A Gentlemen’s Agreement Broken: Life and Annuity Reinsurance Arbitration
As late as the 1980s, the vast majority of U.S. reinsurance arbitrations were handled in-house. An in-house lawyer from the cedent and reinsurer presented their respective cases at a day-long hearing before a panel of industry veterans, usually underwriters or actuaries. The parties and the panel were instructed to interpret the contract as an “honorable engagement,” as often provided for in the contract itself:
The arbitrators and the Umpire shall interpret this Agreement as an honorable engagement, and shall not be obligated to follow the strict rules of law or evidence. In making their award, they shall apply the custom and practice of the insurance and reinsurance industry, with a view to effecting the general purpose of the Agreement.
Reinsurance was an agreement among “gentlemen” who understood their commitment went well beyond a technical reading of the treaty. It was not an arms-length transaction; legal technicalities did not trump the parties’ implicit agreement nor the custom and practice of the reinsurance industry.
The wave of asbestos and other U.S. environmental mass tort liabilities of the 1980s and 1990s changed everything, at least for the property and casualty (P&C) industry. Lloyd’s and other reinsurers were saddled with unprecedented losses under decades old agreements. No longer satisfied with in-house lawyers at single-day hearings, the parties began hiring prominent law firms, staffing panels with lawyers (rather than underwriters and actuaries), and holding week-long or sometimes month-long hearings. The Gentlemen’s agreement was broken.
Accident and health (A&H) (i.e., life, health, disability, long-term care, and annuity) reinsurance remained largely insulated from these types of reinsurance battles increasingly waged on the P&C side of the business. Until recently, most A&H reinsurance agreements still included language of an “honorable engagement” and “utmost good faith.” Indeed, most A&H treaties still require C-suite executive peers to meet and discuss their differences before filing any arbitration demand, remnants of the more genteel and courteous time. Many A&H executives are only now learning that the Gentlemen’s Agreement contained in many of their contracts was broken long ago.
This article is a brief guide to A&H reinsurance disputes for legal practitioners as well as insurance carriers and their reinsurers.
1. A&H Terminology
The A&H industry employs terminology not shared by the P&C industry. Policies do not pay indemnity, they pay benefits (and there are rarely “defense costs,” as such). A single policy is often referred to as a “case”; a single insured, a “life.” A group of policies reinsured under a treaty is a “block” of business. Managing general agents are “MGUs,” or managing general underwriters—at least nominally.
Benefit ratios fluctuate depending on factors not found in the property and casualty business such as persistency and amortization of acquisition costs. The “lapse rate” reflects the frequency with which policyholders allow their coverage to terminate, usually because of cessation (voluntary or involuntary) of premium payments. “Persistency” refers to the rate at which policyholders keep the subject policy in force. “Acquisition costs” consist principally of agency commissions, which may exceed 100% of first year’s premium, and typically are carried as a depreciating asset on the balance sheet.
A&H reinsurance treaties contain distinct provisions foreign to the P&C business, including:
- A multi-life warranty, often found in catastrophe reinsurance, may cover two to twenty (or more) lives, and provides that no liability arises until the specified number of lives is involved in the same event.
- An MAOL (“maximum any one life”) clause sets forth the maximum stated limits, per life, for the policies that will be insured, “or so deemed,” in a reinsurance treaty.
- The Recapture clause governs when and how the cedent may increase its retention, thereby assuming responsibility for corresponding subsequent premium and claims within the new retention. Some contracts contain recapture clauses that expressly provide the right to recapture after a certain period of time with no increase in retention necessary.
- The Reductions and Terminations clause governs allocation of liability between the parties when the insurance in force with the ceding company, for individual life policies, is terminated or reduced.
- An Errors and Omissions clause primarily concerns the cedent’s administration of the business.
- The contract duration of an A&H treaty may be indefinite with no automatic termination whereas P&C treaties rarely exceed 36 months.
Finally, because A&H reinsurance contracts are often perpetual, there are a suite of other clauses governing how policy changes, continuations, and conversions affect the reinsurance.
2. Recurring Issues in Life and Health Reinsurance
While trigger and allocation issues drive many P&C reinsurance disputes, a different set of issues has caused Life and Health reinsurers to proceed to arbitration.
YRT Premium Rates. Yearly renewable term (YRT) treaties typically provide that reinsurance premium rates are not guaranteed. This is a result of regulatory requirements mandating the establishment of a deficiency reserve if the rates are contractually fixed for the life of the agreement. Despite common usage of rate increase language, it is (or has been) extremely rare for reinsurers to raise rates, even in the event of adverse mortality experience.
Over the past decade, reinsurers have increasingly been raising rates on poorly performing blocks of business, citing treaty language permitting the rate increases. Cedents have countered that the parties understood that the rates were guaranteed despite the contract language to the contrary, and that reliance on such contract language is tantamount to bad faith. Cedents have sought to recapture such treaties rather than pay the increased rates, but that may not always be contractually permissible or economically desirable. More recently, cedents have negotiated the right to contractually limit any right to increase rates, employing a wide variety of wordings, including provisions that permit rate increases only if consistent with specified mortality tables, in order to secure the reinsurer’s specified profit margin, or only to the extent necessary to eliminate any deficiency reserve.
Recapture. In excess of loss reinsurance, the reinsurer assumes liability excess the cedent’s retention. A recapture provisions provide that a cedent may increase its retention in the entire class of business reinsured under certain circumstances. Typically, the contract contemplates that recapture cannot be permitted for a specified period of years after the inception of the treaty in order to allow the reinsurer to recoup its acquisition costs.
Because cedents have often sought to exercise recapture rights only with regard to profitable business, to the reinsurers’ financial disadvantage, disputes (and arbitration) over recapture are increasingly frequent. Issues have included whether: (i) the treaty permits recapture; (ii) the reinsurer was given proper notice of recapture; (iii) the notice of recapture is irrevocable; (iv) the recapture must include all treaties between the parties; and (v) the cedent must apply the recapture to its entire class of reinsured business.
Annuities. The reinsurance of annuity benefits resulted in a spate of arbitrations nearly a decade ago. These disputes arose over the reinsurance of guaranteed benefits promised contract holders, including GMIB (guaranteed minimum income benefits), GLWB (guaranteed lifetime withdraw benefit) and GMDB (guaranteed minimum death benefits). In the 1990s and early 2000s, annuity issuers began adding guaranteed benefits to their annuity contracts in order to make them more attractive to the investing public. These benefits included guaranteed minimum annual returns and guaranteed minimum annuity payments. GMDB contracts were exposed to the equity market’s performance, and the guarantees acted as a floor for the purchaser’s investment. The issuers reinsured their market exposure on these guaranteed benefits, frequently by 100%. The reinsurance was often written with an expectation of occasional equity market declines in an overall upward trajectory. For GMDB business, underlying insurance consisted mainly of “permanent” life policies and the reinsured guarantee would only pay in the event of the infrequent coincidence of death and market decline.
In 2008, reinsurers of these contracts suffered substantial losses and were, in many instances, forced to increase reserves by hundreds of millions of dollars due to steep market declines. Some disputes that followed this downturn focused on assignability of benefits as well as the issuer’s ability to change investment options, without notice to the reinsurer. The fundamental area of dispute in annuity reinsurance was the non-alignment of interests between the issuer and its reinsurer given the reinsurer’s acceptance of the entire benefit risk. In such instances, the issuer’s concern was for persistency while the reinsurer’s was to mitigate loss, usually by the strict application of the contract’s terms. The result was double digit percentage rate increases in reinsurance premium, accepting only a quota share percentage of the benefit reinsured, or the withdrawal from the reinsurance market entirely.
Non-disclosure and Misrepresentation. A&H disputes, like those on the P&C side, frequently see claims of nondisclosure, concealment, and misrepresentation. Because of the calculated long-tail nature of life, long-term care, and (certain) disability insurance products, reinsurers may need to rely on “early indicators” of performance. Factors such as persistency and continuance may emerge prior to losses, yet signal that a block of business could underperform. Actuaries monitoring such developments may be able to observe at an early stage that experience is deviating unfavorably from assumptions, potentially warranting strengthening of reserves in view of the likelihood of adverse loss development. Reinsurers have asserted that the failure to disclose such “early warning signs” represents material nondisclosure, warranting rescission. Other nondisclosure issues have arisen over the scope of the reinsured policies’ benefits, use of “aggressive” underwriting practices such as issuance of long-term care policies to nonagenarians residing in Florida, and use of reciprocal reinsurance as a means of spiraling “working layers” of reinsurance. Treaty provisions may define and restrict the policies eligible for cession, according to the amount insured, geographical region, age of insured, or other underwriting guidelines.
The volume of business written may overwhelm the cedent’s ability to accurately cede the appropriate premium and claims. Volume may also impair the capacity to avoid ceding claims and premium precluded by the policy terms. Overlooked claims may prove more likely to be discovered by the cedent than overlooked premium. Disputes often concern whether the error is “clerical” or “grossly negligent.” The result may be that after a decade or more the cedent or reinsurer discovers that millions of dollars in premium or claims (or both) were improperly ceded. Errors in connection with “missed premium” or “missed claims” are often not discovered until long after they occur, when documentation of the error may be incomplete.
Facultative cessions can also generate reinsurance disputes. Life treaties typically contain a clause precluding automatic reinsurance for any risk the cedent previously submitted on a facultative basis to the reinsurer, or indeed to any reinsurer. Such cases nevertheless sometimes are ceded automatically and disputes arise later in the event of a significant claim under such a policy. This is an area in which the panel’s grasp of industry custom and practice can be extremely important. Absent clear treaty language specifying how acceptance must be made, disputes arise if the cedent later claims, for example, that the reinsurer’s failure to expressly reject the cession constituted acceptance. Reinsurers have also disputed facultative cessions in which the policy was not underwritten in accordance with the cedent’s normal procedures for underwriting and issuance.
3. Reinsurance Arbitration Process
Large A&H reinsurers also reinsure property and casualty risks. As a consequence, such reinsurers are more familiar with the players and the arbitration process, usually conducted under the auspices of the AIDA Reinsurance and Insurance Arbitration Society (ARIAS). ARIAS was founded in 1994, and provides training, certification, and continuing education for reinsurance arbiters. ARIAS certified arbiters self-designated as having in-house expertise in life reinsurance represent less than 20% of the organization’s members. While many arbiters understand first-party benefits, few have dealt with the wide range and complexity of issues associated with life, annuity, and disability reinsurance, let alone the custom and practice of the A&H reinsurance industry.
Accident and health treaties, and less frequently life reinsurance treaties, may provide for certain disputes to be decided by “actuarial arbitration.” These disputes are typically limited to: (i) mathematical issues such as reserving or experience refunds and (ii) commutations. In an actuarial arbitration, a single actuary might be selected, or (more commonly) a panel of three actuaries decides the issue. Unlike usual reinsurance arbitration, these panels frequently dismiss the need for a conventional hearing as well as legal argument, seeing the dispute as a mathematical determination, which is often the case.
Expert witnesses are employed with a higher frequency in A&H disputes than in P&C disputes. This may be because expert testimony is more readily received when the arbiters do not have the necessary wealth of experience regarding the subject matter. Counsel’s own mastery of life, health, disability, and annuity concepts is also indispensable as A&H reinsurance disputes often turn on concepts foreign to most lawyers and arbiters. In such instances, a panel may be inclined to have a greater credence to positions presented by lawyers who have mastered these industry concepts.
As with the P&C industry, a more fulsome and knowledgeable dispute resolution process for A&H reinsurance is only now emerging in the wake (or discovery) of the Gentlemen Agreement’s demise. As the arbitration community gains greater knowledge and familiarity with A&H products, its awards and determinations will ultimately bring clarity to the newly developing relationship between A&H cedents and reinsurers. In the meantime, the industry must cultivate seasoned arbiters, translate its customs and practices into legal doctrines, and redraft their reinsurance agreements with an eye toward conflict.