In a standard reinsurance transaction, the typical counterparties are the ceding insurer and the reinsurer. Each, working at arm's length, negotiates the terms and conditions of the reinsurance arrangement and the related contract wording. The ceding insurer may engage a reinsurance intermediary to assist with the placement and negotiation of the transaction or may work directly with the reinsurer to reach agreement on the deal and the language of the reinsurance contract.
In this typical reinsurance transaction, each party is responsible for its own compliance with the obligations under the negotiated terms and conditions of the reinsurance agreement. Given today's economic credit risk climate, the ceding insurer may insist on obtaining security from the reinsurer apart from the typical credit for reinsurance required of non-admitted reinsurers. For example, the ceding insurer may insist on a special termination clause or a security clause triggered by rating agency downgrades of the reinsurer's financial condition. Or the reinsurer may require a letter of credit or trust fund deposit. Whether the ceding insurer will obtain any of these provisions depends on the market position of each party and the importance of the security clause to close the deal.
Of course, if the reinsurer is not admitted in the state where the ceding insurer is based, the reinsurer generally will have to provide security to enable the ceding insurer to take credit for the reinsurance on its annual statement. Various forms of security may be used or required by the reinsurance contract (e.g., trust funds, letters of credit), but other than security, the reinsurer's obligations are not otherwise guaranteed.
In other situations—and the examples are myriad—affiliated companies or individuals, but nonparties to the reinsurance agreement, may be asked to guarantee the obligations of the reinsurer. While a third-party guarantee does not take the place of credit for reinsurance security, it may provide significant comfort to the ceding insurer that the reinsurer—or its guarantor—will meet the obligations agreed to by the reinsurer under the reinsurance contract. This Commentary will discuss these third-party guarantees.
What Reinsurance Transactions Have Third-Party Guarantees?
Third-party guarantees may arise in a wide variety of nonstandard reinsurance arrangements. For example, a small, regional insurer may engage a reinsurer to help expand the regional insurer's business by agreeing to a reinsurance arrangement that allows the regional insurer to write significantly more business, larger limits, and perhaps business in a wider geographical location. The deal may be structured by having the regional insurer act as an excess-of-loss reinsurer for the reinsurer over a certain limit of liability. Or perhaps the reinsurer or its subsidiary will write direct business in geographic locations where the regional insurer is not licensed or approved. In that case, the regional insurer may act as reinsurer of those policies over a certain attachment point. In a third scenario, the regional insurer may form an offshore subsidiary or affiliate to reinsure the reinsurer for the expanded excess liability.
Under any of these situations, the reinsurer may require more than standard credit for reinsurance security for the excess losses reinsured by the regional insurer and may require the parent or the individual principals of the regional insurer to guarantee the regional insurer's or the offshore affiliate's performance on the reinsurance obligations assumed on the excess business.
Another example is where the producer of the business—a managing general agent (MGA) or managing general underwriter for example—owns affiliated insurance and reinsurance companies. An unaffiliated insurer may issue the policies for the MGA in certain geographic locations with certain of those obligations reinsured by the MGA's affiliated reinsurer (onshore or offshore). The insurer here may wish to obtain a guarantee from the MGA's principals to secure those reinsurance obligations. Similar to the regional insurer above, the MGA's affiliated insurer may write the business and cede that business to the unaffiliated insurer, with the MGA's affiliated reinsurer taking all losses over a certain attachment point.
These types of arrangements have also occurred in the area of loans and the insurance purchased to protect against default on those loans. For example, a sub-prime automobile loan originator and servicer obtains default protection insurance from an insurer. The insurer in turn enters into a reinsurance agreement with an offshore reinsurer owned by principals of the loan originator. To protect against the risk that the offshore reinsurer may default on its reinsurance obligations, the insurer obtains a personal guarantee from the principals of the loan originator and the offshore reinsurer.
Why Obtain a Third-Party Guarantee?
While most reinsurance arrangements do not require security to obtain performance of the reinsurance obligations, in this day of economic turmoil, more and more ceding insurers are requiring security. And when dealing with a closely held private counterparty or a small offshore reinsurer, the value of obtaining a third-party guarantee to secure the reinsurance obligations cannot be overstated.
The reasons for enhanced security are obvious. The risk of default or insolvency of a smaller regional insurance company or of a thinly capitalized offshore reinsurer is a recognizable credit risk. While letters of credit and trust funds may provide levels of comfort, a third-party guarantee provides a boots-and-suspenders level of comfort. As we all know, in the current economic client, additional security to mitigate credit risk is a good thing.
A third-party guarantee may avoid the counterparty having to chase a defaulting reinsurer to post-security. This is especially useful if the defaulting reinsurer is offshore, where compelling arbitration or enforcing a judgment or arbitration award against a company with minimal capital and surplus may be difficult. Instead, upon default, the counterparty may look directly to the guarantor for satisfaction. If the guarantor is a U.S.-based company or an individual with assets and property in the United States, the collection effort may be somewhat easier. Moreover, a third-party guarantee is unlikely to be subsumed by the insolvency of a reinsurer and will allow for a direct right of action on the guarantee apart from the reinsurance agreement.
Circumstances Where the Guarantee and the Reinsurance Agreement Intersect
When disputes arise, however, the third-party guarantee and the reinsurance agreement may become intertwined. As most things with reinsurance, it's all in the drafting. Typical reinsurance agreements have arbitration clauses. Typical guarantee agreements do not have arbitration clauses. Both parties need to determine in the drafting stage whether the arbitration clause in the reinsurance agreement will apply to the third-party guarantee. Nonparties to reinsurance agreements have been held to come under arbitration provisions under certain circumstances. If the party obtaining the guarantee from the reinsurer's principal does not want the guarantee subject to arbitration, the guarantee agreement should be clear, and the reinsurance agreement should not incorporate or reference the guarantee.
But even if the reinsurance agreement and guarantee are clearly separate, a dispute under the reinsurance agreement may still affect the guarantor. For example, an arbitration panel may issue an order requiring the offshore reinsurer to post security in advance of the arbitration award to secure the viability of a possible arbitration award against the reinsurer. If the reinsurer refuses to comply with the arbitration panel's order or defaults, the ceding insurer may seek to compel the guarantor to fund the security order in the arbitration. If the guarantee is a broad guarantee of all obligations under the reinsurance agreement, the guarantor may find that the reinsurer's obligation to comply with the arbitration panel's preaward security order is covered by the guarantee. While attempting to force a guarantor to comply with an arbitration security award may result in significant collateral litigation, having the ability to obtain compliance of the reinsurer's obligation may be worth the hassle.
Similarly, if at the end of the arbitration the reinsurer is ordered to pay reinsurance recoverables or post a letter of credit, its default will result in an action to compel payment under the guarantee.
Third-party guarantees of reinsurance obligations are not typically part of a reinsurance transaction, but under certain circumstances, obtaining a third-party guarantee makes sense. Third-party guarantees may be needed to put together a reinsurance program for a small regional insurer looking to expand, or for a program produced by a managing general agent that wishes to take part of the insured risk through an affiliated offshore reinsurer. The guarantees act as an incentive to a capital provider to enter into a somewhat unusual arrangement by providing a guarantee by a third-party as a risk mitigation device. Care needs to be taken in drafting the third-party guarantee and the related reinsurance agreement to avoid unnecessary ambiguities that could result in a later dispute.
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.