Cultural considerations
An auditor dealing in an international context is well advised to sound out not only the legal environment, but also the customs and practice prevailing in the markets he is dealing in. While discussions between mainland Europeans and the British or Americans involve a self-evident language issue, the different customs and interpretations of terms between the US and the UK may also give rise to confusion or misunderstandings. For example, Americans are more familiar with premium and claim audits than with the full range inspections commonplace in the London Market. They are used to opening up their books for review since they are subject to the regulatory practice of triennial state inspections. As a result, a request for an audit in the US is not necessarily considered a token of doubt regarding the company’s integrity, as was once the case in the UK market and probably remains so in continental Europe today. Moreover, Americans tend to be more at ease when confronted with difficult and contentious matters than Europeans. Indeed, they expect direct discussions to be held on thorny issues. If the point in question is not resolved, the options of litigation or arbitration are considered less of a threat by an American than by a European.

Reviews overseas require a great deal more logistical planning to ensure that the appropriate documents will be made available in a timely manner. Preinspection meetings with the inspectee and brokers are strongly recommended, as these help the inspecting team to understand the organisation, its programmes and the scope of documentation in addition to helping to prepare selection requests. A common question arising at this point is whether balances are to be paid before the inspection commences. Discussions of this kind often result in the setting up of an escrow account by way of compromise.

Interpretations
Contractual terms governing the right to inspect are often subject to widely disparate interpretations at an international level. The following examples serve to provide a rough indication of just how broad the range of possible interpretations can be.

Scope of inspection
The scope of records which should be made available for review has been a contentious issue in the courts in both the UK and the US. The source of the debate usually centres around definitions of the terms “relevant” and “reasonable”. For example, in a situation where a quota share was written in the name of the fronting company by its managing agent, which records are the excess of loss reinsurers of that quota share entitled to review ?

Contract exclusions
Interpretations of undefined market phrases, such as “incidental”, “miscellaneous” and “business written as such” generate international debate. For example, does the exclusion of a class of business “except if incidental” mean that the otherwise excluded business must be (at most) incidental to each individual cession, or that a very small percentage of risks so classified are acceptable?

As most older US facultative and direct contracts do not contain arbitration clauses, disputed definitions are subject to litigation. Accepted market custom and practice can, of course, easily be overridden by a judge who is unfamiliar with reinsurance, interpreting contractual terms in a US court.

Allocation issues
An inspectee’s inward commutations constitute a potentially enormous inspection area. Do reinsurers agree with the deal and the manner in which it was allocated through the books and ceded to reinsurers? Are they obliged to follow the fortunes?

The issue of allocation brings up many other questions which cannot always be answered with a simple ‘yes’ or ‘no’: Are insurers and reinsurers entitled to see attorney’s reports? Are declaratory judgment (DJ) costs recoverable? Are the ceding companies’ travelling expenses recoverable as loss adjustment expenses? Has the cedent applied the order of reinsurances correctly?

Jurisdiction
We are all familiar with the diverse interpretations applied by the State and Federal courts in the United States. The jurisdiction which applies to a claim dispute frequently can, of itself, determine whether the loss is ultimately going to be validly recoverable or not.

Why inspect?
Only by understanding the nature and scope of its liabilities can any insurer or reinsurer attempt sensibly to mitigate its exposures and liabilities – the ultimate aim of any company in run-off. Such understanding is not limited to pure information gathering but instead extends to the philosophy of the assured or cedent.

Most inspections are initiated in the wake of poor loss ratios, anomalous claims or apparent misrepresentations. Regrettably, there are relatively few pre-renewal or due-diligence reviews. One increasingly frequent reason for conducting an inspection is to gather information in preparation for commutation negotiations. Successful negotiations in turn generate the need for sophisticated internal accounting procedures facilitating an accurate allocation of the discounted balances. In situations where a company is experiencing difficulties collecting reinsurance recoverables, investigations may be initiated by a cedent rather than by a reinsurer.

Types of inspection
The terms used for the different types of inspection may differ from one company to another, and certainly do in an international context. In fact, there are differences in the usage of the very term “inspection” which, in the US, is associated with the regulatory function and is most commonly used in that context. In an international field, reference should therefore be made to an “audit” or a “review”. Whilst there are no standard definitions of review types, it is possible to divide them into two rough categories of preventative and control or cure inspections:

Preventative inspection
Before signing on a treaty, renewing a Managing General Agency (MGA) agreement, or agreeing substantial LOC requests, a reinsurer may conduct a “comfort” audit. These are also known as preventative inspections. Increasingly, a reinsured may undertake a so-called “devil’s advocate” inspection by instructing an audit firm to critically appraise their own operation and prepare a “hostile” report so as to identify possible problems a reinsurer may subsequently address. Other types of inspection in this category include pre-renewal, due diligence and claims audits.

Control/cure inspections
For a run-off operation, however, most inspections are control or cure inspections. Since a run-off is less likely to have on-going business relationships to consider, it need not be as “sensitive” as an active market player. A run-off company should aim to conduct full-range inspections which are not limited to claims and accounting assessments but also incorporate underwriting and placing reviews, even though these may be more contentious as they concern issues that are fundamental to the contracts themselves. Discovery inspections would also be included in this category.

Triggers for an inspection
An unexpected or severe loss ratio is the most obvious trigger for exploring a particular treaty or book of business. A common root cause is the delegation of underwriting authority, for example by way of a binding authority or lineslip, or by using the services of an MGA. Premium income far exceeding represented estimates is often a warning that a cedent may have delegated control of its underwriting. Unexplained cessions, vague classifications such as “Miscellaneous”, seemingly excluded claims and consistently late or anomalous accounts, all justify research by the reinsurer. Premium or claim reporting may indicate that the spread of an account differs from that represented.

A reinsurer may have specific evidence to suggest that contractual breaches have occurred, such as cessions outside the relevant period. An inspection should establish whether these are isolated incidents or are in fact indicative of underlying problems which may generate many more breaches of this kind. An insured or reinsured should have adequate procedures with which to ensure proper allocation of risks, premiums, claims, reinsurance recoveries and accounts. An inspection should reveal any fundamental weaknesses within these systems. At all events, a detailed evaluation of the financial implications of any defects is imperative, and of the utmost significance to commutation discussions.

Authority for an inspection
Almost without exception, reinsurance contract wordings contain an “inspection of records” clause entitling the reinsurer or their duly appointed representatives to review the books and records of the reassured during normal office hours (a commonly debated set of parameters in itself ). Even if no express provision is set out in the wording, it is probable – at least under English law – that the insurer or reinsurer has an implied right to review the cedent’s books and records.

It should be noted that contractual inspections, that is, those where rights have been conferred by the contract, differ from discovery inspections. In a contractual inspection, a cedent is obliged to provide verbal and/or written explanations to the inspectors, not simply produce the documents. When an inspection is carried out as part of the discovery process in legal proceedings, “walk-throughs” of the cedent’s systems are not compulsory, although the scope of documents produced might be more extensive using this option.

In a “good faith” commutation discussion, it is usual for both parties to open up each other’s records and actuarial projections for review by the other party so as to ensure that negotiations are founded on an agreed base set of facts.

Preparing for an inspection
It is imperative to have clearly defined objectives for the inspection. Before the inspection strategy is finalised, the company’s own records must be reviewed and underwriters and other staff members interviewed. Moreover, it is usually advisable to attempt to create legal privilege if any of the issues arising from the inspection are likely to prove difficult to resolve between the parties. Confidentiality agreements can be complex and require legal attention.

Before testing the operational effectiveness and contractual compliance of a company, it is essential for the audit team to understand both the corporate and underwriting philosophy as well as the programme structures adopted by the inspectee company. This is best achieved by way of reviewing the brokers’ records and calling a pre-inspection meeting or “kick the tyres” review with the inspectee. Make sure you are inspecting the right contracts, protections and documents! The amount at stake should be assessed prior to, as well as during, the inspection.

The operational review of the inspection should be tailored to its specific objectives. Additional basic checks are usually conducted on underwriting guidelines and policy allocations, premium processing, claims procedures and controls, outwards reinsurance mechanisms, accounting systems and financial reporting.

The inspection itself
The formal report on the inspection must constitute an independent reference document for the evaluation of the book of business under review. Consequently, it is essential to document the cedent’s perspective of the history of the relationship with the reinsurer and the way in which the business under inspection fits within the programme structures.

Within the key areas of the review – underwriting, claims reinsurance and accounting – the cedent should first be asked to provide a “walk through” of its procedures and documentation management. The next step is to conduct random and specific tests on the represented procedures alongside more indepth investigations into particular areas of enquiry (eg reviewing IBNR or LOC procedures). The policies and claims to be checked are usually selected during pre-inspection discussions. All the same, it is vital to secure the right to select further files on-site if this should prove necessary.

If, whilst the team is on-site, the cedent fails to provide significant documentation or information agreed in advance, consideration must be given to immediately postponing the inspection. There is likely to be a temptation to proceed with the inspection and review what is made available, even if the material is inadequate. Still, this is not recommended as it may be a tactical ploy by the cedent, who could later reject a completion of the audit on the basis that the reinsurer has “had his chance”.

What follows an inspection?
Whenever possible, “wrap-up” meetings should be held with representatives of the inspectee. Whilst for tactical reasons discussions must be carefully planned, it is sensible to give the inspectee the opportunity to provide answers and explanations to the issues raised during the inspection to avoid any misunderstandings.

Internal and external inspections alike must produce a formal report setting out the objectives, approach, findings, observations and conclusions. This document should be prepared for management and, if appropriate, addressed to lawyers to consider any issues which have arisen and to preserve privilege. It may indicate a clean bill of health which may require only updates in the reinsurer’s reserves. More frequently, inspection reports identify certain procedures which could be improved or minor quantum issues which require adjustment – none of which need endanger the validity of the contracts or the relationship between the parties. A report may also provide the factual and subjective data required to improve the effectiveness of commutation discussions.

In some circumstances, the report contains findings of a serious nature, for example, details of contractual non-compliance or breaches of fiduciary duties. It might also identify major quantum differences which cannot be agreed between the parties. At this point, some form of dispute resolution procedure such as litigation, arbitration, alternative dispute resolution or mediation may be unavoidable.

Closing remarks
It matters not whether you are a cedent with reinsurance collection difficulties or a reinsurer with escalating assumed liabilities seeking a commutation.

If you actively ensure that you are the party who is forewarned with the greater command of the facts, the issues, the other party’s real (and spurious) arguments, then it is you who possesses the knowledge. Knowledge is power. The power to negotiate. The power to play it as cool or as hard as is necessary. The power to get results.

Many, probably most major international cedents and reinsurers “play the game” of utilising inspections to satisfy their concerns and/or to progress their objectives. This is particularly so in the run-off arena. If either party fails to play the game, or at least fully understand that the game is being played and by what rules, that party will be at a great, and usually decisive, disadvantage.

Remember one of business’ oldest sayings:

“You do not get what you deserve, you get what you negotiate.”