What's Natural about the Expiration of In-Force Policies When a Reinsurance Contract Terminates?

The Nature of Reinsurance

Reinsurance comes in many shapes and sizes. Reinsurance contracts were often open-ended, and the liability of the reinsurer lasted until the final policy had all its claims paid or settled. But, because of the diversity of the insurance products reinsured, a reinsurer's liability is not always forever, and different reinsurance contracts provide for different reinsurance obligations.

For example, in a risks- or policies-attaching reinsurance contract, typically the reinsurer is responsible for all legitimate losses that attach to the policies reinsured regardless of when those losses are reported and incurred. In a losses occurring reinsurance contract, the reinsurer is typically only responsible for losses that are incurred and reported within the reinsurance contract period regardless of when the underlying policies to which those losses attach were issued (obviously, the reinsuring clause makes clear how far back the policies can go).

Some reinsurance contracts accept in-force business, and some only accept new and renewal business on policies issued on or after the effective date of the reinsurance contract. Where successive reinsurance contracts on a reinsurance program for a ceding insurer accept in-force business, the ceding insurer has few worries about whether losses arising out of in-force policies will be reinsured. Where, however, the reinsurance contract only accepts new and renewal business after the effective date of the contract, in-force business will either be reinsured under the expiring reinsurance contract or the ceding insurer will take the losses on the remaining portion of the in-force policies net (in other words, without those losses being reinsured). All of this depends on the precise wording of the reinsurance contract.

Termination/Cancellation Clauses

Some reinsurance contracts have no set termination date and continue until one of the parties gives notice of cancellation as provided for in the contract. Other reinsurance contracts are for a set term with an express expiration date. When a reinsurance contract terminates, the termination or similar clause should set forth the obligation of the reinsurer for losses on policies in force at the date of termination.

Many reinsurance contracts have so-called runoff provisions, which inform the counterparties about their respective obligations for claims after the expiration of the reinsurance contract. A runoff clause generally stipulates that the reinsurer shall remain liable for losses under reinsured policies in force at the time the reinsurance contract terminates for occurrences that take place after the date of termination until the natural expiration of the reinsured policies. Sometimes runoff is at the option of the reinsurer, and sometimes it is the default methodology in the reinsurance contract.

The runoff obligation may be articulated differently from reinsurance contract to reinsurance contract, depending on the type of reinsurance agreement, the nature of the underlying policies, and the prevailing market conditions. Some contracts limit the reinsurer's runoff exposure to an additional 12 months. Others require that the reinsurer remain responsible for all losses on all in-force risks until their next anniversary date, their natural expiration, or until those underlying policies are canceled or terminated.

Some examples of runoff language are set out below:

All policies in force as of December 31, 2010, including any policy extensions not exceeding a further 12 months, shall runoff to natural expiration plus discovery or run-off period as applicable.

All policies in force at the expiration of this Agreement, including any policy extensions not exceeding a further 6 months, shall runoff to natural expiration, plus discovery or runoff period as applicable.

The Reinsurer shall remain liable for all losses occurring subsequent to the time and date of termination until natural expiration or prior cancellation of such policies.

In the event this Agreement is terminated, Reinsurer shall remain liable for losses occurring under the Company's policies reinsured hereunder until the expiration date, anniversary date, or prior termination date of such policies, but in no event longer than 12 months after termination date.

In the event of termination of this Contract, the Reinsurer shall remain liable under this Contract with respect to all losses, and corresponding loss adjustment expense, that may occur on any of the Company's covered policies that are in force at the termination date of this Contract until the date of the next scheduled anniversary of each such policy, its natural expiration, cancellation, or nonrenewal, whichever shall first occur.

Some termination or cancellation clauses may also provide for an option to choose a "cutoff" option instead of runoff under certain circumstances. This option may be limited to the ceding insurer or may be at the reinsurer's option. Cutoff means that the reinsurer will no longer be liable for losses on policies in force at the time of termination, but the reinsurer will have to return all unearned premium on those policies to the ceding insurer. This option is typically used by the ceding insurer when the following reinsurance contract assumes in-force business via a portfolio transfer.

As articulated many times in these commentaries, the precise wording on the reinsurance contract will dictate how the particular provision will be interpreted. Careful drafting is important to make sure that the practical outcome of how the contractual provision is interpreted matches the intent of the parties.

The In-Force Policies

The nature of the in-force policies and how the reinsurance contract treats those policies may play a role in determining the reinsurer's runoff obligations. For example, if all the in-force risks are 1-year commercial general liability policies, and there are no special provisions in the reinsurance contract that affect the way those policies are reinsured, determining when those policies naturally expire is not a difficult exercise. If the reinsurer is liable for losses on in-force policies that were incurred after the expiration date of the reinsurance agreement until the natural expiration of those policies, the reinsurer will have to respond to all losses on those policies until the 1-year term of each of those policies has expired.

Where the reinsurance contract is a January 1 to January 1 contract, and the in-force policy attaches to the reinsurance contract on December 1, the reinsurer will be liable for losses on that policy that are incurred until that policy expires the next December 1. If the policy renews, the reinsurer is not obligated to reinsure the renewal because natural expiration was at the end of the original 1-year period.

Where the issue gets trickier is where the policies are written for more than 1 year as the policy period. Depending on the insurance market at any given time, sometimes policyholders are able to negotiate multiyear policies and sometimes they are not. If the ceding insurer is issuing multiyear policies, careful consideration has to be given when drafting the termination clause of the reinsurance contract to address the multiyear nature of the risks attaching to the reinsurance contract.

In a typical risks- or policies-attaching treaty, the reinsurer naturally is obligated to reinsure new and renewal policies issued after the effective date of the reinsurance contract that attaches to the contract until those policies terminate. The nature of a risks-attaching treaty is that the policy attaches to the reinsurance contract when written and remains attached to that treaty until that policy terminates. A runoff clause on a risks-attaching reinsurance contract is considered redundant by many reinsurance underwriters because of the clear design of the reinsurance agreement.

Nevertheless, many risks-attaching reinsurance contracts contain runoff language in the termination clause to either limit or alter the natural runoff liability of the reinsurer or as a belts-and-suspenders provision to make sure that, upon termination, there is no question about the reinsurer's ongoing obligations for in-force business.

If the reinsurance contract has typical runoff language in the termination clause that obligates the reinsurer on all losses on in-force business until natural expiration of all policies (without any time period limitation), then a good argument can be made that a multiyear policy naturally expires at the end of its multiyear period. This would mean that the reinsurer should receive its share of all the premium associated with the multiyear policy in exchange for remaining on the risk until that multiyear policy expires.

If, however, the reinsurance contract has language that expressly addresses how multiyear policies should be treated for reinsurance purposes, then natural expiration may take on a slightly different meaning.

Multiyear Annual Aggregate Policies

Multiyear policies may be issued with a single aggregate limit or with annual aggregate limits for each year of the multiyear policy. A multiyear policy with annual aggregate limits mimics an individual policy, but one that renews multiple times with its own aggregate limit of liability for each annual policy period. A multiyear annual aggregate policy provides the insured with stability of coverage, while providing full aggregate limits protection for each of the multiyear periods.

Because multiyear annual aggregate policies essentially subject the ceding insurer (and the reinsurer) to multiple annual aggregate limits as opposed to a single aggregate limit, their treatment under the reinsurance contract may be different from a typical policy. For example, a reinsurance contract may require that policies issued on a multiyear basis with annual aggregate limits be treated as separate policies for each policy period with each anniversary date attaching to the reinsurance contract year then in effect. If each year of a multiple year policy is treated as a separate policy and attaches only to the reinsurance contract in effect on its anniversary date, how does that affect the liability of the reinsurer upon expiration of the reinsurance agreement if there is a runoff clause that uses the phrase natural expiration?

Where the express terms of the reinsurance contract require that each policy period of a multiyear annual aggregate policy is to be treated for reinsurance purposes as a separate policy, it arguably makes logical sense to treat each policy period as a separate policy under the runoff language of the termination clause of the reinsurance contract. In other words, natural expiration is not the end of the multiyear period of the policy but occurs at each anniversary date of the multiyear policy because each policy period independently attaches to the reinsurance contract, if any, in place at the date of the anniversary period of the policy as if each period was a separately issued insurance policy.

Conclusion

Natural expiration for an insurance policy ceded to the reinsurance contract may mean when the policy expires or may mean when a multiyear policy reaches its anniversary date. It may be cut off by a time limit or may continue to its actual termination date or anniversary date. In each case, the precise wording of the reinsurance contract and the context in which the words are used when reviewing the reinsurance contract as a whole are critical. Those words will guide the parties as to whether the obligation of the reinsurer extends to losses incurred after the termination date of the reinsurance contract or whether the losses become the responsibility of someone else.