Interplay of Loss Portfolio Transfers and Other Reinsurance Contracts

What Is a Loss Portfolio Transfer?

For decades, insurance and reinsurance companies have used loss portfolio transfers (LPTs) to address the issue of legacy business no longer core to the company. The IRMI Insurance Glossary of Risk Management and Insurance Terms defines an LPT as:

A financial reinsurance transaction in which loss obligations that are already incurred and will ultimately be paid are ceded to a reinsurer. In determining the premium paid to the reinsurer, the time value of money is considered, and the premium is therefore less than the ultimate amount expected to be paid. The cedent's statutory surplus increases by the difference between the premium and the amount that had been reserved. An insurer seeking to withdraw from writing workers compensation coverage in a given state could, for example, use a loss portfolio transfer to meet its obligations under policies it has written, without the need to continue the day-to-day management of the claims resolution function.

An LPT is a great way to move a legacy book of business off the balance sheet. LPTs often are used for direct written business as well as for assumed reinsurance business. As described in the definition above, an LPT allows an insurer or reinsurer to meet its policy obligations on its original policies without being responsible for the management of the ongoing claims. The LPT reinsurer generally manages the claims and is responsible for the administration of the business. While the ceding insurer is still on the regulatory and contractual hook for those original policies, it is really the LPT reinsurer that is economically and administratively the real party of interest.

The Odd Reinsurer Out

What is often forgotten when considering an LPT transaction, however, is the interplay between the proposed LPT and the existing reinsurance contracts reinsuring the original policies. This is especially so when the LPT is of an assumed reinsurance book of business rather than direct insurance.

Existing reinsurers and retrocessionaires are not always in the loop while an LPT is being negotiated between the ceding insurer and the LPT reinsurer. When they learn about an LPT (sometimes from a press release or at a market conference), they may not be thrilled.

The existing reinsurers have no contractual relationship with the LPT reinsurer. Yet, it's the LPT reinsurer that will now be administering the claims ceded to the existing reinsurers. Reserving may change, claims handling may change, administrative and accounting relationships will change, and motivations will change. Not quite the original bargain entered into by the existing reinsurers.

Many LPTs, if not all, are structured to be net of third-party reinsurance. This means that the liabilities transferred to the LPT reinsurer are only those that should remain after existing reinsurance has paid its share of the liabilities on the original business ceded. This also means that the existing reinsurers have to fulfill their contractual obligations to the original ceding insurer even if the loss advices and requests for payments are now coming from a new party with whom the existing reinsurers have no contractual relationship.

Of course, if the ceding insurer is not highly rated or is mostly in runoff, the existing reinsurers may welcome an LPT, especially if the LPT reinsurer is strong and well managed. Timely settlements and administration cost less money than a poorly managed runoff for all parties. The existing reinsurers may be more comfortable dealing with a new administrator than the original ceding insurer if there were significant problems in claims administration and handling.

The Effect of an LPT on Existing Reinsurance Contracts

The LPT may have an effect on various contract provisions in existing reinsurance contracts. Consideration should be given to whether the existing reinsurance contracts have antiassignment provisions, retention warranties, or other provisions precluding cessions of retained business.

For example, if the original reinsurance includes a broad quota share treaty with a requirement that the ceding insurer maintains its percentage share, an LPT of the entire reinsured portfolio might result in a breach of the original reinsurance contract. Similarly, if there are excess-of-loss contracts that contain retention warranties or have provisions that preclude assignment of the ceding insurer's retention, an LPT of the entire retained portion of the book may invalidate the excess-of-loss contract.

Clearly, the LPT reinsurer has no interest in losing the value of the existing reinsurance. The LPT reinsurer wants the LPT to cover only those liabilities net of existing reinsurance. The failure to carefully evaluate existing reinsurance and then obtain buy-in from existing reinsurers can result in the LPT turning into something it was not meant to be and result in what should be preventable disputes.

Some reinsurance contracts also have special termination provisions. These provisions are customized to each reinsurance transaction. There are special termination provisions that trigger if the original ceding insurer transfers its liabilities to another reinsurer. An LPT may trigger that kind of special termination provision.

Can an Original Reinsurer Walk Away after an LPT?

Some reinsurers and retrocessionaires may view their ceding insurer's LPT of an entire book of business as a "get out of jail free card." The question is whether that is, in fact, true. Of course, review of each relevant reinsurance contract is necessary to determine whether an LPT changes or affects anything about existing reinsurance or retrocessional relationships.

In a recent case, a New York federal court confirmed a final arbitration award between a retrocedent and its retrocessionaire. In Continental Ins. Co. v. AXA Versicherung AG, No. 18-CV-7349 (VEC), 2019 U.S. Dist. LEXIS 583 (S.D.N.Y. Jan. 2, 2019), a retrocessionaire argued that it was no longer bound by its quota share retrocessional agreement with the retrocedent after the retrocedent entered into an LPT with a third party on the same business. The arbitration panel's final award determined that the LPT did not relieve the retrocessionaire of its responsibility to make retrocessional payments to the retrocedent. The court confirmed the final arbitration award.

The details of the underlying dispute were not available in the decision, and the arbitration information is confidential, so we don't know whether there was a retention warranty, antiassignment clause, or special termination provision in the quota share retrocessional agreement. All of these cases are very fact-specific, and as they say, the devil is in the details.

In addition, while this decision did not involve the merits of the dispute (the petition to confirm was unopposed), it is pretty clear why the arbitration panel ruled the way it did.

The retrocedent remains responsible under its existing reinsurance and retrocessional agreements unless the LPT contains a novation agreement or a separate novation agreement accompanies the LPT, which replaces the retrocedent with the LPT reinsurer as a matter of contract. While the retrocedent's administrative and accounting obligations were shifted to a new reinsurer under the LPT, the retrocedent remained on the hook under the existing retrocessional contract in case the LPT reinsurer fails to perform in the future.

While these principles are more relevant to assumed business than ceded business, the same principles apply. An LPT generally does not alter an existing reinsurance or retrocessional contract unless the original reinsurer or retrocessionaire has agreed to the transfer of all obligations itself in the form of a novation.

There are many scenarios where the outcome may differ because of specific contract wording. For example, the existing reinsurance or retrocessional contract could have had a retention warranty or special termination provision that might trigger upon the retrocedent entering into an LPT. Each circumstance is different and must be reviewed completely to determine if an LPT has any effect on the liabilities under existing reinsurance or retrocessional contracts.

Conclusion

Determining how existing reinsurance contracts will interact with an LPT is a critical step to avoiding significant problems and future disputes. While it is easy to think that an LPT cannot affect existing reinsurance contracts because it is a separate and unrelated contract, retention warranties, antiassignment provisions, and special termination clauses in existing reinsurance contracts could be triggered by an LPT. Keeping all parties, including existing reinsurers, in the loop while negotiating an LPT should avoid unwanted surprises.