UK: Finite Reinsurance And The Use Of Side Agreements

Last Updated: 24 August 2005
Article by Colin Croly and Joanne Jolly

Regulators in both the US and UK have been paying close attention to finite reinsurance. The use of side letters in particular has been causing the regulators concern.

On 9 March 2005 John Tiner addressed the ABI Conference and informed the delegates of progress that the regulator was making in the supervision of the insurance industry in the UK. Among a comprehensive list of initiatives was one that, although mildly phrased, may well have caused some concern in a number of boardrooms. Talking on the subject of "financial engineering or finite reinsurance", Mr Tiner made a reference to actions taken against some insurers and their senior management who have used "financial arrangements" to distort their results. Mr Tiner promised (or perhaps threatened) that the FSA would shortly be writing to the CEOs of insurance companies asking for "specific information about financial arrangements they have entered into where the economic value of the transaction differs materially from the value placed on the transaction in their firm’s balance sheet."

In focussing on abuses of finite reinsurance the FSA is acting in line with the stance taken by US regulators and Eliot Spitzer, the New York Attorney General, in particular. Suggestions have been made that finite reinsurance is no longer a viable form of reinsurance. Many companies are being cautious about buying or selling finite reinsurance products. This is not, however, the first time that finite reinsurance has come under scrutiny.

In the past, fiscal or regulatory authorities have been concerned with the appropriateness or legality of finite reinsurance products due to a possible lack of risk transfer. Regulators have made it clear that some form of meaningful risk transfer had to occur but have never sought to define the parameters of meaningful transfer. A rule of thumb has been adopted by many and is known as the "10/10 rule". A 10 per cent chance of a loss in excess of 10 per cent of the premium had to exist. The existence of risk, however, was not to everyone’s liking and some have sought ways to minimise the risk and to make the transaction more predictable. The use of side agreements or letters of intent have been employed in this regard. It is this use of side agreements which is causing the regulators most concern.

The regulators have not been slow to react. In June 2004 the FSA banned Christopher Headdon, the former chairman of Equitable Life, from the market for six years following his failure to disclose a side letter which limited the regulatory value of a finite reinsurance treaty previously valued at £800 million.

The collapse of the HIH Insurance group resulting in part from its use of side agreements removing the risk from its finite reinsurance treaties, has had serious consequences for those involved. Two of the group’s directors, Rodney Adler and Ray Williams, received four and a half year prison sentences and its reinsurers are currently being investigated by the Australian regulatory authorities.

In New York, Eliot Spitzer has accused reinsurers offering finite reinsurance of aiding and abetting accounting fraud by US companies. AIG have already paid US$123 million to settle two such allegations, providing a powerful illustration of the potential consequences for reinsurers.

Not all side agreement however, are unacceptable. A side agreement which pursues legitimate objectives and is drafted properly, can be legally effective. For example, in multi-party agreements, side agreements are used to effect arrangements between two of the parties which are confidential from the other parties.

On the other hand, a side agreement with a legitimate purpose but which is structured or drafted in such a manner that it does not achieve its aim, is legally ineffective. Side agreements which do not demonstrate an intention to create legal relations between the parties (so called "Gentlemen’s agreements") are prone to being construed as letters of intent or statements of present policy and of no legal effect. Sometimes side agreements are used to explain or clarify the terms of the main agreement. These are ineffective – if the main agreement requires explanation, redraft the main agreement. Further, side agreements concluded in spite of an effective "entire agreement" clause contained in the main agreement will be negated.

Clearly, side agreements can take many forms and are common in many forms of commercial activity. Side agreements can be useful. Sometimes they are simply ineffective. Sometimes they fall foul of hypothetical dispute which arose out of regulations. Given the modern drive for "contract certainty", parties should take extra care when entering into side agreements to ensure that the side agreement achieves its aim and is not being used to conceal the reinsured’s true financial position as the consequences of this are likely to be very serious.

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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