EU Directive May Impact U.S. Reinsureds U.S.insurance companies that buy reinsurance from companies in Germany,Sweden or Great Britain may have more than hard market conditionsto consider once an EU “directive” is implemented in the secondquarter of this year.

The European Union directive, which creates guidelines forinsolvency procedures for insurance companies in EU countries, maycause reinsurance buyers to reconsider ceding business to companiesthat arent among the financially strongest players in thosecountries or from those reinsurers that also include directwritings among their coverage offerings.

The directive was issued in April 2001, and all EU countriesmust implement the procedures outlined in the directive by April30, 2003. Essentially, it creates a system for reorganization andwinding up proceedings for defunct insurance and reinsurancecompanies throughout the EU.

While the directive generally does not create uniform insolvencylaws throughout the EU, it does mandate a uniform priority forclaimants in winding up proceedings.

With respect to insolvency laws, under the directive, thecountry in which the reorganizing or winding up insurer wasauthorized, the “home state,” has jurisdiction over thereorganization and winding up proceedings for the company.Consequently, the home states laws will determine the specificmeasures to be applied in the proceedings.

Nevertheless, all other EU states must fully recognizereorganization measures once they become effective in the homestate. Therefore, while each EU state will generally not applyidentical substantive laws to these matters, each EU state must, inessence, extend “full faith and credit” to any reorganizationdecision of another EU statejust as a U.S. state would extend fullfaith and credit to a similar decision by a court or regulatorybody in another U.S. state.

The priority of claimants is a differentmatter. Specifically, the directive accords claims under insurancepolicies higher priority than other claims against the company,with the possible exception of claims for the costs of the windingup proceedings.

This new priority scheme is the facet of the directive that hasimportant implications for cedents in the United States.

While the directive provides that the claims of insureds againsta winding up company shall take precedence over the claims ofgeneral creditors, it does not provide such protection for theclaims of reinsureds. The claims of reinsureds remain equivalent tothose of general creditors.

This change brings the mandatory EU approach to claim priorityinto line with insurance company liquidation laws in the UnitedStates, where the various states accord insureds a higher prioritythan reinsureds in liquidation.

Most of the continental EU countries already followed thisapproach to claim priority. However, for Great Britain, Germany andSweden, the directive changes the order of priority for claimants,as in all three of those countries, the law had accorded claims ofinsureds the same priority as those of general creditors.

U.S. cedents must now analyze reinsurers in Britain, Germany andSweden with an eye towards the deleterious effect of this directiveupon any claim they may have in the liquidation of a reinsurer thatalso writes direct insurance.

This should further accelerate the on-going “flight to quality”and could hasten the demise of weaker British, German and Swedishreinsurers, which are likely to lose business to their strongercompetitors or, in order to maintain their market share, writebusiness on terms more favorable to cedents.

Another significant impact of the subordination of reinsured'sclaims to those of insured's in winding up proceedings in GreatBritain, Germany and Sweden may be a swifter recourse tocommutation agreements when early warning signs of financialdifficulties appear.

(A commutation agreement is an agreement between a cedinginsurer and its reinsurer that provides for the complete dischargeof all obligations between the parties under particular reinsurancecontracts, with particulars on valuation and payment of futureobligations, according to a definition listed on the Web site ofthe Reinsurance Association of America.)

Since the claims of reinsureds will be junior to those ofinsureds in all EU winding up proceedings, there will be anincentive for cedents to enter into commutation agreements withtroubled EU reinsurers to avoid losing their entire claim since itmay be unlikely that, as a general creditor, a cedent will recoverany reinsurance proceeds.

An important task for U.S. reinsureds, either on their own orwith the help of outside advisors, is to develop a thoroughunderstanding of the EU reinsurance market. The directive may causecedents to shift business towards pure reinsurersthose companiesthat exclusively write reinsurance as opposed to those which writeinsurance and reinsuranceto reinsure their risks. Since a purereinsurer will not have any insurance policy claimants, cedentswill not find themselves in a disadvantageous position vis-?-visdirect insureds.

The increase in demand for reinsurance with pure reinsurers maylead to structural changes among EU composite companies.

Some of these companies may choose to split their reinsuranceand insurance businesses into separate entities in order to avoidlosing reinsurance business or having to write less desirablebusiness.

EU composite companies must take into account all of theimplications of such a corporate transformation, and cedents shouldmake sure that there are two clearly separate entities anddetermine if there are historic liabilities from direct businessstill borne by the newly formed reinsurer.

In summary, the most important aspect for U.S. cedents of the EUinsolvency directive that will take effect on April 30, 2003, isthat the claims of insureds will be subject to a higher prioritythan the claims of reinsureds in winding up proceedings.

The primary impacts of such a change will be a “flight toquality” by cedents when seeking out reinsurers in Britain, Germanyand Sweden, a possible preference for pure reinsurers, and anincrease in commutation in the face of financial weakness ofcomposite companies.

Attorney Lewis P. Fickett, III, is an Associate with theInsurance and Reinsurance practice group of Edwards & Angell,LLP, a national law firm focusing on financial services, privateequity and technology with eight offices in the U.S. and arepresentative office in London. Mr. Fickett may be reached [email protected].

Reproduced from National Underwriter Edition, February 3, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.