traditional sense—then the ceding insurer may have a big problem recovering its costs because of this misalignment of the policy wording to the reinsurance contract.
This problem can be a big issue in drafting reinsurance contracts for cyber policies, especially cyber policies that have both first-party and third-party coverages. A traditional property or liability reinsurance contract wording might be a starting point for a cyber reinsurance contract, but a cookie-cutter approach will not work because of the complexities of cyber risk and the hybrid nature of the coverage.
Standard or Organizational Terms
In the London market and elsewhere, there are standard clauses that are used in both insurance and reinsurance contracts. Those clauses are often referred to by number and are incorporated by reference in the insurance and/or reinsurance contracts. Lloyd's Market Association clauses are an example. Often, those standard terms are modified by the specific contract in additional terms and conditions. This can be quite confusing when referring back and forth to wording manuals and lists.
Incorporating numbered forms by reference and amending some of those forms within the policy can easily lead to misalignment with the associated reinsurance contract, which may also be using numbered forms incorporated by reference. Special care is required to follow the applicable terms and conditions in the policy and to make sure the reinsurance contract is in proper alignment with the numbered clauses or their modified versions.
When Disputes Arise
Most reinsurance contracts have arbitration clauses. This means that if a reinsurer refuses to pay based on a misalignment in the contract wording, it is likely that the dispute will be resolved by a panel of industry arbitrators. Subject to the terms in the arbitration clause, it is more likely that an arbitration panel will consider the misalignment in its deliberations and will not merely hold the parties to the words of the contract if the wording makes no practical sense.
The likelihood of this scenario is enhanced if the arbitration clause has "honorable engagement" or similar language that directs the arbitration panel to decide the dispute based on industry practice rather than interpret the reinsurance contract as strictly a legal document. Experienced arbitrators may recognize the misalignment and may interpret the reinsurance contract in such a way that conforms with proper business practices. Of course, arbitrators may also recognize that the parties are experienced commercial entities with a team of contract drafters and lawyers and may hold the parties to their misaligned bargain. Obviously, the better practice is to avoid misalignment and thereby avoid a dispute over contract wording.
Conclusion
The key to avoiding unnecessary disputes is to draft reinsurance contracts that align with the underlying policies and risks being reinsured. Blindly using model contracts or standardized clauses without conforming them to the substance of what is being reinsured can lead to a misalignment between the reinsurance wording and underlying policy wording being reinsured. No good can come of this—only disputes.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.