It is not uncommon for six to nine months (or much longer) to elapse between a reinsurer underwriting a risk and the production of the contract wording.

Background

The problem of slow agreement to the final terms of a contract wording has been around a long time. Whereas a bank loan requires immediate final documentation, the traditional method of placing reinsurance business involves the use of a slip representing the initial contract, which may later be replaced by a final contract (the contract wording). This is surprising given the many millions of dollars which are often at stake.

It is not uncommon for six to nine months (or much longer) to elapse between a reinsurer underwriting a risk and the production of the contract wording. The London market has attempted to address this timing issue by introducing the concept of ‘Contract Certainty’. However, the timing issue (which is the main thrust of the concept) is just one problem amongst many related to contract wordings that need to be adressed, and as such is unlikely to be radical enough. Naturally, these issues apply to all reinsurance centres and not just London.

Why the drive for contract certainty now?
It could be argued that, inter alia, the high number of disputes coming out of the London market has driven business away to other countries, such as Switzerland, Bermuda, and the US. In response, the London market has been keen to attract business back in to London and contract certainty is seen to be a method of achieving this. It is hoped that the concept will lead to less litigation.

Why is the contract wording important?
The contract wording is the most important document to be reviewed by the underwriter since it contains the full terms and conditions and, once signed, becomes the main basis for the legal contract between the parties. As soon as one becomes entangled in a legal dispute the first thing that the lawyer will ask for is the signed wording. The contract wording is essential to the acceptance, evaluation, and the management of the exposure to risk – which is a reinsurer’s core business.

The lack of contract certainty has the following effects:
● It increases the costs of disputes since the ability to avoid, manage or resolve disputes at any early stage, and on a reasonable commercial basis, is diluted by the impreciseness or non-existence of documentation.
● It creates risks for cedants, reinsurers and the brokers, and has created expensive problems for these players.

There have been a number of recent cases arising from the absence of one or more of the above elements. The Silverstein case in New York as to whether the attack on the World Trade Center constituted one or two events is only one of many disputes which arose from a lack of final agreement of all terms.

What are the problems associated with contract wordings?
The terms are unclear or ambiguous. Traditionally, the quality of contract wordings has been very poor so that there is uncertainty over the terms of risks accepted. Even where a full contract wording is developed, rather than just the slip, it is often the case that there is not enough attention to detail. (However, the poor quality was often overlooked since the reinsurance relationship was long - and profitable). According to Leboeuf Lamb , there are three inextricably linked elements to the documentation of contractual terms:

Agreed terms and underlying information (and the right to access such information) are reduced to writing and are permanently recorded and readily accessible

Any given term is expressed in such a way that its meaning is fully comprehensible on a reasonable, objective basis

Any and all of the terms make sense when read together as a whole

‘Contract Certainty’ seeks to make the submission clear and unambiguous and all the terms clear and unambiguous, however, in practice this will be very difficult to achieve and its satisfaction requires greater analysis and attention to the terms and phrases used, rather than merely ticking a box. At the same time, the requirement for the choice of law and jurisdiction clauses to be clear and unambiguous is an excellent start.

The problem of mix and matching clauses.
Cedants often follow a mix and match method of constructing contract wordings. They take last year’s imperfect wording and add a couple of clauses which reflect this year’s changes. The problem is that the document as a whole lacks consistency and some clauses may even contradict each other in an extreme case. For lawyers, the outcome is a god-send, they can charge a lot of hours work trying to understand the contradictory clauses and fathom the intention of the parties to the contract.

Non-standard wordings.
Although there have been some moves towards standardising the wording of the clauses, it is a fact of life that there is no accepted standard wording for say an excess of loss contract. This is because each party is free to negotiate his own contract to reflect the cedant’s individual circumstances and the state of the reinsurance market (in hard market, terms and conditions are generally strict, in a soft market the opposite applies). It can also be argued that ‘one size does not fit all’ when it comes to reinsurance arrangements (inappropriate use of standard wordings may bring as many problems as they solve), and different classes of business have different requirements. Furthermore, there is no recognised body which is recognised internationally to produce such standard clauses. The nearest to this is the Market Wordings Database organised by the IUA and Lloyd’s. It contains some 7000 insurance and reinsurance policies and clauses for the Lloyd’s and company markets in the U.K. and USA.

Uncertain legal interpretation - Cynics would argue that ‘Contract Certainty’ is an oxymoron since there is never any real certainty with respect to the interpretation of contracts. From a review of reinsurance cases which have reached the courts, it is clear that each case depends on the actual wording of the reinsurance contract, with subtle differences leading to different outcomes. The use of arbitration (which is private) as the preferred dispute resolution method adds to this problem, because the same clauses are interpreted time and time again. Companies should utilise those clauses which have been tested in court. However, many of the words used in reinsurance contracts have unclear meanings and this has presented courts with difficulties. For example, in Caudle v Sharp [1995] LRLR 433 the Court of Appeal construed the writing of 32 run-off reinsurance contracts as 32 “events” whereas in Municipal Mutual Insurance Company Limited v Sea Insurance Company Limited [1996] LRLR 265 numerous acts of vandalism were treated as one “event”.

Individual claims circumstances – The saga of US asbestos and pollution claims is a good example of liabilities which were never anticipated by the contract wordings issued at the time – from the 1930’s until the mid-1980s. Of course, the fact that the terms were consequently unclear on coverage and that the cases were decided by juries did not help the matter. As a result, insurers, reinsurers and courts were left grappling with addressing issues not anticipated in the wordings. It is unlikely that all claims circumstances can be provided for in one wording, but there is a need to anticipate changes in the claims field.

Contract wordings are often not properly reviewed. Every clause of every contract needs to be reviewed thoroughly to evaluate the effect of the language in the light of court decisions, and market practice. The title of the clause is often unhelpful, and should generally be ignored. Some reinsurers may leave the review of the contract to underwriters who are not trained in the art and importantly are not legally trained. Faced with a pile of such documents to sign in the summer months, some underwriters may prefer to quickly sign them all rather than seeking clarifications from in-house specialists. Furthermore, the characteristics required to be an underwriter such as an outgoing negotiator may not be consistent with the strong analytical skills required to properly review contracts. Most major Continental European reinsurance companies have a dedicated person responsible for reviewing and signing wordings in addition to the underwriter. Such legally-trained people will take into account the legal principles of reinsurance terms and contract wordings; they will understand the common clauses and legal considerations including incorporation of clauses; understand the various types of dispute clauses and know when they should be used; be up to date with the latest developments in dispute resolution and avoidance in the main jurisdictions – England and USA. In Europe, the two pairs of eyes principle mean that two signatures are necessary in most firms.

Contracts are boring and complicated – who wants to read all those complicated terms and conditions whilst they could carry out a sexier job like underwriting? Apart from insomniacs, there are likely to be few takers. Whereas in the past, wordings were short and relatively simple with the reinsurance relationship often on a proportional basis and hence a sharing of fortunes, nowadays, especially with the trend to writing nonproportional business, there is no sharing of fortunes, and wordings have become more complex with more exclusions.

Conclusion
As can be seen, there are many problems associated with contract wordings and, given the nature of the problems, ‘contract certainty’ alone cannot solve them, even though it is a large step in the right direction.

Contract certainty is not ideal because it does not address the practice of producing wordings which do not reflect the terms of the parties’ original agreement – most reinsurance contract wordings are very poor and contain a myriad of mistakes and ambiguities.

Contract Certainty needs to be introduced with:
● An increase in the status of the wordings function e.g. wordings director for each company?
● Better education for wording drafters – a qualification which includes legal training?
● A market-wide best practice unit which monitors
● Standards – e.g. FSA reviews 4 random wordings per day to see if they reflect the parties’ intentions and make sense.
● The legal interpretation of contract terms and issues guidance.

What is Contract Certainty?
‘Contract Certainty’ as defined by the London Market is achieved by the complete and final agreement of all terms (including signed lines) between the insured and insurers before inception. The aim, therefore, is that all terms must be agreed before the parties go on risk. In practice, the effect of this is that the full wording of the contract must be agreed before a binding contract will take effect and appropriate evidence of the cover must be issued within 30 days of inception or renewal for commercial business, and 5 working days for retail business.

This Special item appeared in issue 108 of JTW News - September 2006

Author: Peter Wedge - Converium