Trending risk transfer techniques challenge legal conventions
March 2016 | SPECIAL REPORT: INSURANCE COVERAGE
Financier Worldwide Magazine
The use of captive and other non-traditional insurers to manage risks may pose challenges to accepted legal doctrines and conventions. Below we focus on some evolving aspects of risk transfer that warrant caution for lawyer and client alike.
Captive insurance as a self-insurance technique has been a fixture in the risk management landscape now for decades. By forming a closely held, special-purpose insurer, designed to accept only those risks of the sponsor – or affiliated or related entitles – a business can efficiently reserve for future losses while accessing the commercial reinsurance markets and possibly taking advantage of tax benefits. Captives are widely available, with certain key jurisdictions (e.g., Vermont, Hawaii and Delaware in the US, Bermuda and Cayman Islands offshore) being domiciles of choice due to regulatory familiarity and professional infrastructure.
The use of captive and captive-like insurers has spread to contexts beyond self-insurance. Sellers of credit protection (such as mortgage guaranty insurance or trade credit insurance) can use captive reinsurance to allow a protection buyer to participate in the upside of the credit exposure. This type of ‘kicker’ can be used to induce protection buyers to buy coverage from that particular carrier. Producer-owned reinsurance can permit a seller of risk protection, such as an insurance agent or vehicle warranty provider, to participate in risks placed by it. Commercial lenders can use captives to structure investments and obtain credit enhancement from the reinsurance markets. When using a bespoke insurance arrangement such as one of these to hedge a particular risk, care should be taken to make sure risks are properly insulated. For example, ceding risk to an insurer – even a purportedly special-purpose insurer – and then having the insurer cede the risk to another insurer may be frustrated if the fronting insurer has written other business. In other words, one’s reinsurance coverage is not necessarily bankruptcy remote.
By way of a brief example, if a protection buyer cedes risk to a fronting company, and then that fronting company enters into a back-to-back reinsurance agreement with a second insurer, the protection buyer may believe that it is simply exposed to the second insurer’s credit risk. As a matter of ordinary practice, it may be correct – depending on the situation, the fronting carrier may simply pass through all loss claims to the second insurer. However, where the fronting carrier has other in-force business (or other liabilities), the protection buyer might have cause for concern. In the extreme case of an insolvency of the fronting company, under typical state laws in the US, the fronting company’s receiver is unlikely, ceteris paribus, to view the back-to-back arrangement as isolated from any other business of the insolvent carrier. Instead, the receiver will impose a stay on all claims payments until a claims process can be established for the estate, and will marshal all reinsurance (and other recoveries) available from whatever source. Furthermore, it is a staple of US reinsurance agreement forms (for credit for reinsurance purposes) that the reinsurer may discharge its obligation to the ceding company, at a time when the ceding company is in receivership, by paying claims to the receiver. In other words, such a back-to-back arrangement to insure risk is not necessarily bankruptcy-remote as to the fronting company.
Sometimes to address this need, protected or segregated cells and similar structures offer the benefits of segregating risks, assets and liabilities within distinct cells of a single insurer. These arrangements are now available by statute in numerous states as well as offshore (non-US) jurisdictions. Typically under such statutes, a single insurer (with a single licence) can comprise multiple segregated accounts with each being isolated from the others’ assets and liabilities. Such accounts can often be authorised to issue securities or other contracts allowing a third party to be exposed only to the risks and rewards of that particular account. These arrangements are inconsistent with traditional notions of corporate personhood, in which assets and liabilities are generally commingled, and the corporation’s equity holders and creditors cannot be ‘ring-fenced’ from one another (although the use of security interests, tracking stock and similar techniques can approximate this result in an ordinary corporation, they have limitations and risks). Therefore, segregated cell statutes, with their unequivocal insulation of assets and risks as a legal matter, have proven attractive in risk management situations. State captive statutes have not been judicially challenged. (One US court recently stated in dicta that a protected cell has many de facto aspects of a legal identity but is not a separate de jure legal entity, and held that it was not the proper party in a particular arbitral setting at issue. However, the case did not squarely address the validity of a segregated cell structure, and the reference seems to be an oblique outlier on this subject.)
Another way in which the proliferation of new insurance and reinsurance solutions could challenge accepted legal conventions relates to the reinsurance doctrine of ‘utmost good faith’ (uberrima fides). To encourage risk-spreading and protect reinsurers, this legal doctrine historically imposed on cedents a stringent duty (of disclosure and otherwise) when underwriting risks covered under a reinsurance treaty. The theory underlying the doctrine was that the cedent is in a better position to know the contours of underlying risk than the reinsurer, who typically relies on the cedent for pricing, sizing and binding the risk that the reinsurer will be exposed to. It is believed that this heightened standard of good faith is more rigorous than the good faith standard that governs sellers of other goods or services and other contractual relations generally. However, in a world in which the format of a reinsurance treaty is increasingly being used in non-traditional risk-management contexts – e.g., in business combinations, credit enhancement, lending, alternative risk transfer, insurance-linked securities and others – will the cedent always be in the best position to understand and bear the risk, and accordingly should the reinsurer be entitled to rely on the cedents’ efforts so confidently? It seems highly likely that disputes arising from alternative risk transfer situations (some of which have already been visible in the aftermath of the 2008 credit crisis) will test the durability and the logic of utmost good faith as a reinsurance catalyst. Like the other trends noted above, utmost good faith exemplifies the potential for shifts in the law as it responds to changing risk transfer trends.
Dan Rabinowitz is a partner at Kramer Levin. He can be contacted on +1 (212) 715 9378 or by email: firstname.lastname@example.org.
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