UK: Contract Certainty –A Market Driven Approach

Last Updated: 24 August 2005
Article by Clive O'Connell and Joanne Jolly

The SEC and Spitzer investigations in the US, and the FSA’s calls for market reform in the UK, with the goal of contract certainty by 2007, will have farreaching implications for the insurance and reinsurance markets. What are the likely consequences for the ART market?

The finite (re)insurance markets have come under considerable scrutiny recently. The SEC and the New York attorneygeneral, Eliot Spitzer, instigated the process towards the end of last year, with other States following. The SEC and Spitzer investigations were primarily concerned with a perceived lack of transparency over the accounting treatment of financial (re)insurance and the need for risk transfer. This has led many (re)insurers to review transactions entered into, often several years ago, to consider whether they will withstand external scrutiny in the cold light of 2005 and, in some cases, to review their involvement in the market per se. This is not surprising when Mr Spitzer has said he views "the whole Island of Bermuda and other offshore ventures sceptically" because they "will be perceived as being behind some sort of veil of secrecy and, therefore, suspect".

Although the FSA has recently stated in March that it will be looking at specific "financial arrangements", it is also expecting market reform as a whole. Following the introduction of the International Accounting Standards from 1 January 2005, John Tiner, Chief Executive of the FSA, has made it clear that the (re)insurance markets must attain contract certainty by 2007 or the FSA will intervene: "we want to see an end of the practice which is deal now, detail later." This coincides with the FSA’s new-found role in the regulation of intermediaries who, in many cases, have an integral role to play in the production of wordings in more traditional reinsurance.

So how is contract certainty to be achieved? There has been much debate in the market – some say that the FSA does not require absolute legal certainty in the sense that contractual documentation is to survive legal scrutiny – this is said to be unattainable and would stifle innovation; instead, all that is required is that the deal is accurately documented at the time of transacting. So what is new for the ART market, a market which deals in complex and bespoke financial (re)insurance transactions which are generally documented in an extensive and bespoke manner at the time of contracting?

Guidance on what the FSA hopes to achieve can be found in the Integrated Prudential Sourcebook (PRU) on the interpretation of PRU1.4 which relates to risk management. It came into force at the end of 2004 and applies to all firms regulated by the FSA that carry on insurance and reinsurance business.

PRU 1.4.19R(2) requires a firm to "document its policy for insurance risk, including its risk appetite and how it identifies, measures, monitors and controls that risk". In the guidance to PRU 1.4, Chapter 7.1, paragraph 30 requires a (re)insurer to "pay close attention to the wording of its policy documentation to ensure that these wordings do not expose it to more, or higher, claims than it is expecting". In doing so, a (re)insurer is to consider:

(a) whether it has adequate in-house legal resources;

(b) the need for periodic independent legal review of policy documentation;

(c) the use of standardised documentation and referral procedures for variation of terms;

(d) reviewing the documentation used by other (re)insurers;

(e) revising documentation for new policies in light of past experience; and

(f) the operation of law in the jurisdiction of the policyholder.

In our experience, in-house and external legal counsel referred to in (a) and (b) are regularly employed in individual ART transactions. If they are not, they should be. Furthermore, the guidance given at (d) is interesting in the context of ART where deals are often highly sensitive and confidential. Confidentiality is unlikely to be waived. We also query whether the FSA is advocating the practice of ‘cutting and pasting’ which is often used in more traditional reinsurance. We think not. What the FSA wants is for companies to have adequate controls in place to ensure that contract certainty is obtained. It requires the (re)insurance market to achieve the same level of contract certainty as the banking and capital markets.

Given the involvement of the banking and capital markets in the field of ART, the FSA’s certainty requirements have been an issue for some time and often in the past it has been the interaction between the different legal regimes and market practices that have resulted in ART disputes. Not all ART transactions are documented with the degree of certainty that would be expected for such high value and bespoke products. In fact, the Capital Markets section of the FSA has still singled out those operating in the area of credit derivatives for specific criticism.

The FSA requires a transaction to be documented with clarity prior to inception. All terms must be agreed. This is important in the context of ART where there is room for a mismatch between the expectations of those who regularly do business in the banking and capital markets under a different legal framework from those who operate in the (re)insurance market.

At the time of going to print it had just been announced that a blueprint for contract certainty had been approved by the main (re)insurance market bodies. The blueprint will see at least 85 per cent of contracts written in the London market achieve contract certainty "by the complete and final agreement of all terms between the insured and insurers before inception." Furthermore, over 250 insurers and brokers have been asked to explain within two weeks how they intend to achieve contract certainty. The blueprint will give the FSA a framework against which to assess whether contract certainty is being achieved. If it is not, it will remain open for the FSA to penalise faltering companies through capital loading for example, or by regulation which, ultimately, may be less effective and more costly than a marketdriven response. What is clear is that contractual certainty is no longer an optional luxury for the market in 2005.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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