by ~ Alexander Henlin (Email) (Web Site)
Attendees at this year’s MReBA Symposium spent the first part of the afternoon session participating in the interactive workshop. Questions raised during the morning session about the scope of reinsurance audit rights found practical application in the context of hypothetical claims under three bond insurance policies. The workshop consistently highlighted areas where tension can develop between cedents and their reinsurers, even when the claim may appear to be routine.
The workshop was moderated by MReBA members Nicholas Cramb, Adam Doherty, Bill Erickson, Michael Mullins, and Anne-Marie Regan. The hypothetical focused on four series of bonds that had been issued by an economically-distressed municipality. Echoing the LIBOR scandal that has been in the news these past several months, the bonds’ interest payments were tied to a floating rate that reset dramatically when news broke that various banks had colluded to keep the rate artificially low for a number of years. Among those banks whose benchmarks were used to set the rate was the largest single purchaser of the municipality’s debt. The sudden increase in interest rates on the bonds caused the municipality to default.
The default triggered certain insurance coverage that the municipality had purchased for its three later series of bonds. The issuer of the bond insurance, at the insistence of the bank that had purchased the lion’s share of the municipal debt, had included in its policies a non-standard fraud exclusion that waived all defenses based on the fraud of any party other than the municipality.
The bond insurance issuer, in turn, ceded a 25% quota share of its policy for one of the bond series to a first reinsurer via a facultative certificate. For the other two series, the bond insurance issuer had entered into an excess-of-loss treaty with a second reinsurer. The treaty reinsured all of the cedent’s policies written on the “customary form,” to which the cedent could make “reasonable modifications” without the reinsurer’s approval. Both the facultative certificate and the reinsurance treaty contained independent terms, conditions, and exclusions about receiving notice of a claim from the cedent, dispute resolution, access to records, and restrictions on coverage in the event of fraud.
Participants were randomly assigned to play out the hypothetical from the perspectives of the municipality, the bank, the bond insurance issuer/cedent, and each of the two reinsurers. Among the issues that the participants had to confront were:
• How the cedent might respond to the initial claims under the bond insurance policies by the bank and by the other investors;
• The substance and timing of notice of the bond insurance claims by the cedent to its reinsurers;
• How the reinsurers might respond to the cedent’s notice, including whether to invoke their audit rights;
• The extent to which the reinsurers may inquire into the circumstances surrounding the cedent’s manuscripted fraud exclusion, which had been added at the insistence of the bank;
• Whether the reinsurers might be required to accept the validity of the revised fraud exclusion in the bond policies being reinsured;
• The extent to which the reinsurers may have had rights to review the cedent’s underwriting and claim records with respect to the bond policies; and
• The scope and effect of any confidentiality promises made by the cedent to both the municipality and the bank, in light of the reinsurers’ audit rights.
The workshop was able to illustrate the tensions that can arise between cedents and reinsurers when audit rights are invoked, particularly in the midst of an active claim. Whether those tensions can successfully be resolved short of a formal dispute-resolution process will depend upon any number of factors, not least of which is the strength of the relationship between the cedent and the reinsurer.
Alexander Henlin is an associate in Edwards Wildman’s Boston office. He may be reached at firstname.lastname@example.org.
© 2012 Edwards Wildman Palmer LLP. All rights reserved.
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