Special Termination Provisions in Reinsurance Contracts

Why Have a Special Termination Clause?

Every reinsurance contract has a termination or cancellation date. But long ago, parties recognized that certain events occurring after the contract is in force may negatively affect the purpose of the reinsurance contract such that termination in advance of the contracted termination date under those special circumstances is appropriate. Having the special termination clause allows the parties to end the relationship and put the contract into runoff based on these contingent triggers.

Robert W. Strain explained as follows in Reinsurance Contract Wording:

No organization would be expected to enter [a reinsurance] relationship without carefully investigating the management, reputation, and solvency of the other. If any of those three change, especially quickly, the other party may wish to terminate the agreement because of the special circumstances, hence the name of the clause. ¹

As the example demonstrates, the special circumstances focus on solvency and company control issues.

Other special termination clauses trigger on changes to or the ceasing of underwriting operations, downgrades by rating organizations, drops in policyholder surplus, failing to post collateral, transfer of claims paying authority, or other organizational or financial activities. An example of a broad special termination clause follows:

SPECIAL TERMINATION AND OTHER REMEDIES

This Agreement may be terminated or commuted by the Company at any time by giving ten (10) calendar days notice in writing by certified or registered mail or by any electronic means providing receipt or confirmation of transmission to the Reinsurer upon the happening of any one of the following circumstances:

A. The Reinsurer has announced its intent to cease, or ceases underwriting operations.

B. A state insurance department or other legal authority orders the Reinsurer to cease writing business, or the Reinsurer is placed under regulatory supervision.

C. The Reinsurer has become insolvent or has been placed into liquidation or receivership (whether voluntary or involuntary), or there has been instituted against it proceedings for the appointment of a receiver, liquidator, rehabilitator, conservator, trustee in bankruptcy, or other agent known by whatever name, to take possession of its assets or control of its operations.

D. The Reinsurer's equity (or the equivalent under the Reinsurer's accounting system (e.g., surplus as regards policyholders)) as reported in such financial statements of the Reinsurer as designated by the Company has been reduced by 20% or more at any date during the prior 12-month period (including the period prior to the inception of this Agreement); or if the Reinsurer has lost any part of, or has reduced its paid-up capital (also known as "gross paid-in and contributed surplus").

E. The Reinsurer has failed to post collateral as required by the FUNDING ARTICLE within thirty (30) calendar days of the Company's funding request.

F. The Reinsurer has announced its intent to, or has merged with or has become acquired or majority controlled by any company, corporation, or individual(s) not controlling or not under the common control of the Reinsurer's operations at the inception of the term of this Agreement.

G. The Reinsurer has reinsured its entire liability under this Agreement without the Company's prior written consent, except for retrocessions to and/or pooling arrangements among members of the Reinsurer's holding company group.

H. The Reinsurer's A.M. Best's financial strength rating has been suspended or withdrawn or has been assigned or downgraded below "A-", or the Reinsurer's S&P Global Ratings financial strength rating (FSR) has been suspended or withdrawn or has been assigned or downgraded below "BBB+", or as respects underwriting members of Lloyd's, London, the Reinsurer's Moody's Syndicate Performance Rating has been suspended or withdrawn or has been assigned or downgraded below "B+".

I. There is a severance or obstruction of free and unfettered communication and/or normal commercial and/or financial intercourse between the United States of America and the country in which the Reinsurer is incorporated or has its principal office as a result of war, currency regulations, or any circumstances arising out of political, financial or economic emergency.

J. The Reinsurer has transferred its claims-paying authority under this Agreement to an unaffiliated entity or in any other way has assigned its interests or delegated its obligations under this Agreement to an unaffiliated entity without the Company's required prior written consent.

K. The Reinsurer has invoked any statute, legislation, or judicial proceeding to enable the Reinsurer to utilize a regulatory-permitted novation or commutation without the Company's required prior written consent.

Termination will be effected on either a runoff or cutoff basis as applicable at the sole discretion of the Company. Additionally, the Company will have the option at any time subsequent to special termination under this Article to commute the Reinsurer's liability for losses including Loss Adjustment Expenses, unearned premium, incurred but not reported losses on Policies covered by this Agreement and any other obligations of the Reinsurer under this Agreement. The option to commute will not apply to a Reinsurer who, as of the effective date of this Agreement, has been assigned an A.M. Best's financial strength rating of A+ or better….

There is a lot to unpack from this sample clause. Beyond solvency and management control, the broader special termination clause triggers on an announced intent to cease underwriting, political risk, transfer of claims paying authority, and failure to post collateral, among other triggers. Moreover, further down in this sample clause is a section that allows the ceding insurer to deem the reinsurer a "Runoff Reinsurer" if any of the enumerated triggers are activated, subjecting the reinsurer to the limitations of a "Runoff Reinsurer" clause.

The Company, at its sole option, may classify the Reinsurer as a "Runoff Reinsurer," where said Reinsurer experiences one or more of the circumstances set forth in subparagraphs A., B., C., G., J., and K. of the first paragraph of this Article.

Runoff or Cutoff or Commutation?

Besides the triggers to special termination, another critical term in the special termination clause is how the ceded losses will be handled once termination occurs. Some clauses terminate the reinsurance contract on a cutoff basis, others allow for termination on a runoff basis, yet others give an option for commutation to avoid the runoff altogether. It is important to understand how the claims will be handled upon termination and whether and who has the option to choose the methodology.

In the first example above, the reinsurer's liability terminated just as if the contract terminated at the end of the contract term as set forth in the termination provision of the contract. In the second example, the ceding insurer has the option of cutoff, runoff, or commutation.

If the termination is on a cutoff basis, it means that the reinsurer is not liable for losses as a result of occurrences taking place after the date of termination: The remaining unearned premiums are returned to the ceding insurer. If termination is on a runoff basis, the reinsurer remains liable for losses as a result of occurrences taking place after the date of termination for reinsured policies in force at the date of termination until their expiration or for a specified time period, and each has its advantages and disadvantages. Typically, the choice is up to the ceding insurer.

With commutation, the parties have to agree on a commutation amount, and special termination clauses with the commutation option generally have a dispute resolution procedure for resolving any issues concerning the commutation amount.

Potential Disputes over the Special Termination Clause

Some of the triggers for the special termination clause are objective. For example, if a party goes into receivership, the counterparty can invoke the clause. However, some of the triggers may be subject to dispute. What if one rating agency downgrades a party, but the others do not? What if there is some disruption in communication because of a dispute between countries, but not a full cutoff or war? What if the party disputes a surplus penalty? As you can see, some of these triggers may be subject to dispute themselves, and invoking the clause may result in a further dispute.

Another example of a potential disputed area is the underwriting trigger in the example above: Ceasing underwriting operations is a very broad statement. What does "underwriting operations" mean when it is not defined in the reinsurance contract? Does continuing to runoff the reinsurance responsibility for the assumed risks while taking a pause in assuming new risks in a subsequent underwriting year constitute the ceasing of underwriting operations? Without more and without a clear definition, this trigger can result in a dispute.

Conclusion

The special termination clause in a reinsurance contract is there to protect the parties from contingent events that alter the status of the parties and thereby affects the reinsurance relationship. Each special termination clause is unique, and each contains different triggers that allow a party to seek early termination of the reinsurance contract.