Collateralized reinsurance contract details matter: Clyde & Co

As alternative or ILS capital, in the form of sidecars, industry loss warranties, catastrophe bonds and collateralized reinsurance, becomes an increasing part of the reinsurance market’s furniture, attention to contract details is a must, according to law firm Clyde & Co.

Over the last few years’ alternative capital providers have relentlessly entered the traditional reinsurance space, and as a sub-sector, collateralized reinsurance is now the fastest growing insurance-linked securities (ILS) instrument in use in the reinsurance market.

In fact, with catastrophe bonds hovering around $22 billion of capital at risk, but with the ILS sector commanding nearer to $65 billion (or even 70) of alternative capacity, collateralized reinsurance is now thought to make up around $30-35 billion of this.

But a recent report by international law firm Clyde & Co titled, ‘Beware catastrophe reinsurers bearing gifts… The possible downside of the collateralized reinsurance boom,’ has warned that extra care needs to be taken with the asset class’ legal and contractual technicalities, specifically with the reinsurance wording and its interpretation in law.

The law firm explains that despite the market embracing extra catastrophe coverage options, opposed to purely traditional reinsurance, some industry players have scrutinised “the differently constructed and negotiated transactions that comprise collateralized reinsurance placement.”

Clyde & Co advises that scrutiny surrounding the way reinsurance wordings, often subject to English law, collaborate with Trust Agreements, which are often subject to New York law, has become a key focus. “With the added complication that many reinsurers operate subject to Bermudian law and regulatory oversight,” notes Clyde & Co.

The law firm continues to discuss the potential problems that can occur from the interaction between collateralized reinsurance contracts and trust agreements, and details them as follows:

• 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:
  1. Contracts where it is clear that reinsureds can draw down from the trust at any time without notice.
  2. 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.
  3. Contracts which are silent in relation to withdrawals but where the trust agreement provides that withdrawals have to be made on notice.

Also, warns Clyde & Co, those involved should note the following provisions made in reinsurance contracts, when reinsurers have solvency issues, or are otherwise unable to meet their requirements:

• 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.

As collateralized reinsurance contracts become more popular within the space, those under contract would be wise to make themselves aware of the any potential confusion, which could result in unnecessary costs and exposures.

“The level of review becomes more important as collateralized reinsurance becomes ever more prevalent,” concluded Clyde & Co.