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Perspective

Non-Traditional Reinsurance - Lessons Learned the Hard Way

December 08, 2014| By Martin Hacala | P/C General Industry | English

Region: U.S.

Insurance-linked securities continue to be viewed by some as an attractive alternative or complement to traditional CAT reinsurance. Those advocating for these products ignore the many questions they raise and instead seem to be guided by Alfred E. Neuman's motto, "What, me worry?"1 But insurers who buy these products may have plenty to worry about. Recent litigation in New York between an insurer and a special purpose entity created to provide a type of nontraditional reinsurance begs the question: How attractive is alternative capital if it doesn’t stand with you when you need it most?2 

The New York case arose out of a dispute over a type of Cat bond.3 The alternative reinsurer, Mariah Re Ltd., contracted to provide up to $100 million in reinsurance coverage to the P/C insurer for certain severe weather events. The structure of the deal and the facts of the dispute are complicated, but for our purposes they can be distilled down to a few essential points. Mariah's obligation to pay was dependent on whether the industry loss exceeded a contractually prescribed amount. A key factor in determining the amount of the payment obligation was whether the losses occurred in a metro area. The calculations were to be made by AIR Worldwide (AIR), based on information compiled by ISO’s Property Claim Services (PCS). The dispute arose when PCS revised its final loss estimate to attribute certain losses to a metro area. AIR used the revised PCS estimate and calculated that the reinsurer owed its contract limit. The insurer instructed the bank holding the funds in trust to pay, which it did. The reinsurer (now in voluntary liquidation) responded by suing all the parties, from insurer to PCS, AIR and the bank,  seeking to recover its $100 million.

At its core, the alternative reinsurer’s  argument wasn't about whether PCS’s loss estimate was correct. Nor was it about whether and to what extent the losses occurred in a metro area. Mariah never seriously disputed either of these points. Instead, its  claim for return of the funds was all about the process by which PCS issued and revised its loss estimates, the process by which AIR calculated Mariah’s payment obligation, and the process by which the bank released the funds to the insurer. To add intrigue, Mariah threw in allegations of fraud among the parties. The court bought none of it and granted the defendants' motions to dismiss, meaning that for now the insurer gets to keep its $100 million.

This seems like a happy ending. But is it really?

First and foremost, the dispute isn't over yet. The reinsurer has filed a notice of appeal. At a minimum, that prolongs $100 million of uncertainty for the insurer. At the worst, it means having to pay the money back if the reinsurer ultimately prevails.

More fundamentally, the answer lies in contrasting the alternative reinsurance deal and dispute to traditional reinsurance and the types of disputes that can and can’t arise in that context. Mariah's claims about the purportedly improper procedures followed by the parties are akin to a traditional reinsurer complaining about the way the ceding company handled the claim. Under follow the fortunes principles, however, a traditional reinsurer is not permitted to second guess the ceding company's reasonable, good faith claims handling decisions. In fact, that's one of the fundamental tenets of reinsurance. The alternative contract here did not include a follow the fortunes clause.

Moreover, the reinsurer didn't lose in the district court because of a legal doctrine that favors ceding companies over reinsurers. It lost primarily because a close reading of the contract did not support its core claims. A few changes to the contract and the outcome might have been different. That’s hardly comforting to the next insurer that enters into a similar deal.

The essential lesson is that the dispute may have exposed a deep flaw under the purportedly attractive exterior of nontraditional reinsurance products - the greater uncertainty of collecting and keeping claim payments. This is largely because these products often do not afford the insurer the protections against such disputes that are afforded by traditional reinsurance. It also may be that investors in insurance-linked securities don’t have the same appetite for paying losses as a reinsurer does. Given that these nontraditional reinsurers do not have a track record of following fortunes and paying claims, it is hard for an insurer to know this – until a loss arrives. In a recent blog post, Tad Montross posed the question of how committed alternative capital is to the reinsurance market. Assuming willingness to pay and commitment go hand in hand, the answer from the New York dispute is not very reassuring.

 

1. Neuman, of course, is the fictional icon of Mad Magazine.
2. It bears noting that Neuman briefly changed his motto to, “Yes, me worry” following the Three Mile Island incident. See “Alfred E. Neuman,” Wikipedia: The Free Encyclopedia, Wikipedia Foundation, Inc., October 13, 2014, WEB October 16, 2014.
3. Mariah Re Ltd. v. American Family Mutual Insurance Co., 2014 U.S. Dist. LEXIS 140859 (S.D.N.Y. Sept. 20, 2014).

 

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