July 24, 2014
The 13 Oddest Aspects of Reinsurance
I have not figured out why reinsurance is not fully regulated, like insurance. Reinsurance needs to move into the 21st century.
Looking behind the curtain of reinsurance, you find a most unusual business. Here are 13 anomalous features:
–Reinsurance is for the most part unregulated, but users — insurance companies — are regulated.
–Insurers must use a system of accounting that makes reinsurance attractive: If a reinsurer gives insurers a discount off a list price (ceding commission), they may show on their books that they paid the list price and may treat the discount as income.
–Reinsurance may be marketed by independent brokers that owe the insurance companies no fiduciary duties. The broker leads insurance companies to believe that it has their best interests at heart, but courts have ruled that the broker does not even have a duty to not inflate its commissions. The broker’s relationship with the reinsurer is much more important than the broker’s relationship with the insurers.
–The reinsurer can insist that all disagreements must be arbitrated, and that the arbitration does not set precedent or provide guidance should a similar issue arise in the future. That way, the reinsurer can argue the same issue over and over and over. The findings of arbitration are not only not recorded, they are often confidential.
–The outcome will not be determined by legal construction and interpretive rules but by the “custom and practice” of the industry — but which “custom and practice” is neither written down nor uniformly agreed upon or adhered to by those in the industry. That is, the contract can specifically say one thing, and the wording can be ignored in any arbitration finding if it is not in line with “custom and practice.” A reinsurer can do all this and at the same time argue that the lopsided arrangement is an “honorable engagement.”
–The reinsurance contract likely has an “entire agreement” clause, meaning that nothing from outside the contract can be used to establish rights or obligations. That is, the four corners of the contract supposedly set the parameters of the agreement. You may ask: Isn’t “custom and practice” contained outside the contract? Yes, it is. So, at the same time that there is the argument that the contract is the entire agreement, there is also the provision that unwritten rules outside the contract determine the interpretation of the contract.
–If there is a disagreement as to what the contract says, the dispute must be arbitrated as not a legal obligation — yet the contract says it applies the laws of the state where the insurer is based.
–Who is responsible for writing this convoluted and lopsided contract? Often, that is the broker — which is not a party to the contract.
–If a broker fails to even issue a memorialization of the product to the insurer, nine months after having “sold” the product, it is the insurance company that is punished, not the broker or the reinsurer.
–Even though some states specifically provide that reinsurance falls within the statutory definition of a regulated product, states do not regulate reinsurance directly. Reinsurance should be regulated federally, because it is clearly interstate commerce and falls within the U.S. Constitution’s commerce clause, but the federal government does not actually regulate reinsurance, apart from income tax issues. So, reinsurers do not have to obtain regulatory approval for rates or for products.
–Talk about a lobbying force. Legislatures have been convinced that taxing it would raise the price of everything for the general populace. That argument could be made for any business, because all taxes are ultimately borne by the general populace, but has not caught on for other industries.
–Reinsurance is amazingly simple. It comes in essentially one of two forms: treaty (for groups) and facultative (for individuals). Treaty comes in essentially two varieties: proportional and non-proportional. But reinsurance becomes esoteric by design. It has cloaked itself in mystery by avoiding the courts as a venue and by taking advantage of the fact that few legislators have ever dealt with the product.
–Although with similar financial products, courts would find that third parties might have rights, third parties have no rights under reinsurance.
I have not figured out why reinsurance is not fully regulated, as is insurance. I have heard the logic that the parties to the contract are equally sophisticated, and therefore no regulation is necessary. The problem with that logic is that the premise is false. Many of the parties do not have equal bargaining power; they are not equally qualified to enter into the transaction; and there are no real arm’s-length negotiations. Many small companies spend a great deal on reinsurance each year.
So why not at least tax reinsurance? I have heard the logic that this would be “double taxation,” because the original (the insurance) transaction was taxed. However, that ignores the realities of reinsurance. Reinsurance is not insurance of insurance. It is insurance on the performance of an insurance company’s core business, which happens to be insurance. Why does insurance covering loss from a collection of insurance products get to escape taxation on premiums when insurance covering loss from a fleet of cars does not? The same hurricane can cause loss to the core business of the car dealer and the insurance company, but coverage for the car dealer carries taxes on premiums while coverage for the insurance company does not.
I have also heard that reinsurance is like any other wholesale business, where sales tax is not applied. This logic ignores the realities of reinsurance. Reinsurance is not a commodity that is purchased in bulk to then subdivide into smaller units for sale by insurance companies. Reinsurance is a retail sale; it is not a wholesale transaction.
I am not necessarily advocating for regulation or taxation of reinsurance, but I am advocating for leveling the playing field and bringing transparency to the process of reinsurance.
I think that could be done with the abolition of any mandatory arbitration in reinsurance contracts by the NAIC. The plaintiff’s bar has a history of efficiently “regulating” where no regulation exists, if given the proper venue. Arbitration has not brought lower costs and timely determinations. Indeed, arbitration has proven to have none of the benefits and all of the problems of litigation.
It really is about time that reinsurance is made to come out from the shadows and to fully participate in the 21st century judicial system, rather than allowing it hold on to the faux vestiges of yesterday’s “gentlemen’s agreements.”