EU Directive May Impact U.S. Reinsureds

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 conditions to consider once an EU “directive” is implemented in the second quarter of this year.

The European Union directive, which creates guidelines for insolvency procedures for insurance companies in EU countries, may cause reinsurance buyers to reconsider ceding business to companies that arent among the financially strongest players in those countries or from those reinsurers that also include direct writings among their coverage offerings.

The directive was issued in April 2001, and all EU countries must implement the procedures outlined in the directive by April 30, 2003. Essentially, it creates a system for reorganization and winding up proceedings for defunct insurance and reinsurance companies throughout the EU.

While the directive generally does not create uniform insolvency laws throughout the EU, it does mandate a uniform priority for claimants in winding up proceedings.

With respect to insolvency laws, under the directive, the country in which the reorganizing or winding up insurer was authorized, the “home state,” has jurisdiction over the reorganization and winding up proceedings for the company. Consequently, the home states laws will determine the specific measures to be applied in the proceedings.

Nevertheless, all other EU states must fully recognize reorganization measures once they become effective in the home state. Therefore, while each EU state will generally not apply identical substantive laws to these matters, each EU state must, in essence, extend “full faith and credit” to any reorganization decision of another EU statejust as a U.S. state would extend full faith and credit to a similar decision by a court or regulatory body in another U.S. state.

The priority of claimants is a different matter. Specifically, the directive accords claims under insurance policies higher priority than other claims against the company, with the possible exception of claims for the costs of the winding up proceedings.

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

While the directive provides that the claims of insureds against a winding up company shall take precedence over the claims of general creditors, it does not provide such protection for the claims of reinsureds. The claims of reinsureds remain equivalent to those of general creditors.

This change brings the mandatory EU approach to claim priority into line with insurance company liquidation laws in the United States, where the various states accord insureds a higher priority than reinsureds in liquidation.

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

U.S. cedents must now analyze reinsurers in Britain, Germany and Sweden with an eye towards the deleterious effect of this directive upon any claim they may have in the liquidation of a reinsurer that also writes direct insurance.

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

Another significant impact of the subordination of reinsured's claims to those of insured's in winding up proceedings in Great Britain, Germany and Sweden may be a swifter recourse to commutation agreements when early warning signs of financial difficulties appear.

(A commutation agreement is an agreement between a ceding insurer and its reinsurer that provides for the complete discharge of all obligations between the parties under particular reinsurance contracts, with particulars on valuation and payment of future obligations, according to a definition listed on the Web site of the Reinsurance Association of America.)

Since the claims of reinsureds will be junior to those of insureds in all EU winding up proceedings, there will be an incentive for cedents to enter into commutation agreements with troubled EU reinsurers to avoid losing their entire claim since it may be unlikely that, as a general creditor, a cedent will recover any reinsurance proceeds.

An important task for U.S. reinsureds, either on their own or with the help of outside advisors, is to develop a thorough understanding of the EU reinsurance market. The directive may cause cedents to shift business towards pure reinsurersthose companies that exclusively write reinsurance as opposed to those which write insurance and reinsuranceto reinsure their risks. Since a pure reinsurer will not have any insurance policy claimants, cedents will not find themselves in a disadvantageous position vis-?-vis direct insureds.

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

Some of these companies may choose to split their reinsurance and insurance businesses into separate entities in order to avoid losing reinsurance business or having to write less desirable business.

EU composite companies must take into account all of the implications of such a corporate transformation, and cedents should make sure that there are two clearly separate entities and determine if there are historic liabilities from direct business still borne by the newly formed reinsurer.

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

The primary impacts of such a change will be a “flight to quality” by cedents when seeking out reinsurers in Britain, Germany and Sweden, a possible preference for pure reinsurers, and an increase in commutation in the face of financial weakness of composite companies.

Attorney Lewis P. Fickett, III, is an Associate with the Insurance and Reinsurance practice group of Edwards & Angell, LLP, a national law firm focusing on financial services, private equity and technology with eight offices in the U.S. and a representative office in London. Mr. Fickett may be reached at lfickett@ealaw.com.

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