UK: The Credit Crunch - Clauses To Consider This Renewals Season

As the credit crunch has deepened, its effects have rippled outwards. The sub-prime crisis in the US, market losses and failing confidence in the banking market have led to rating downgrades, emergency raising of capital and, ultimately, state intervention.

The insurance market has not been immune, AIG's high-profile failure being the paradigm example that the security of even the largest insurers may fail.

This renewal season more than in previous years clauses which in better times might have been treated as little more than "boilerplate" will come under much greater scrutiny. With deals unwinding, contracts being cancelled and the spectre of insolvency looming large, we focus here on termination, downgrade, insolvency and set-off clauses, the issues arising from them and their potential importance for reinsurance contracts.

Termination clauses

Termination clauses in reinsurance contracts will be of particular relevance in contracts written on a long-term or continuous basis. Generally, long-term reinsurance contracts provide for either a Notice of Cancellation at Anniversary Date (NCAD) or a Provisional Notice of Cancellation (PNOC). The difference between the two is that, once a PNOC has been given, a consultation process between the reinsured and the reinsurer follows to decide whether the contract should be continued past its anniversary date. This consultation period also gives each party the opportunity to reassess the credit worthiness and financial strength of the other. NCAD clauses, by contrast, simply allow the reinsurer to cancel the reinsurance with effect from its anniversary date, provided notice is given not later than the date specified in the clause (for example 90 or 120 days). Reviewing and possibly terminating a reinsurance contract close to its anniversary date may, however, prove too late to make alternative arrangements considering the fast pace at which some reinsureds and reinsurers have become a higher credit risk in the current economic conditions. For Lloyd's Market reinsureds, the loss of a major reinsurance contract may be a matter which will need to be reported to the Franchise Board under the requirements of the Underwriting Byelaws.

General termination provisions, allowing termination of the contract after a specified notice period, may be helpful, and parties will need to ensure that these strike the right balance between flexibility to cancel reinsurance arrangements and promoting certainty of ongoing cover, or at least give sufficient time for the reinsured to source alternative reinsurance.

Downgrade clauses

A downgrade clause is an exit option linked to the financial strength of either party, which can be triggered at any time during the duration of the contract, complements a general notice of termination.

Unsurprisingly, there has been a surge in requests from reinsureds and brokers for downgrade clauses to be inserted into reinsurance contracts, which usually allow the reinsured, or alternatively either party, to terminate the contract if the reinsurer suffers a rating downgrade. A reinsured may see such a term as reducing its exposure to its reinsurer's credit risk and of protecting the value of its reinsurance programme. However, downgrade clauses could sit awkwardly in the relationship between reinsureds and reinsurers, and set out below are some of the factors which parties should bear in mind when considering possible downgrade clauses:

  • most downgrade clauses give the reinsured the option to terminate the contract. By doing so, of course, a reinsured's own rating may be affected if the level of its reinsurance declines;
  • the period in which the reinsured may exercise its option to terminate the contract must be adequately defined;
  • alternatives to termination in case of a rating downgrade should be considered, such as a provision for additional security; and
  • termination will result in a pro-rata refund of premium and a cap on the reinsurer's exposure.

The parties' bargaining power will decide the shape of these clauses. The extent to which they become a standard feature within reinsurance contracts this renewal season remains to be seen.

Insolvency of reinsurers

Parties to reinsurance contracts will need to be aware of the order of priority given to creditors in the winding-up of a UK insurer, set out in the Insurers (Reorganisation and Winding Up) Regulations 2004 ("the Reorganisation Regulations").

The Reorganisation Regulations do not apply to pure reinsurers, but provide for super-priority for "insurance debts" of a UK insurer, which would not apply on a general insolvency.

An "insurance debt" is a debt for which a UK insurer is or may become liable, pursuant to a contract of insurance, to a policyholder or to any person who has a direct right of action against that insurer. It includes premium paid which the insurer may be liable to refund. The definition of "insurance debt" excludes reinsurance claims.

The exclusion of pure reinsurers and reinsurance claims from the Reorganisation Regulations has certain commercial ramifications. Reinsureds frequently take into account prospective reinsurers' security when placing business. If a reinsured has bought reinsurance from a company that writes, or is authorised to write, both direct insurance and reinsurance, then its reinsurance recoveries may be adversely affected if the reinsurer encounters financial difficulties, as those with "insurance debts" (i.e. direct policyholders) will be able to take advantage of the super-priority, potentially exhausting the company's funds before any reinsurance recoveries can be made.

Reinsureds may therefore try to negotiate price readjustments, or avoid buying reinsurance from any company other than a pure reinsurer. Correspondingly, reinsurers which also write insurance business often split the business so that separate entities write either solely reinsurance or solely insurance business.

Insolvency clauses

Insolvency clauses generally provide, among other things, that on the reinsured's insolvency, reinsurance recoveries are still payable to it (or its liquidator), notwithstanding the insolvency. Historically, such claims operated on a "pay as paid" basis; the reinsured was obliged to pay underlying claims before being able to recover under the reinsurance. This meant that liquidators of insolvent reinsureds could not access reinsurance recoveries if they were unable to pay underlying claims first.

In Charter Re v Fagan (1996), however, the House of Lords established that the trigger for reinsurance recoveries becoming collectible should be the establishment of the reinsured's liability to pay its policyholders, rather than actual payment. Insolvency clauses now reflect this position and the fact that the reinsurer is liable to pay the reinsured even though the reinsured is unable to pay its policyholder first by reason of its insolvency.

Set-off clauses

Set-off clauses allow a reinsurer to set off any amounts due from a reinsured against any amounts which are or may become due to it. This is particularly useful where an insolvent reinsured has defaulted, or is at risk of defaulting, on premium payments.

However, such clauses may be void if they purport to give greater rights than those allowed under the Insolvency Rules 1986. Rule 4.90(3) of the Rules (which is mandatory and cannot be excluded by contract) provides that "An account shall be taken of what is due from each party to the other in respect of the mutual dealings, and the sums due from one party shall be set off against the sums due from the other." Any sums due from the insolvent party in excess of that which is owed to it by the solvent party must be proved for in the liquidation in the ordinary way. Similarly, if the solvent party owes to the insolvent party more than the insolvent party owes to it, it must pay the balance to the liquidator.

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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