Institutional investment in reinsurance risk has become part of the mainstream. Insurance-linked securities first appeared nearly 20 years ago, but by the end of 2012 the market for catastrophe bonds, industry loss warranties and collateralised reinsurance had soared to USD 28 billion. Collateralised reinsurance, in particular, has become the structure du jour for (re)insurers seeking comprehensive non-life protection. An investor and insurer agree a contract with a defined limit, premium and loss trigger, as with traditional reinsurance. Collateral equal to the limit is posted to a special-purpose reinsurer to hold in trust either until maturity (when it is returned to investors) or on the occurrence of a pre-defined event (when it is paid out to the reinsured).
The wave of money into the sector and attractive structures (involving reduced counterparty risk, highly tailored coverage, and costs reduction) are clearly good news for the market, which has barely been able to contain its excitement. Whereas ‘traditional’ reinsurance was once the only option for (re)insurers seeking catastrophe coverage, they now have various options.
However, alongside the possibility that the rush toward collateralised reinsurance is artificially softening the market, should the market be wary? Some reinsureds think so and have scrutinised the differently constructed and negotiated transactions that comprise a collateralised reinsurance placement. Particular focus has fallen on how reinsurance wordings (often subject to English law) interact with Trust Agreements (generally subject to New York law), with the added complication that many reinsurers operate subject to Bermudian law and regulatory oversight.
Experience shows that the reinsurance contracts adopt a ‘slip plus standard wording’ configuration and are generally sound. Similarly, the trust agreements (while not so standardised) tend to be valid and enforceable under New York law. However, potential issues arise from the interaction between reinsurance contracts and trust agreements, which should be reviewed carefully. In outline:
- The use of standard ‘loss settlements binding’ wording means that reinsurers are obliged to follow settlements made by reinsureds, subject to losses falling both within the cover of the underlying policies and within the cover created by the reinsurances
- There is, however, a tension between trust agreements permitting withdrawals without reinsurers’ consent and loss settlements wording which requires “reasonable evidence of the amount paid”. That tension is lessened where the trust agreements leave reinsureds free to withdraw assets from trust at any time without notice. The tension is heightened where the contracts require a reinsurer payment default before the reinsured is entitled to withdraw, thereby affording scope to delay payments and rendering the trust a fall-back rather than a fund against which a reinsured can, in the first instance, withdraw funds relating to its losses
- Similarly, provisions defining reinsurers’ payment obligations vary between reinsurance contracts. We have seen three main variables:
- Contracts where it is clear that reinsureds can draw down from the trust at any time without notice
- Contracts which are less explicit regarding the basis for withdrawal but where the trust agreement leaves reinsureds free to withdraw assets from the trust at any time without notice
- Contracts which are silent in relation to withdrawals but where the trust agreement provides that withdrawals have to be made on notice
It is important from a reinsured’s perspective that any reinsurance contract and related trust agreement permit it to withdraw assets from the trust at any time without notice (thereby reducing counterparty risk). In any event, parties should beware the different structures.
Parties should also note the provision made in reinsurance contracts for when reinsurers are subject to solvency issues or otherwise unable to meet their obligations:
- Many wordings limit the means by which reinsureds can enforce the contracts simply to the recovery of funds remaining in trust. Where monies are not paid under reinsurance contracts, the threat of petitioning for receivership/winding-up is often an effective means of forcing payment. Some collateralised reinsurance wordings remove that option and reinsureds may wish to reject any wording that limits enforcement methods
- By contrast, the benefit of the same provisions (and trust accounts operating as segregated accounts under the relevant Bermudian legislation) is that, in the event of reinsurer insolvency, trust assets are ring-fenced from claims by company creditors or creditors of other segregated accounts
- Many reinsurance contracts also include Special Cancellation Clauses which protect reinsureds, allowing them to cancel a reinsurer’s participation if its ability to meet its obligations is in doubt and/or if there is a material failure to comply with the reinsurance contract terms. The obvious limitation is that, upon cancellation, the reinsurer’s liability will be limited only to losses occurring pre-cancellation
Contracting parties to collateralised reinsurance should beware the differing structures and the potential pitfalls. Failing to review and understand a collateralised transaction (particularly the interplay between the contracts) may lead to unintended consequences; the level of review becomes more important as collateralised reinsurance becomes ever more prevalent.