Reinsurance industry is moving to sign contracts at inception. Is it possible?
The Sellers and Buyers in reinsurance have always been notoriously slow to get “actual contracts” negotiated and drafted. All of us are familiar with the stories of “handshake agreements” and “cover notes written onto napkins”. Everyone knew each other, and deals were made as a gentleman’s agreement. While the deal was the priority, it was not the contract. The growth of the reinsurance industry and greater involvement of large sums of money led to “regulatory involvement” in 1994, when the Plenary Committee of the National Association of Insurance Commissioners adopted amendments to Chapter 22, NAIC Accounting Practices and Procedures Manual. This was known as the “Ninth Month Rule”.
Rule for the Ninth Month
In the early 1990’s, regulatory concerns arose about the possibility that parties to a contract for reinsurance might rewrite essential terms of an agreement. This could happen after losses have occurred.
On September 18, 1994, amendments were approved that revised Chapter 22 of NAIC Accounting Practices and Procedures Manual. Most states use the Manual to establish statutory accounting procedures for insurers. Chapter 22 outlines how reinsurance transactions should be included in financial statements for insurance and reinsurance companies.
One amendment provided for special accounting treatment of reinsurance transactions if the contract associated with the transaction is not signed within nine months from the inception date (i.e. The “Nine Month Rule”. The “Nine Month Rule” states that if a contract has not been signed within the nine-month period, the transaction will be subject to retrospective accounting treatment. This would have a significant impact on the financial statements of the insurer.
Silverstein and Spitzer
It is easy to see regulators looking at the way the industry executes contracts after the events of September 11, 2001. This is what we as an industry want.
Ronald Reagan once stated that “the nine most frightening words in English Language” were: “I’m from government, and I’m here for help.” Well… Although regulators can be frightening, I will not say that they are inhumane. However, if we fail to take action to protect ourselves, we will be subject to more regulations.
Silverstein’s case was about the definition of “occurrence”, or the lack thereof. This was due to the fact that the parties had not reached an agreement on contract language before the loss occurred. This is an example of an insurance binder. However, the same issues can be found with reinsurance placement slips. This exposed to the public and brought to the attention of regulators the less-than-sophisticated business practices that occur in the insurance and the reinsurance industries. (i.e. (i.e., incomplete terms at inception). This should not be surprising, as many of these types of issues have been around for many years.
The New York Attorney General Eliot Spitzer’s probe drew attention to a previously unknown industry. The lack of disclosure has undoubtedly cast doubt on our industry’s image with regulators and consumers. This is because contracts are signed almost nine months after inception.
These events have prompted some industry professionals to demand that contracts be signed at inception and fully disclosed.
London Market and Contract Certainty
The Financial Services Authority (FSA), a London-based non-governmental organization, has challenged the UK’s insurance industry to attain “contract certainty” by 2006. The FSA indicated that the FSA could intervene if the industry fails to meet the deadline.
In a speech to Insurance Insider Breakfast Briefing, Nick Prettejohn, CEO at Lloyds, stated that there are commercial reasons and regulatory reasons for a shift towards contract certainty. He defined contract delivery as “not just contract delivery” (i.e. A contract that was drafted or produced prior to inception, but also a complete and final agreement between the insureds and their insurers. Prettejohn stated that contract certainty is crucial to minimize risk. Without it, underwriters are uncertain about their exposure. “Uncertainty over underwriters leads to not only reserving risk, but also an inability to correctly understand business performance and pricing.” Capital misallocation can result from inability to accurately calculate exposure. He states that there is a commercial case for contract certainty.
Prettejohn further explained that if insurance/reinsurance companies fail to achieve contract certainty and thus cannot fully assess their exposure then the rationale for regulatory interest (FSA) is obvious.
Prettejohn concluded that “we have no choice in our drive for contract certainty; it is a must-have.” It is clear that there are commercial and regulatory reasons for this. Therefore, Lloyd’s should not be required to enforce compliance with any mandate or sanction. It is clearly preferable to a voluntary market solution and is definitely to be preferred over FSA enforcement.
The London Market is well on its way towards achieving their goal. What are our current positions? Can we work together to achieve the same goal, without regulation?
Slip vs. Contract
Many of the same principles that Nick Prettejohn outlines also apply to the US Reinsurance Market. To have “contract certainty”, (to borrow the phrase from our UK colleagues), there must be a final and complete agreement between the ceding company, and all reinsurers, before or immediately after inception.
My first “reinsurance job” was just out of law school. I had no idea what “reinsurance” was. My new boss showed me a stack of contracts, which “just came in” on my first day. After reviewing the contracts, I discovered that they had been in existence since January 1, 1977. Although they were property cat covers it was still offensive to a recent law graduate. Without a signed and complete contract, what industry is it? I was unsure what I was getting myself into.
These “sensibilities”, I am not ashamed to say, became less important as I worked in reinsurance and discovered that contracts were signed before or at the time of inception. These were also known as “placement slips” and “cover notes”, which were legally binding contracts. As my personal experience shows, a more complete contract would be negotiated, drafted, and signed at a later time, sometimes even later.
If the writing shows that the parties intend to offer or accept, it is sufficient to create a contract. A slip that promises to give or cede risk and premium in return for the reinsurer’s promise to accept premium and risk is a valid contract. It is possible that a slip does not contain enough information to address all questions regarding the contract’s interpretation. Any questions not thoroughly vetted will be left to the parties or to be resolved by an arbitrator.
Many brokers and reinsurers complained about the inability to complete contracts within the Nine Month Rule. History shows that this was incorrect, but it was the prevalent belief at the time. The new compressed time frame prompted brokers and the direct markets to include more than just the usual list of clauses on the slip. They also attached examples of clauses that were expected in the contract. We have come a long way since the simple cover note. It has become something with substance. We need to move further in the light of current market conditions.
For “contract certainty”, I believe we should push for a complete actual “contract” at the beginning, and not just a “completely signed slip”. The use of a slip may imply that terms and conditions have not been fully set. It may also seem that an actual contract is not yet in place for those not involved in the business, such as shareholders and consumers.
There are many problems in securing contract certainty. Having to negotiate contract provisions other than the strictly financial terms of a placement can lengthen and intensify the negotiation/placement process and put further pressure on an already hectic and harried renewal period. It is possible for brokers to take longer to negotiate the placement slip and fail to place coverage on time. This could be detrimental to clients. You should be aware that, especially in the broker market, coverage is purchased by subscription. This means that you might not get agreements from all reinsurers in time to put the contract into place by the inception date. Often, negotiations take place right up until the date of inception. This is because an underwriter’s authorization depends at least partly on contract provisions. In such a case, the underwriter wouldn’t be able have a contract “in-hand” at inception that does not reflect what has been negotiated.
Others suggested using “standardized wordings.” It might be easier to review the wording if it is familiar. Practically, each policy is unique. The rate charged to the business for the cover will vary. Therefore, “standardized wordings” won’t work in every situation. It is also a matter of who “standard wordings” are. The ceding company may want what the reinsurance industry would prefer as a “standard”, and vice versa. Anti-trust concerns may be raised if any “industry standard is used.” It is important to remember that reinsurance placement is a negotiated process. The type of wording an underwriter is willing to accept for one piece of business may not work for another. If the contract is to reflect this and be a negotiated solution, then all underwriting submissions must be submitted earlier for a full review. If the contract is not a negotiated process, these “standard” contracts may be viewed as contracts of adhesion. Standardization isn’t a panacea for contract certainty.
How can the Reinsurance Industry adapt to this change? One solution is to have more regulations. The insurance industry is already highly regulated. I think most people would agree that regulations and bureaucracy would not be welcomed. We need to change the way we do business. This is called a paradigm shift. This paradigm shift must be supported by all parties – brokers, ceding companies, and underwriters – if we want it to work. This change in behavior is only possible through the leadership of the board and senior management. Human nature resists change. The change is already happening and we as an industry must move forward.
It is important that you note the resistance to The Nine Month Rule in early 1990’s. Contract writers and underwriters said that it was impossible. It would have been difficult for the industry to produce and sign contracts within nine months. It was possible, and almost all contracts are negotiated, drafted, and signed within nine month of their inception. This was done because it was necessary, despite the apparent difficulty, and because there were too many accounting penalties for failing to do so. It was achieved with much anguish, at least from the brokers and reinsurers, and fear of accounting penalties for client ceding businesses.
Our industry faces additional regulations, and possibly more anxiety in complying with any regulations, so it is better to make voluntary changes than have new regulations with harsh penalties thrust upon us.
If the reinsurers receive the contract terms earlier in the placement process (September to October), they can negotiate, agree to and sign the contract before inception. They may also assign a subscription deadline prior to the inception date. This would mean that brokers must obtain all information regarding renewals and placements from clients as well as agreement to the contract terms at an early date.
Cultural shifts can lead to changes in business structure, business practices and work cycle. number of employees required. Brokers might suggest to their clients that they stagger inception dates throughout each year, rather than 1/1 or 7/1.
Version identification is an important consideration when there are changes due to negotiations. (Are you looking at the most recent document?
If it doesn’t address contract ambiguity, any movement towards signing contracts by/at inception is remiss.
Without my participation in a conference involving some top contract experts in the industry, this article wouldn’t have been possible. It was an honor to be invited to participate in the discussion on this topic. Eileen Villeroel and Jon Colello of AXIS Re, whose invaluable comments and assistance with this article are also appreciated. Last but not least, Ron Moore from AXIS gave me the opportunity to create this article for “Declarations”.