A current feature of the economic climate has been the further development of contractual provisions within insurance and reinsurance policies which aim to protect insureds against (re)insurer default. Insureds are, understandably, concerned about credit risk and the potential for counterparty insolvency and various types of protection are now a frequent point of negotiation where such clauses may have, until recently, been overlooked. Amongst the protections being negotiated are collateralisation techniques and downgrade clauses.
The Reinsurance Directive prohibits any EU State from requiring reinsurers from other States to post collateral with cedants in order to obtain capital relief. Despite the abolition of collateral requirements between EU Member States, parties can still provide contractually for security for reinsurance claims.
The current renewal season has witnessed the enduring appeal of traditional forms of collateral. However, a number of alternative collateralisation techniques are being developed – or re-discovered. These include:
- Letters of credit (collateralised or otherwise).
- Cash-deposits (in particular through funds-withheld accounts).
- Trust funds (although their recognition under some continental legislation is in doubt).
- Structured transactions, which can involve offshore protected cell companies (PCC).
Great care needs to be taken in drafting these provisions and, in particular, ensuring that the reinsurance contract and security documents work together as the parties intend and that the security given is enforceable.
In addition, the prevalence of downgrade clauses (in addition to a variety of other termination clauses) in annual covers is notable (their use was traditionally limited to multi-year covers). Downgrade clauses allow the (re)insured to terminate the policy (triggering a return of unearned premiums) in the event that the insurer or reinsurer suffers a ratings downgrade below a pre-agreed level.
The following points need to be considered:
- Whether the downgrade should trigger a termination right or whether it should give rise to an obligation to provide security for payments.
- If a termination right, consider whether the policy should give the (re)insured an option to terminate in preference to automatic termination.
- Single rating agency triggers may not give a true representation of the financial position of the counterparty. Further, consider whether rating agencies are the appropriate arbiters of financial strength.
Managing capital efficiently and monitoring counterparty exposures are critical in the current economic climate. The prevalence of these types of protections are not surprising, but great care needs to be taken to ensure that they operate as the parties intend and that counterparties are indeed complying with their obligations.