Commutation - The Debate Rages On

Article by Ed Stanley and Mark Everest

Under a commutation, the reinsurer pays an agreed amount to his reinsured and in return, is released from future ongoing liabilities. The payment will typically comprise a mixture of the following:

1. Unpaid Claims
amounts notified by the reinsured as being due and payable under the reinsurance policy but which the reinsurer has not paid.

2. Outstanding claims
estimates of future liabilities for known losses reported to the reinsurer.

3. Incurred but not reported claims (IBNR)
estimates of the value of possible future liabilities.

Problems arise however when the reinsurer looks to its outwards protections for recovery.

The issue in its simplest form is as follows. A reinsurer is generally only liable in respect of unpaid claims. Retrocessionaires cover is in respect of a reinsurer’s liability. Therefore, if a reinsurer has settled in respect of outstanding claims and IBNR as well as unpaid claims, retrocessionaires might complain.

A more applied version of the problem is this; imagine a retrocession contract with no "follow settlements" clause. A reinsurer must prove that, on the balance of probabilities, it had a legal liability in respect of the underlying "settlement". While it should be able to identify legitimate paid claims as liabilities, a reinsurer will be less able with respect to outstanding claims and IBNR because, having quantified the estimates for the sake of the commutation agreement, its liability for them has been artificially accelerated.

Frustratingly, there is no English precedent on the point. However, an interesting angle was recently tested in the Singapore High Court in Overseas Union -v- Home and Overseas Insurance, (2002). This involved a reinsurance contract which provided that "All loss settlements made by the Reinsured, including compromise settlements, shall be unconditionally binding upon Reinsurers…" The reinsured entered into a commutation and argued that the commutation was a "loss settlement" to which its reinsurer was bound. The Court disagreed, reasoning that "a loss settlement is one where a loss is being settled whether by a court order or an arbitration award or via a compromise" and that a commutation agreement was different because, amongst other things:

• It is a separate agreement over and above a reinsurance contract whereas a loss settlement comes under the reinsurance contract;
• It releases the reinsurer from any future ongoing liability and the reinsurer may therefore pay a premium over and above what it would otherwise have agreed to in the usual settlement of a loss as consideration for this.

At first sight, the decision looks a little harsh and it cannot be assumed that the English Commercial Court will necessarily follow it. However, until there is a binding English decision or the market can establish a convention acceptable to all, the controversy will continue. The only protection a reinsurer can practically take remains to try to obtain the prior consent of its retrocessionaires before commuting with its reinsured.