UK: Disputes in ART - They Can be Avoided

Last Updated: 21 November 2002

Article by Clive O'Connell

Alternative Risk Transfer deals are, almost by definition, both novel and complex. Such deals offer a new approach to the transfer of risk, combining elements of insurance risk transfer with credit or banking risk transfer. Many deals are unique and all are individually tailored.

These elements alone create a very fertile ground in which disputes can develop. New concepts must be expressed in new words. Often these new words fail to reflect clearly the intentions of both parties. Many clauses and phrases are untried and untested before the courts. What one party understands by a phrase is the opposite of the other’s understanding.

Disputes are already arising in relation to ART deals. These disputes are typically of high value and are legally and evidentially complicated. A good number of disputes, in whole or in part, arise from differences of interpretation of particular clauses; differences which have arisen because the wordings have not expressed the true intention of the parties or, more likely, because there was never any true meeting of the minds in respect of the particular provision.

It is the failure of the parties to ART transactions to have a common view of the purpose of the transaction which is probably the hallmark of all ART disputes, not merely those relating to the interpretation of wordings, but also, more worryingly, those dealing with the very validity of the contracts themselves.

ART combines the skills of both insurers and bankers. Both come to the transaction with their own cultural references. Insurers view risk in a particular way. They are willing to assume risk at a low price provided that all material facts are made known to them in advance. If facts are misrepresented or not disclosed, the insurer can avoid the contract. Bankers, on the other hand, are used to the assumption of risk being undertaken after due diligence and then performance of the guarantee to operate automatically and without question. For this banks charge a higher fee.

The main issue that is beginning to emerge in ART disputes is that the parties’ understanding of the nature of the risk being transferred is not always identical. Banks, in some instances, have been looking to off load banking risk to alternative markets at low cost. Insurers, caught in the soft market of the late 1990s, sought to obtain business that was nonaccumulative with their traditional books and which provided higher rates of premium.

In its simplest form, banks sought to obtain cover for risks on banking terms at insurance rates and insurers sought to write business on insurance terms at enhanced rates. The result is that either one party or the other failed to obtain what it expected and disputes arose.

Banks require immediately enforceable contracts. Often ART deals sit as part of larger complicated transactions and performance of each part of the structure is essential to the overall performance of the whole. Banks will therefore insist upon clauses which will both remove, insofar as is possible, the right to avoid the contract as well as introducing "pay now sue later" provisions. These terms are compatible with an insurance contract and therefore may be entered into by insurers. However, insurers must recognise these clauses for what they are and the changes that they make to the usual nature of underwriting risk. While insurers may assume banking risk, they should not do so for significantly less premium than banks would require for the same risk nor without performing due diligence. An insurer cannot give the same guarantee as a bank without providing the same safeguards for itself as a bank would.

Disputes in ART do not just arise between banks and insurers. A further area which has seen disputes is in reinsurance. Where insurers have assumed banking risk they have often done so with capacity provided by reinsurers. Whereas the insurer has the option of performing due diligence or asking questions about the risk, the reinsurer is reliant upon the information provided by the insurer. Where the insurer waives its remedies against its insured, a reinsurer, particularly a treaty reinsurer, does not necessarily do so. The result is a dispute which, at the very least, can cause the insurer a short to medium term cash deficit as it is obliged to pay its assured while waiting to resolve its dispute with its reinsurer. At worst, the insurer can find itself caught between two worlds and with a significant hit to its capital base.

With the development of ART and the increasingly innovative nature of risk transfer, disputes will arise. They will arise, to a large extent, from differences in understandings as to the nature of the transaction, how it is worded and how it is priced. These disputes are, however, to a great extent avoidable with proper care and diligence.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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