Our recent 3-part series focusing on issues that arise for cedants and reinsurers involved in cross-border reinsurance arrangements reviewed two recent English judgments which highlighted the inherent risks where fronted risks are placed ‘back to back’, and reinsurers exercise ‘claims control’. The full 3-part series can be accessed here.

In this final article we identified the following potential pitfalls and how to avoid them:

1.  Fronting issues

Local cedants commonly ‘front’ for foreign reinsurers by substantially reinsuring the risk (sometimes up to 100%). Significant risks arise for both local cedant, who is responsible for 100% of the risk whether or not the reinsurance cover responds, and reinsurers, who are reliant on the cedant’s underwriting and claims handling in the local jurisdiction.

In the Princess of the Stars, the cedant faced the invidious position of being left without any reinsurance cover for a major loss which was still to be adjudicated by the local courts. In Beazley v Al Ahleia, following market reinsurers were bound by the cedant’s and lead reinsurer’s actions  in compromising the claim, without their knowledge or involvement, notwithstanding the reinsurance including a claims control clause.

Additional fronting risks arise for reinsurers where:

  • The cedant has a wider relationship with the underlying insured
  • Cedants are substantially owned by the underlying insured
  • The same broker is involved at underlying and reinsurance level

In order to mitigate these risks cedants and reinsurers need:

  • To recognise and identify the risks
  • Ensure the reinsurance documents deal with inherent conflicts of interest
  • Deal with brokers’ inherent conflict of interest

Cedants ought to include provisions dealing with any failure of reinsurance security (eg non-vitiation provisions). Ensuring that underlying and reinsurance wordings will be interpreted identically is vital.

Reinsurers need to be aware that cedants retain negligible risk; understand underlying relationships; and ensure adequate controls in the reinsurance contract to permit control over claims settlement.

2.  Different legal systems applying to the direct and reinsurance placements

Middle East risks are almost always subject to local law and jurisdiction, no matter what the policy wording might say. Policies governed by foreign law will inevitably be interpreted in accordance with local law.

Local courts may well interpret policy wordings differently to international practice. However, this should not affect ‘back to back’ reinsurance placements subject to English law and jurisdiction. English law has established jurisprudence to accommodate local interpretations of insurance wordings on a ‘back to back’ basis, so that the reinsurance wording is construed in a manner that follows the underlying interpretation.

However, the ruling in Princess of the Stars shows it is essential that the English court be supplied with sufficient evidence as to how a foreign court will interpret the underlying policy wording. The English court accepted  that Philippine law and English law were likely to reach a similar conclusion in relation to the construction of a typhoon warranty, without the Philippine court having considered the issue. Countering this issue will require specific provisions to provide that the reinsurance policy will follow the interpretation of the underlying wording under local law. 

In Beazley, a partial settlement by the lead reinsurer  and cedant appeared to be in breach of a claims control clause. The judge appeared not to have been provided with sufficient information on Kuwaiti law that ‘without prejudice’ correspondence between parties is fully disclosable before the local courts, and payment of part of a claim is likely to constitute an admission of liability, and thus render the entire claim payable. Had this been appreciated it is doubtful the court would reached the decision it did.

The common factor in both cases concerns the lack of local law information put before the English court. It is imperative that parties to Middle East reinsurance disputes, whether in the local courts or London , are properly advised and appreciate the local law position.

A number of market participants contend that the answer is to have both the underlying and reinsurance wording subject to local law and jurisdiction. However, this is unlikely to provide a satisfactory solution for either party. Middle East jurisdictions lack reinsurance jurisprudence, and the local court is seldom equipped to deal with a genuine reinsurance coverage dispute. Although cedants may find the prospect of litigating on ‘home turf’ attractive, lack of reinsurance expertise, and issues associated with securing jurisdiction over a foreign reinsurer and procedures to enforce a local judgment, detract from the perceived advantages.

3.  Conflicts of interest

Conflicts of interest can arise where:

  • Cedants have entrenched existing relationships with underlying insureds
  • The same broker handles direct and reinsurance placements
  • Cedants retain negligible risk
  • Subscribing reinsurers have competing interests

Conflicts need not be insurmountable but should be recognised and managed. In practice it appears that reinsurers, cedants and brokers, rarely take any positive steps to manage these inherent conflicts.

A number of mechanisms can be used, including:

  • Insisting independent brokers in direct and reinsurance placements
  • Requiring cedants’ to warrant their ‘net retention
  • Using express wordings recognising the fronting relationship
  • Reviewing subscription market procedures (eg the London market General Underwriting Agreement)

4.  Market wordings

Middle East wordings tend to use international wordings which, although possibly tried and tested internationally, may be subject to different construction when translated into Arabic and considered by a local court.

 Wordings used for Middle East risks need to be reviewed in the context of local law and adapted accordingly. In new areas of business (e.g. Financial Lines or Cyber) a good understanding of the local law and potential exposures is required in order to customise wordings.

Reinsurers cannot rely on international interpretations of wordings. It is not sufficient for cedants to ‘cut and paste’ terms and wordings provided by reinsurers into a local policy.

The way forward

Middle East reinsurance is extensively cross-border and market participants need to appreciate the issues involved in order to avoid the problems identified above arising.