Expert Commentary

To Commute or Not To Commute, that Is the Question

The reinsurer's obligation to cede and pay claims continues many years after the termination of the contract, unless it is commuted. A commutation allows the reinsured to receive cash now to invest for the payment of future claims, and the reinsurer's commitment ends. Regardless the reason for the commutation, and there are many, care must be taken in drafting the agreement to avoid future disputes.


Reinsurance
July 2003

Depending on the business reinsured, a reinsurance relationship may last long after the reinsurance contract has terminated. In long-tail lines of business, it may take 20 or more years for all underlying claims to be reported and resolved. If that business was reinsured, particularly through a quota share treaty, the reinsurance relationship will last until the final claim is paid and the final reinsurance claim is submitted by the reinsured to the reinsurer.

Although the reinsurance contract itself may have only existed for a year or two, the obligation to cede and pay claims will continue for many years after the termination of the reinsurance contract. An alternative does exist to this often long-drawn out reinsurance relationship. That alternative is the commutation.

What Is a Commutation?

A commutation is a settlement agreement reached between a reinsured and a reinsurer by which the reinsurance obligation is terminated by an agreement by the reinsurer to pay funds at present value that are not yet due under the reinsurance agreement. Similar to a policy buy-back with an insured, a commutation allows the reinsured to receive cash now to invest for the payment of claims that will come due in the future. The reinsurer’s obligations for future payments are terminated and the reinsurance contract is finally terminated in its fullest sense.

A commutation also may be a term of the existing reinsurance contract. Particularly in life reinsurance, accident, and health reinsurance, and workers compensation carve-out reinsurance agreements, sunset and commutation clauses often exist. These provisions contractually conclude the reinsurance relationship or provide the opportunity for the reinsurer to terminate the relationship after a certain number of years based on an agreed upon formula or other negotiated provisions. While problems do arise if these preexisting clauses are not drafted properly, the real issues arise with commutation agreements negotiated outside of the terms of the underlying reinsurance agreement.

Why Commute?

The reasons for commutations differ from company to company and from line of business to line of business. A reinsured may want to commute because it is no longer in that line of business or it wants to maximize its reserves for transfer or sale to another entity. A reinsured also may want to commute to avoid the credit risk associated with its reinsurer, particularly if its reinsurer has suffered recent downgrades and its long-term viability is questionable. A reinsured may believe that its claims department will do a better job at settling the underlying claims than the reinsurer believes so that it would rather take a present value payment from the reinsurer now and eliminate the need to report to the reinsurer on future claims. If the reinsurance agreement was placed through an intermediary that no longer exists or is no longer capable of handling the reinsurance claims function, a commutation may be in order for the reinsured to avoid assuming the expense of reinsurance collections.

A reinsurer may want to commute to terminate a relationship with a reinsured that is in run-off or one with which it no longer does business. If a reinsured has solvency issues, a reinsurer may want to commute to avoid having to deal with a state guarantee fund or liquidator. Commuting with a potentially impaired company raises other issues such as voidable preferences if the reinsured becomes insolvent shortly after the commutation agreement is negotiated. Of course, a reinsurer would rather have a deal done with funds paid to a reinsured then have to deal with a liquidator in the future. The flip side is that a reinsurer does not want to find itself subject to reinsurance collection efforts from a liquidator after it commuted in good faith with a reinsured.

A reinsurer may also want to commute where it is concerned that the reinsured has a radically different viewpoint about the future emergence and payment patterns of the underlying claims. If the reinsurer believes that its actuaries have it right, a properly structured commutation may save the reinsurer future expenses.

Evaluating a Commutation

The negotiation of a commutation requires a detailed financial and actuarial analysis of the book of business being commuted. Each party must have a clear understanding of the number and nature of the policies issued, the value and credibility of the reserves established by the reinsured, and, most importantly, the value of the losses anticipated to arise in the future, otherwise known as incurred but not reported (IBNR) losses. Each party performs its own evaluations, but both sides must have general agreement on the policies actually issued, the claim payments made to date, and the existing case reserves. While the parties may differ on the IBNR, each side’s evaluation of the IBNR will have to be within a reasonable range of each other for agreement on a commutation payment to occur.

Present value calculations and investment income assumptions are also a crucial part of the commutation process. The reinsured will want to receive from the reinsurer a payment that it believes will pay all future losses and expenses based on the payout pattern for the losses and the investment income anticipated on the commutation payment amount and its current reserves. The reinsurer will want to pay an amount at as deep a discount as possible so that its present value payment today will enhance its bottom line by lowering its reserves for losses and future payment obligations. Slight differences in interest rate assumptions may make very large differences in the economic results of a commutation.

For the reinsured, the risk is greatest because the reinsured will have to pay the claims as they come due without recourse to the commuted reinsurance agreement. If the reinsured guesses wrong, it will have lost the original value of the reinsurance and the value of the commutation agreement.

The Commutation Agreement

Like any contract, careful drafting of a commutation agreement will avoid future disputes. There have been a number of cases in the past few years where parties thought they commuted all the business only to learn that other contracts existed that were not included in the commutation agreement. Other disputes have occurred where a company commutes the business it underwrote and ceded to the reinsurer, only to learn that the reinsurer considered business written by a managing general agent or pool manager for the reinsured to come within the commutation. Careful drafting avoids these problems.

As in any agreement, it is crucial to properly describe and identify the exact business that is the subject of the agreement. Sometimes a reinsurer will agree to commute all business with a reinsured. This often happens when the reinsured is in run-off or has otherwise stopped writing business. If the reinsurer and the reinsured had a long-standing relationship, there may be literally hundreds of reinsurance agreements that might be subject to the commutation agreement. The importance of specifically identifying each contract commuted cannot be over emphasized.

Some commutation agreements will include an appendix listing all contracts commuted. Others will also include a clause that purports to incorporate all reinsurance contracts between the parties, whether listed on the appendix or not. Obviously, it is to the reinsurer’s advantage to have as broad a clause as possible if the goal is to commute every possible agreement that may exist with the reinsured. If the reinsured does not intend to commute a certain category or class of agreement with the reinsurer, then those specific contracts or categories of contracts must be specifically excluded from the commutation agreement. Confusion or ambiguity on this point is a guarantee for a future dispute.

The clear identification of the parties subject to the commutation agreement is another critical point to a successful commutation agreement. Because of the holding company structure of many, if not most, insurance and reinsurance companies today, it is necessary to identify the correct parties to any commutation agreement.

Very often, reinsurance agreements will define the reinsured as a number of affiliated companies, including any companies that it manages or which may come under its control during the term of the reinsurance agreement. This is particularly important if the business being reinsured is business underwritten by an underwriting manager, managing general agent, or a pool manager that writes for multiple companies. The older, long-tail business that parties seek to commute often has these types of relationships. Proper and unambiguous identification of the parties to the commutation is critical to avoiding future disputes.

Conclusion

Commutations are a routine occurrence in reinsurance. Commutations allow both the reinsured and reinsurer to truncate an old reinsurance relationship to the economic advantage of both parties. Care must be taken in drafting commutation agreements to avoid disputes in the future by making sure that all the commuted business is clearly identified and that the proper parties are named.


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.

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