Reinsurance arbitration 2001: Will the new ways cripple "arbitration clause"?

• Author: McDonald, John J., Jr.

A solution to the movement away from honoring parties' intent to arbitrate might be found in expanding the language of placement slips

REINSURANCE is a transaction in which an insurance company (the primary insurer or reinsured) cedes all or part of a risk of loss to another insurance company (the reinsurer). In return for agreeing to indemnify the reinsured for losses that may occur, the reinsurer receives premiums from the reinsured. This practice is not limited to a primary insurance company and a reinsurer. It is commonplace for a reinsurer to turn around and retrocede risk to another reinsurer. In that transaction, the reinsurer is known as the retrocedent, and the insurance company assuming the risk of loss is the retrocessionaire.

There are two general types of reinsurance contracts--facultative reinsurance and treaty reinsurance. A facultative reinsurance contract is transacted on an individual risk basis under which the ceding company has the right to offer an individual risk to a reinsurer, and the reinsurer has the right or "faculty" to accept or reject the risk. These contracts are usually referred to as certificates.

Treaty reinsurance, on the other hand, is more of an ongoing agreement between the parties and involves ceding blocks of an entire book of business to a reinsurer. In this type of reinsurance contract, the reinsurer does not have the option to reject the risk if it falls within the parameters of the contract between the parties. These contracts usually are referred to as treaties.

Focusing on treaty reinsurance contracts and the nature of the business relationship between the parties to these contracts, this article examines the traditional relationship between reinsureds and reinsurers and how this relationship predisposes the parties to use arbitration as a method of resolving disputes. But there is a recent trend away from arbitration. Why has this trend arisen? What are the possible safeguards against attempts to circumvent the use of arbitration?

REINSURANCE RELATIONSHIP

1. Historical and Traditional

   Reinsurance contracts traditionally have been considered "gentlemen's agreements." Business was done on a handshake with written contracts that were brief and arcane. At the commencement of performance of the contract, the only existing documentation of the transaction generally was a placement slip. A reinsurance placement slip is a model of brevity; its terms are restricted to single paragraphs and incorporate only industry boilerplate terms by reference. For instance, if the formal treaty is to include an arbitration clause, the slip would simply state "arbitration clause." Then a treaty would be generated providing a more formal and detailed documentation of the reinsurance contract. Sometimes a formal treaty may never be generated, the only terms of the reinsurance contract being in the placement slip.

   Formal treaties often were not much clearer than the placement slips. The treaties usually incorporated antiquated language that rarely was read, or for that matter, legally understood. A typical example of the traditional relationship is found in an anecdote told by a gray-haired reinsurance executive, perhaps in contemplation of the "good old days." He remarked:

   [A]fter a treaty had been executed in those days, the superior threw it in the bottom drawer and it remained there for the duration of the treaty relationship. If a question was raised by the reinsured company about the treaty, as unlikely as that was, an amicable discussion would have followed and an agreement would have been reached without either party consulting the treaty. If the treaty had to be removed from the drawer, that suggested a major schism in the reinsurance relationship, even if the immediate questions were ultimately resolved.(1) A casual observer of this industry might wonder how business could be transacted under such practices. As the editors of Robert Strain's Reinsurance text note, every industry has its own set of standards or practices for which it is known. After a period of time, these practices become so ingrained in the minds of the customers or parties negotiating the business that they become regarded as requirements of doing business in that industry.(2)

   This explanation is certainly applicable to the reinsurance industry. Reinsurance business was negotiated among closely knit groups that maintained long-term relationships, so that all the parties to the reinsurance agreement intimately understood the custom and practice of the industry. Because all sides were interested in maintaining amicable relations, if and when a dispute arose, it usually would be handled with an eye to maintaining the relationship. This eliminated much of the need for a carefully constructed commercial contract. Resolution of claims was subsumed into the over-all, usually profitable, relationship of the reinsurer and reinsured.(3)

   This practice allowed the relationship between the parties to remain congenial, and it also enabled its continuation. It is no wonder that the traditional reinsurance relationship has been likened to a marriage.(4)

2. Modern Times

   In recent years, reinsurance contracts have moved away from the handshake agreements of yesterday and focus more on the realities of the bottom line. While most of the industry's historic customs and practices remain--for example, slip agreements and antiquated language--the relationship between the parties has changed fundamentally. No longer is it the norm for parties to work out their differences in the boardroom. It is the exception. Indeed, the reinsurance industry has seen an increase in formal reinsurance disputes, whether in the form of arbitration or litigation.

   Several views have been offered to explain this fundamental shift, but two main reasons emerge. First is the notorious soft property and casualty market of 1979-84, a period that brought an influx of new entrants to the market, attracted by the cash flows available. Because of their relative inexperience, many of the new reinsurers did not charge enough in premiums for the risk protection they were offering. The flood of inexperienced players, record low prices, and new long-tail loss exposures--for instance, asbestos--caused extraordinary underwriting losses that logically lead to a dispute explosion.(5)

   The second reason for the drastic change is the globalization of the reinsurance industry. The rapid advancement in computer and electronic technologies has shrunk the marketplace and given the reinsurance market a more international perspective. The traditional network of familiar faces has become a plethora of faces both new and old. The new entrants do not always play by the "old" rules, forcing old participants to move away from their traditional way of doing business in an effort to stay competitive. Essentially, the new entrants are applying their traditional ways of doing business to the reinsurance industry, reshaping the way reinsurance transactions are conducted.

   The "in with the new and out with the old" phenomena has left little room for procedures to become ingrained in the minds of anyone. There may no longer be customary practices in the reinsurance industry. Customs are created only when they become so ingrained in the minds of customers that they are considered requirements of doing business.

   One casualty of this shift appears to be arbitration.

   ARBITRATION IN REINSURANCE

1. Preference for Arbitration

   The reinsurance industry's preference for arbitration is very unusual in the commercial world.(6) Industry experts offer an amalgamation of reasons for this preference, but the most obvious and intimate, from the standpoint of the reinsurer and the reinsured, are these:

   * Reinsurance treaties are not typical of most commercial contracts, which are usually drafted by knowledgeable lawyers and cover numerous contingencies. Were reinsurance treaties drafted with the same care as most other commercial agreements involving comparable sums, they would be longer and more complex. Since the realities of the reinsurance trade make it impractical to negotiate and draft such complex documents, the parties expect that in the event of disputes, expert arbitrators will fill in the unavoidable blanks using "custom and practice," "intent of the parties" and "honorable undertaking" as guidelines for decision.

   * Arbitrations are far less adversarial and confrontational than litigation, which is an important consideration when the parties are in an ongoing relationship despite the current dispute.

   * Discovery is more restrictive and predicated on confidentiality.

   * Most arbitration decisions remain between the parties, are not published, and have little or no precedential effect.

   These should sound familiar. They are a combination of the reasons that produced the traditional reinsurance relationship. One could say using arbitration was never a conscientious decision by the industry participants; rather it was simply an extenuation of traditional business practices. Much as the traditional reinsurance relationship, arbitration has come under siege in the era of the "new" reinsurance relationship.

2. Standard Arbitration Procedures

   Although exact arbitration procedures vary according to the parties' agreement, there are typical steps in almost any formally arbitrated dispute.

   * Service of a demand for arbitration. This must comply with the arbitration clause in the treaty, and generally the demand will set forth the relief...