Cavent Cedant: Does Your Reinsurer Have a Complete Balance Sheet
O&B Insurance Advisory
October 20, 2003

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As they enter this renewal season, insurers seeking to purchase reinsurance need to take into account major changes to insolvency laws affecting all insurers based in the European Union ("EU"). This is a major change from the prior insolvency regime in the United Kingdom , and will include Lloyd's.

New legislation concerning insolvent insurers has been introduced by the EU member states effective as of April 2003, in accordance with a European Parliament directive. Of greatest importance to purchasers of reinsurance are the provisions governing the priority of creditors ¹ : according to the new laws, all insolvent EU reinsurers must pay their direct policyholder claims first and the claims of reinsured policyholders ("cedants") are subordinated. This downgrading in priority should inform the counterparty credit decisions of all companies ceding business to companies in the UK market that write both direct (insurance) and reinsurance business (for the purposes of this article, such companies are referred to as "composite" re /insurers) 2 , or to companies whose capital position depends heavily on the collectability of retrocessional coverage from the UK. Moreover, this issue generally highlights the necessity of understanding potential risks arising out of jurisdictional issues - which cedants (and their placing intermediaries) have historically ignored, to their increasing peril.

OVERVIEW

While it has long been the case in the United States that direct policyholders take priority over ceding insurers in the distribution of an insolvent insurer's assets 3 , until very recently ceding companies could take comfort that in the United Kingdom and some other European countries they ranked equally, in legal parlance " pari passu ," with direct policyholders 4 . Effective April 20, 2003 the pari passu rule is no longer operative to any liquidations occurring after 20 April in any EU country.

This represents a change in the UK , including ultimately the Lloyd's market entities, all of which are subject to the Directive. Lloyd's and the balance of the UK market is characterized by insurers that offer both reinsurance and direct, primary coverage. Going forward, companies that cede reinsurance

to a "composite" EU re/ insurer should verify and evaluate the extent of the reinsurer's direct business 5 . If the evaluation is ignored, or miscalculated, the ceding company should be prepared to stand in line behind direct policyholders if its "composite" re /insurer is reorganized or wound-up. In the US, his torically, creditors standing behind first priority policyholders in insolvency have received little, or nothing, from the proceeds of the insolvent's estate, and it is possible, if not likely that under the new EU regime reinsurance creditors will have the same experience. The changes in the EU rules may potentially have a ripple effect worldwide. That is because the rules potentially impact:

• A cedant that purchases reinsurance from a "composite" re /insurer domiciled in the EU.
• A cedant that purchases reinsurance from a non-EU re /insurer, even if the re /insurer's domiciliary jurisdiction follows the pari passu rule, if the re /insurer is heavily reinsured in the EU market by "composite" re /insurers.
• A direct policyholder of a non-EU re /insurer, if the insurer is heavily reinsured in the EU market by "composite" re /insurers.

Experience has shown that many participants in the Lloyds and "London" markets have both direct and assumed reinsurance books of business, and as a result, neither Lloyd's nor the London reinsurance markets offer the level of security once taken for granted. Given the changes in the EU rules, and the longstanding US approach, with the notable exception of business ceded to a company based in Bermuda , there are disadvantages to being a foreign ceding insurer of any domestic "composite" re /insurer that encounters financial difficulties 6 . Consequently, insurance carriers and their intermediaries cannot afford to concentrate their due diligence review merely on the reinsurer's A.M. Best or similar claims paying rating, and limit that review to its balance sheet and related financial statements alone. The credit risk assessment which in the past may have focused purely on an undifferentiated claims paying profile of a "composite" re /insurer should now also include, if they are a US or EU insurer, an assessment of that reinsurer's direct business; and the retrocessional coverages of the party, including and the extent to which its US or EU retrocessionaires have written direct business.

THE EU DIRECTIVE

Directive 2001 /17 /EC of the European Parliament ("Directive"), which came into force on 20 April 2001, provides for the supremacy of direct policyholder rights over the rights of other creditors. While this is a central element of the Directive, the Directive's stated principal purposes are:

(i) The coordination of rules among the EU member states to ensure that reorganization measures applied by a member states' regulatory authority are recognized and implemented consistently throughout the EU; and

(ii) The coordination of rules for winding up proceedings in order to ensure that proceedings commenced in one member state will be recognized and given full effect throughout the EU 7 .

The Directive gives EU member states two options from which to choose in implementing its requirements.

Directive Option 1

The first option provides that direct policyholders will have absolute priority - no ifs, ands, or buts- in respect of those assets of an insurer representing the "technical provisions." The priority would not apply, presumably, to other assets of the insurance undertaking, including those other assets held as collateral 8 .

Directive Option 2

The second permitted method 9 provides for direct policyholders to have priority over all assets of the insurance undertaking, with the possible (i.e. permitted) exception of:

(i) Claims by employees arising from employment contracts and employment relationships,

(ii) Claims by public bodies on taxes,

(iii) Claims by social security systems,

(iv) Claims on assets subject to rights in rem.

THE UK REGULATIONS

The UK has adopted the second method of implementation permitted by the Directive 10 . The UK Regulations make provision for the treatment of insolvent insurers domiciled in other EU countries, for example by prohibiting the UK courts in most circumstances from issuing a winding up order in respect of an EEA insurer 11 . The UK Regulations also implement the Directive in the UK with respect to the reorganization and winding up of UK insurers 12 . Of interest to cedants seeking guidance with respect to the availability of funds withheld or other forms of security (e.g. so-called "New York Regulation 114 Trusts", and letters of credit (LOCs)) as collateral for a "composite" reinsurer's obligations to them, the UK's definition of "preferential debts" does not include or make reference to rights in rem 13 . Although the writer is aware of some commentary that the references in the Directive and in the UK Regulations to assets in rem would include assets held by a cedant as collateral, in the UK preferential claims are technically not rights in rem . From the standpoint of the cedant the end result - the ability to liquidate such assets - is most probably unaffected.

The various references to rights in rem appear to be to specific assets that are subject to a security interest, such as a filed lien or duly recorded mortgage deed. The right to liquidate collateral held by a cedant probably would not qualify as a right in rem , however, the view among the UK's legal community appears to be that, because the intent of the Directive and the UK Regulations is to leave untouched the substantive law of insolvency, the historical rule that funds withheld and similar collateral do not form part of the insolvent's estate to begin with means that cedants should still be able to obtain the benefit of such collateral. To the extent that the Directive and the UK Regulations do not specifically address this issue, however, it is possible that an aggressive liquidator will seek to include such funds within the insolvent's estate, and thus subject to the priority of the direct policyholders. Although such an outcome would represent a departure from the law of insolvency in the UK prior to implementation of the Durective, clarification from a court in the UK would be a welcome development.

That said, a LOC held by a cedant would give the cedant the right to require the issuing bank to make payment under the LOC, leaving the issuing bank, if anyone, in a precarious position with regard to any collateral it obtained as security for issuance of the LOC, in other words, caveat bankor! 14

In summary, exactly how the Directive and its UK implementing regulations will be applied to the claims of US and other non-EU ceding companies in the case of future insolvencies is obviously uncharted territory at the present time. What is clear is that, going forward, direct policyholders will take priority over other unsecured creditors, including reinsurance creditors.

LLOYD'S

The UK Regulations apply to all UK insurers except Lloyd's. The UK regulator, however, the Financial Services Authority, has made it clear that it believes the Directive indeed applies to Lloyd's and intends to move forward with implementation. That said, Lloyd's should be expected to seek, and may well be afforded, a degree of separate treatment geared towards its particular interests. Thus, as stated by the UK Treasury Department in its November 2002 Consultation Document:

It is clear that the Directive is intended to apply to reorganization measures affecting or a winding up of insurance business at Lloyd's, since the "association of underwriters known as Lloyd's" falls within the definition of insurance undertaking for the purposes of this Directive . . .. We will therefore need to make provision in relation to Lloyd's that will have equivalent effect to that for other forms of insurer. In some cases, it will be possible simply to extend the provisions in the [regulations] to cases where relevant reorganization measures are imposed, or winding up proceedings are opened, in relation to insurance business carried on at Lloyd's. Where that is not feasible, because of the unique nature of the organization of insurance business at Lloyd's, we intend to implement the Directive in a way which will achieve its required purposes . . .. While we consider that some changes may need to be made to the way in which the statutory insolvency regime currently applies in relation to persons carrying on insurance business at Lloyd's to ensure the proper implementation of the directive, there are some fundamental aspects of the Lloyd's structure that we do not believe it is appropriate for us to interfere with. In particular, it is fundamental that members of Lloyd's underwrite for their own account and they do not therefore have responsibility for the liabilities of other members. The only way in which such liabilities are "mutualised" is in that members have an obligation to pay certain levies to the Central Fund 15 . That obligation is not unlimited. Our starting presumption is that the several liability of the members would need to be respected.

11/02 UK Treas. at ¶¶11-15.

As of the date of this writing, the UK 's Treasury Department is preparing another Consultation Document concerning the Lloyd's issue, presumably with draft regulations attached, which is due to be published in the near future. In the meantime, while it remains to be seen how successful Lloyd's will be in blunting the application of the Directive to it, it is certain that ceding companies and intermediaries should be careful to check the composition of the books of business (direct versus reinsurance) written by at least each syndicate that participates in their reinsurance. Reinsurance creditors of Lloyd's syndicates (and potentially of individual Names) that also write direct lines will likely come behind direct policyholders in the event of a future insolvency 16 . In addition, the heightened possibilities of uncertainty and delay until outcomes are clear are not irrelevant.

Before leaving the topic of Lloyd's, it should be noted that the Directive presents its own issues for the Lloyd's market, which has itself heavily ceded reinsurance to "composite" balance sheets. The insolvency of these reinsurers may well create even more difficulties for Lloyd's than before the Directive went into effect. The lesson to be learned is that cedants, as well as direct policyholders, that purchase insurance from carriers that are heavily reinsured by Lloyd's, should take into consideration the potential ripple effect of any Lloyd's insolvency in their decision-making process.

THE US APPROACH TO INSURER INSOLVENCY

While the new EU rules establish a priority for direct policyholders over ceding companies (for the first time in the UK ), direct policyholders have long enjoyed such a priority in US jurisdictions. Unlike the EU, which has a European Parliament with authority to promulgate requirements such as the Directive, the US Congress has left regulation of insurer insolvency to the individual states. While the National Association of Insurance Commissioners has adopted model rehabilitation and liquidation rules that each state has enacted, these rules address primarily the respective roles of domiciliary receivers and ancillary receivers when insurers doing business across state lines become insolvent. Each state also has enacted provisions establishing the priority of creditors of an insolvent insurer in the event of liquidation (but the US laws are typically silent in this regard in the context of a rehabilitation).

Although the statutes vary from state to state, direct policyholders also take priority over reinsurance creditors in the US in the order of distribution. For example, the New York order of priority for creditors of an insolvent insurer is as follows:

(i) Costs and expenses of administration of the insurer's estate.

(ii) All claims under direct insurance policies, including those claims paid by the state guaranty fund.

(iii) Claims of the federal government.

(iv) Claims for wages owed to employees.

(v) Claims of state and local governments other than insurance policy claims.

(vi) Claims of general creditors including, but not limited to, claims arising under reinsurance contracts.

(vii) Claims filed late.

(viii) Claims for advanced or borrowed funds.

(ix) Claims of shareholders or other owners in their capacity as shareholders 17 .

In part as a result of this doctrine, that cedants are trumped by direct policyholders, the US market evolved such that most participants generally offer either direct or reinsurance coverage on a monoline basis, but seldom both. There have been several notable exceptions, however. Creditors of reinsurance "divisions" embedded in US corporate entities that also offer direct coverage, have thus found themselves structurally subordinated - perhaps to their surprise. Indeed, a review of recent US insolvencies of companies principally offering primary coverage indicates an unexpectedly large number of subordinated reinsurance cedants. Moreover, state insurance guaranty funds are limited to claims arising under direct business issued by licensed insurers 18 , and reinsurance claims are not covered.

BERMUDA

The possibility that some European reinsurers may be compromised by having significant direct insurance on their books means that Bermuda may become regarded as perhaps the "friendliest" jurisdictions for foreign cedants among the principal global markets.

The winding up of insurance companies domiciled in Bermuda is conducted in accordance with the Companies Act 1981 of Bermuda . Unlike the US and Europe, the Companies Act treats ceding insurers pari passu with direct policyholders in the event of insolvency. As a practical matter, this issue is less important in Bermuda than in either the US or Europe , because there are fewer "composite" re /insurers operating in Bermuda , as a percentage of the total market, than elsewhere. Further, the leading members of the Bermuda market do not have the same historical baggage as their US and EU counterparts, in terms of asbestos, toxic tort, environmental, and other long tail horror stories.

Bermuda also has a strong legal system and a rigorous regulatory regime. Bermuda 's court system (and Parliament) is modeled after the UK system. Indeed, there is a direct appeal from the Bermuda courts to the UK 's highest court, the House of Lords (sitting as the judicial branch of the UK 's Privy Council). Among the major insurance markets around the globe, therefore, currently Bermuda alone does not subordinate foreign cedants of a domestic "composite" re /insurer that encounters financial difficulties. Bermuda currently treats direct policyholders and ceding insurers as being part of the same class of creditor, without any question mark concerning the ability to liquidate collateral. Indeed, as the vast majority of financial services businesses based in Bermuda are international as opposed to local Bermudian businesses, it is not surprising that Bermuda does not discriminate against non-Bermudian ceding companies in its reorganization and winding up regimes.

We cannot say, however, that that there are no companies in Bermuda affected by the Directive. Even some of the most respected Bermuda insurers and reinsurers have purchased reinsurance from EU "composite" companies, including from Lloyd's. In some cases the collectability of this reinsurance could well be important to such a company's financial position, particularly following a major market loss. Accordingly, it seems advisable to have an understanding of how exposed such a company would be to the ripple effect if its EU retrocessionaires became insolvent, and to rigorously consider appropriate haircuts on unsecured reinsurance obligations of the reinsurer from such markets.

PRACTICAL TIPS FOR RESPONDING TO THE NEW RULES

It is possible that, over time the change in the EU will lead to some restructuring (particularly in the UK market), for example through the formation of dedicated reinsurance-only companies. Such a response, however, will take potentially years to be accomplished. In the meantime, ceding companies and intermediaries should take a careful look at:

• The regulatory regime of the proposed reinsurer's domiciliary jurisdiction. Find out whether cedants take second place to direct policyholders before making a decision.
• The proposed reinsurer's asset base as declared under the EU rules described above, for pur poses of understanding, if possible, which assets will be subordinated to the claims of direct policyholders.
• The ratio of the proposed reinsurer's direct business to its reinsurance assumed.
• The proposed reinsurer's track record of making timely payment to ceding companies (sometimes referred to as "willingness to pay").
• Doing everything possible to mitigate against the possibility of being one of the last creditors in line, including maximizing appropriate collateral security, and insisting on the tightest possible contract language consistent with the applicable regulatory regime. In that regard, specific language in a reinsurance agreement or trust agreement stating that the collateral is not to be deemed part of the reinsurer's estate in the event of insolvency, and reciting that no other credtor of the reinsurer shall be permitted access to the funds, possibly with an express reference to the Directive, is advisable.
• Obtain a letter of credit as collateral instead of funds withheld or a so-called New York "Regulation 114" Trust 19 .

ROLE OF INTERMEDIARIES

Historically, intermediaries have by and large not provided their clients with a jurisdictional analysis of the credit risk assumed by a ceding insurer that purchases reinsurance in the global reinsurance market, nor have they performed a financial analysis of the reinsurer with a view to making recommendations about the proposed reinsurer's financial security that takes into account, inter alia, the interplay between these jurisdictional rules and - as so often applies - the "composite" nature of many re /insurers' balance sheets.

Going forward, ceding companies should expect additional information, perhaps including the type of information suggested above, from their intermediaries. However, a "one size fits all" informational checklist is most likely unsuitable and substantial reinsurance recoverable issues should be scrutinized on a case-by-case - and jurisdiction-by-jurisdiction - basis. At this writing an intermediary's failure to provide data and analysis informed by this perspective would seem to represent a potential new E&O exposure for the intermediary. Further, ceding companies may be prudent to require certain representations and warranties from their intermediaries concerning these matters.

CONCLUSION

In the new European environment, the credit risk assumed by a ceding company will be different from that of a primary policyholder. Ceding companies and their brokers should review a detailed financial

analysis of the reinsurer's balance sheet, including a S&P or equivalent report, addressing the ability of the reinsurer to pay subordinated debt obligations. These developments underline the importance of analyzing the legal and credit issues arising from the jurisdiction of domicile of reinsurance providers. In these respects, Bermuda may be alone in continuing to offer a stable regulatory environment in which the impact of reinsurer insolvency is not only predictable but favorable to the ceding company.

1. Directive 2001/17/EC, Article 10.

2. In the EU, the term "composite insurer" has a different meaning, and refers to an undertaking that writes both long term (i.e. life) insurance, as well as general (i.e. property/casualty) insurance. Such insurers typically have separate assets dedicated to their long term and general business. This separation is recognized in reorganization and winding up proceedings. See, e.g. Insurers (Reorganization and Winding Up) Regulations 2003, UK Statutory Instrument 2003 No. 1102 (herein the "UK Regulations"), Part IV, at Regulations 21 to 26.

3. See National Association of Insurance Commissioners' INSURERS REHABILITATION AND LIQUIDATION MODEL ACT, at §47 (Priority Class

3 Claims, obligations under insurance policies issued by the insolvent, do not include "[obligations of the insolvent insurer arising out of reinsurance

contracts.")

4. Whether cedants paid attention to this detail is another matter; the author suspects that pricing, market conditions, and other factors may have obscured the advantage formerly offered by the European market.

5. Even if a reinsurer's direct business is minimal, the composition of its own reinsurers' books of business may make it vulnerable in the event of their insolvency.

6. Almost alone among the other major financial center jurisdictions, Japan would treat cedants and direct policyholders pari passu , although the current Japanese laws on insolvency are of very recent vintage, and it remains to be seen how a non-Japanese cedant would be treated in the event its Japanese reinsurer were to become insolvent. Australia and New Zealand would treat ceding insurers pari passu with direct policyholders, but these jurisdictions raise other problems for foreigners in the insolvency context because claimants resident in these countries take precedence over foreign claimants, potentially even foreign claimants that are holding collateral.

7. Coordination of rules and procedures is not the same as substantive uniformity in the laws of the EU member states. The Directive expressly states in its preamble that harmonization of member states' laws is not the objective "Therefore . . . the fundamental principle . . . is to maintain existing insolvency law, making only minimum changes necessary to comply with the requirements of the Directive." (U.K. Treasury Consultation Document, November 2002 ("11/02 UK Treas.") at ¶17. ).

8. The term "technical provisions" is not defined in this Directive, but refers to those assets required under EU law and the laws of each individual member state to be maintained by the insurance undertaking in connection with the various aspects of its business. Where member states opt for this method, they must require insurance undertakings to maintain a special asset register in accordance with rules set forth in the Annex to the Directive. From the standpoint of a cedant, it appears that the assets maintained by its EU "composite" reinsurer that would not be included within the technical provisions are unlikely to be meaningful in assessing the credit risk presented by the reinsurer.

9. The Preamble of the Directive provides that the two optional methods for treatment of insurance claims are considered substantially equivalent. In order to strengthen equivalence between both methods of treatment of insurance claims, the Directive requires member states that select the second option to require every insurance undertaking to represent, at any moment and independently of a possible winding up, claims, which according to that method may have precedence over insurance claims and which are registered in the insurance undertaking's accounts, by assets allowed by the insurance directives in force to represent the technical provisions.

10. The Republic of Ireland has selected option 1 in its implementing legislation. Germany , Austria and the Netherlands have not yet finally adopted the Directive, although they are likely to do so in the near future, retroactive to April 20, 2003 .

11. Defined as an insurer domiciled in an EEA State (see note 16) other than the UK . (UK Regulations, regulation 4).

12. UK Regulations, Part IV, particularly regulations 17 through 27.

13. The UK Regulations address separately the claims of creditors against UK insurers with respect to assets subject to rights in rem , where such assets are situated in EU countries other than the UK . Thus, regulation 41, which is part of Part V of the UK Regulations ("Reorganization or winding up of UK insurers; recognition of EEA rights.") provides that "A relevant reorganization or a relevant winding up shall not affect the rights in rem of creditors or third parties in respect of tangible or intangible, movable or immovable assets (including both specific assets and collections of indefinite assets as a whole which change from time to time) belonging to the affected insurer which are situated within the territory of an EEA State at the relevant time." (An EEA State is defined as a country other than the UK, which is a signatory to the European Economic Area Treaty of Oporto of May 2, 1992.)

14. It should also be noted, however, that the potential uncertainty relating even to LOC's poses potential risks of delay and uncertainty, which cedants may wish to consider when evaluating haircut rates and similar considerations.

15. An interesting question is whether the Central Fund, or for that matter, the various Lloyd's US trust funds, would be deemed subject to rights in rem of the affected creditors.

16. The writer recognizes that there are practical obstacles in the way of following this advice; however, it is to be hoped that the Lloyd's market will recognize that it is in its long term interests to be as transparent as necessary in its per syndicate financial reporting requirements.

17. N.Y. Ins. Law §7434(a).

18. Only New Jersey provides insolvency fund protection for claims arising under policies issued by surplus lines companies.

19. In addition, seeking counsel's advice is recommended.