As the reinsurance industry’s memory of the unprecedented level of losses of 2005 is fading in the generally warm glow of positive results for 2006, it is worthwhile giving some consideration to one of the issues that has had a significant impact on the market in the aftermath of the events of 2005 and which is likely to re-surface at some time in the not too distant future.

This article considers the use of ratings and in particular, their potential consequences on the cedant/reinsurer relationship. Their impact may be most keenly felt when provision is made in the agreement for a special termination clause (STC) - an increasingly common feature in many contracts.

It is easy to speculate why STCs are increasingly found in agreements but it is clear that the issue of financial security remains paramount and such clauses that utilise a rating trigger have become a central requirement of a cedant’s/reinsurer’s risk management. The impact of these clauses has been brought into sharp focus following the unprecedented losses arising from the wind storms of 2005. Such clauses have the potential to magnify the financial difficulties that have in many cases led to a downgrade.

Typically an STC gives one or both parties the option to bring the reinsurance contract to an end prior to its natural expiry. It expressly defines those circumstances and events that will trigger the right for one or both parties to elect to cancel the reinsurance contract. The circumstances provided for will often include: failure by either party to comply with the terms and conditions of the contract (whether or not such a breach amounts to a repudiation of the contract); insolvency or a defined material change in the financial circumstances such as a rating downgrade of one or both parties; a material change in the management, ownership or control of one or both parties; or a change in law or regulation or some other external event that renders the whole or some part of the reinsurance agreement impossible to perform.

The parties may wish to ensure that the opportunity to terminate the reinsurance contract arises well in advance of an insolvency event occurring. A special termination/cancellation clause may therefore provide for either party to cancel in the event of a change in the other party’s financial circumstances that falls short of an insolvency event but indicates a significant worsening of its financial status and ability to pay its debts and the real prospect of it being declared insolvent in the near future. Typical examples include a given percentage impairment of the reinsurer’s capital or a reduction in paid up capital (effectively the same thing) or a percentage loss of policyholders’ surplus funds.

Consideration of issues from cedant perspective in the event of a rating downgrade

From the cedant’s perspective, in the contractual relationship, it goes without saying that it has an obligation to pay claims to its policyholders whether or not it has reinsurance. If its reinsurers are downgraded, it has to consider how it should react taking into account the effect it may have on its own ratings and in many cases, potentially its shareholders.

Ultimately the reliance on STCs with ratings triggers should not replace the requirement for effective financial due diligence. This would be altering what (ie the rating) has traditionally been a tool used to identify the financial strength of reinsurers (in the case of cedants) and should not be considered a fail safe. The financial strength of a potential counterparty should be a matter for the cedant’s security group which would use a wider remit to consider the credit worthiness of reinsurers. This might range from applying the criteria used by the rating agencies (insofar as the information is available) to talking to people in the market. This will ultimately lead to the creation of an approved list of reinsurers. The question that the cedant ultimately has to consider is whether it wants a particular reinsurer to be on risk at the time of CAT losses.

In the event that the reinsurer’s rating is downgraded and the contract provides for a STC with a rating trigger, it will not necessarily be the case that the cedant will exercise the option. The cedant may wish to maintain its relationship with the reinsurer but at the same time, it should consider reserving its right to exercise the option to terminate. Recent history has provided examples in which cultural differences between the US and Europe have had an impact on whether cedants will support a relationship where a reinsurer is in difficulties. This has meant that US cedants have in the past appeared to have taken a shorter-term and more opportunistic approach to their relationships with reinsurers.

In situations where a cedant has concerns about a reinsurer’s solvency, it may look to alternative methods of providing additional security. Such alternatives may include letters of credit and more recently trust agreements. Commonly, these will involve the deposit of assets (usually referred to as being by way of ‘trust’) with a third party who is mandated to hold those assets for the benefit of the party taking the security. Very often, the structure will also involve the provider of the security being allowed to remove assets from the ‘trust’ and replace them with equivalent assets and/or to receive income granted from the assets in the event of enforcement.

Consideration of issues from a reinsurer’s perspective in the event of a rating downgrade

For the reinsurer, if any issue arises regarding the solvency of the cedant, it clearly will have concerns and will wish to ensure that it has the appropriate safeguards in place. For a reinsurer, it will not wish to continue to be bound to a reinsurance of an insolvent company because of statutory insolvency procedures (under English law) that may impact on the usual claims settlement process to the detriment of the reinsurer and/or mean claims payments end up in the hands of creditors rather than original insureds. The reinsurance contract itself may provide for alternative claims settlement procedures in the event of the cedant’s insolvency. Claims may be settled on behalf of the cedant by the administrator or liquidator and the process for notification of claims to the reinsurer may be altered once the cedant becomes insolvent. There may also be a risk of cutthrough liability to the original insured and consequent double payment of losses.

As with all contracts, it is up to the parties to negotiate the terms. However, it is likely that the larger, more successful reinsurers with a strong rating will hold the whip hand in any negotiation and thus potentially have the bargaining power to negotiate the removal of any STC with a rating trigger.

Those companies with weaker ratings are often in a lessadvantageous position to negotiate with their rating likely to be closer to any rating trigger. Clearly from a cedant perspective, this type of security may be less attractive particularly in the event that the reinsurer experiences any future adverse development. The consequences for the reinsurer in circumstances where the rating trigger is reached and the cedant opts to terminate the agreement, have the potential to be disastrous resulting in cash-flow issues that could turn into further downgrades leading to an eventual collapse. It is clearly not in the cedant’s interests for its reinsurer to fail.

It is inevitable that there will be some reliance placed on the analysis of rating agencies and there is increasing pressure being applied by the market to ensure the accuracy of this information. The recent past has shown that the market is increasingly looking to question the level of responsibility that the agencies should bear particularly where there has been a plethora of downgrades with its potentially destabilising effect on the market as a whole.

Establishing a breach of contract between a cedant/reinsurer and an agency would be difficult owing to the contractual terms and conditions which are likely to include any number of caveats and disclaimers as to the accuracy of the information.

Similarly, establishing negligence would be difficult as the duty owed to third parties for negligent mis-statements is very limited.

An uneasy tension has always existed between rating agencies and cedants/reinsurers. This tension is usually accentuated in the aftermath of catastrophic events as has become clear since the unprecedented losses arising from the wind storms of 2005. Since this time, it is understandable that the popularity of STCs with a rating trigger provision has grown. However, it is clear that such a provision will not necessarily be to the benefit of the cedant. Careful consideration of a potential reinsurer is vital prior to the inception of any agreement. It is essential that both parties have effective security committees to understand its counterparty’s financial health. It is insufficient to rely on ratings alone particularly when used in this manner and, particularly at a time when the market’s confidence in these agencies is only just starting to return.