The sub prime crisis is constantly developing. In this article, we look at issues which reinsurers may want to consider in relation to claims arising from sub prime liabilities.
As banks reveal increasing exposure to sub prime debt, the (re)insurance industry is reviewing how it is affected. Although for the reinsurance market claims problems are a way off and specific issues are difficult to predict, it is worth highlighting some potential areas to which reinsurers could give consideration when thinking about their reaction to claims relating to sub prime investments and liabilities.
Touching very briefly on the cause of the problems, sub prime debt has been pooled and sold on, organised into tranches and sold again or become the subject of credit default swap products. These complex securitised structures are underpinned by real assets. If those assets lose value, so do the securities which use them for collateral.
In the (re)insurance market immediate hurt is being felt on assets, by those involved in credit default swaps or other similar instruments and by those backing bond insurers. D&O and E&O claims are undoubtedly in the pipeline. Although the (re)insurance market is still liquid from the gains of the last few years, there may be liquidity issues arising if new capital is needed. Also affected are ART deals relating to sub prime debt such as the insurance of credit default swaps. If liability and contractual rights relating to ART contracts are being reviewed it is worth remembering that in order to assess these issues properly one needs to consider whether the contract in question is governed by insurance law or the general law of contract. If a contract is of insurance (containing uncertainty, insurable interest and some element of risk transfer), the duty of good faith and the law relating to breach of warranty will apply.
The reinsurance press suggests that this (in terms of global size of loss) does not spell catastrophe for the reinsurance market. Nevertheless, it is important for reinsurers to be aware of the areas where there is potential for impact, now or in the future.
Aggregation
If a loss in the value of a debt and the subsequent fallout is the subject of litigation there may be many potential targets. It may well be that reinsureds would attempt to aggregate claims relating to each of these liability losses where they all stem from the loss in value of a debt or collapse of a fund. How one aggregates will depend upon the wording. Where there is an event/occurrence wording the question will be 'what is the event to which the losses may be aggregated?' Caudle v Sharp (1995) held that to be an event the common factor must be capable of creating legally relevant consequences - the event must be causative of the loss.
This raises the question of what is it that causes the loss? There is clear argument that each act of negligence causing liability causes the loss on the insurance policy, not the background to which the liability relates. American Centennial Insurance Company v Insco Limited (1996) is an illustrative case. The reinsured claimed to be entitled to aggregate a number of losses on the basis that they all arose out of the same event; the collapse of a fund. However, the judge said that Insco's liability depended in each case upon the omissions of the directors, officers and auditors concerned. It was these acts or omissions rather than the subsequent collapse of the fund which rendered Insco liable. Arguably, an attempt to aggregate D&O losses, auditors' and other advisers' losses following a particular fund collapse may be difficult for similar reasons.
If the reinsurance aggregates on the basis of an "originating cause", the potential for aggregation is broader. This may cause difficulties where policies are not "back-to-back". If a reinsurer aggregates losses inwards on an originating cause basis and has retrocessional cover which aggregates on a per event basis, there may be a gap in cover.
Allocation
The reinsured must show that the losses sustained have occurred during the period of reinsurance. This is of particular relevance to "Losses Occurring During" policies. If it is established that poor decisions were taken over a period of time leading to sub prime losses, it may be difficult to say which decisions/actions caused which losses. The courts may take the practical approach to allocation, (they have previously allocated equally between years), and establishing a timeline will be important.
Notification
Notification provisions are common in reinsurance contracts. They are often expressed as conditions precedent and therefore breach of such a clause will allow the reinsurer to reject the claim. Accordingly, it can be crucial to determine whether a notification clause has been complied with. Standard clauses require notification upon knowledge of any losses which may give rise to a claim. This raises the question: what constitutes a 'loss' for the purposes of the clause? In AIG v Faraday (2007) the Court of Appeal held that 'loss' meant not the insured's (or reinsured's) settlement but the underlying loss - in that case a fall in the share price following a restatement of accounts - which might cause legal proceedings. In this situation reinsureds face some difficulty deciding when to notify. Should they notify upon the write-down of assets which their insureds advised on? Certainly they should consider notifying early.
Follow the settlements
Reinsurers may also wish to look at their follow settlements provisions. Absent any follow settlement wording, and in some cases, even where a clause is in place, the reinsured must prove their loss. Where there is a follow settlements clause which does not require the reinsured to prove the loss, it must still show that the loss was settled in an honest and businesslike fashion and within the terms of the reinsurance contract. If insurers in the US yield to any pressure to pay losses which fall outside policy terms, or do not take obvious defences, they may face difficulty in collecting from reinsurers.
It is difficult accurately to predict whether these will cause problems for the market. One thing that can be said is that there are constant developments in the sub prime and credit crunch crisis and we hope that this article provides useful food for thought.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.