Reinsurance Arbitration Clause Pitfalls for Captive Insurers

Almost without exception, every captive insurer purchases some type of reinsurance. Both parties—the issuing reinsurer and the captive insurer—enter the relationship with the best of intentions. While many captives will never have a claim that results in a dispute with a reinsurer, such disagreements will be subject to the reinsurance contract's arbitration clause. 

Standard arbitration clauses are similar between reinsurers, and while a captive's board and management will no doubt be familiar with their existence, often little time is spent reviewing the arbitration clause section of reinsurance contract(s). As with any contract, pitfalls can and do exist. Captive insurers should seek to understand arbitration clause pitfalls and how, with some additional contractual language, they can be mitigated.

Following is an example of a fairly standard reinsurance contract arbitration clause. For purposes of this article, contract sections are omitted where (we believe) there are no potential pitfalls. However, captive insurers, together with their general counsel, should carefully review each section in their own reinsurance agreements for possible areas of conflict.

SAMPLE STANDARD REINSURANCE CONTRACT ARBITRATION CLAUSE

As a condition precedent to any right of action hereunder, any dispute arising out of this Agreement shall be submitted to the decision of a board of arbitration composed of two arbitrators and an umpire, meeting in Dallas, Texas, unless otherwise agreed.

The members of the board of arbitration shall be active or retired disinterested officials of insurance or reinsurance companies. Each party shall appoint its arbitrator, and the two arbitrators shall choose an umpire before instituting the hearing. If the respondent fails to appoint its arbitrator within four weeks after being requested to do so by the claimant, the latter shall also appoint the second arbitrator. If the two arbitrators fail to agree upon the appointment of an umpire within four weeks after their nominations, each of them shall name three, of whom the other shall decline two, and the decision shall be made by drawing lots.

The board shall make its decision with regard to the custom and usage of the insurance and reinsurance business. The board shall issue its decision in writing based upon a hearing in which evidence may be introduced without following strict rules of evidence but in which cross-examination and rebuttal shall be allowed. The board shall make its decision within 60 days following the termination of the hearings unless the parties consent to an extension. The majority decision of the board shall be final and binding upon all parties to the proceeding. Judgment may be entered upon the award of the board in any court having jurisdiction thereof.

Each party shall bear the expense of its own arbitrator and shall jointly and equally bear with the other party the expense of the umpire. The board shall allocate the remaining costs of the arbitration proceedings.

Let's walk through each of the above clauses to identify vulnerabilities for captive insurers.

As a condition precedent to any right of action hereunder, any dispute arising out of this Agreement shall be submitted to the decision of a board of arbitration composed oftwo arbitrators and an umpire, meeting in Dallas, Texas, unless otherwise agreed.

The first vulnerability deals with how many individuals should be involved in the arbitration. In the clause above, it calls for three: two arbitrators and one umpire. While this may seem obvious, it is important to have an odd number on the arbitration board. This ensures that the board renders a decision favorable to one party or the other. A potential problem with a single arbitrator is that he or she renders no decision. We are familiar with a case where the arbitrator wanted to find in favor of the captive, but due to potential political ramifications ended up not rendering a verdict. Costs also enter into the equation, since a three-person board will be more expensive than a one-person board.

The second area of vulnerability surrounds the arbitration's location. Most clauses indicate that the arbitration will be held in the reinsurer's domicile (i.e., not the captive's domicile). This may entail both a foreign venue with different rules and regulations as well as additional travel costs to the captive. Where possible, the captive insurer should look to have the arbitration held in its political entity or domicile.

The members of the board of arbitration shall be active or retired disinterested officials of insurance or reinsurance companies. Each party shall appoint its arbitrator, and the two arbitrators shall choose an umpire before instituting the hearing. If the respondent fails to appoint its arbitrator within four weeks after being requested to do so by the claimant, the latter shall also appoint the second arbitrator. If the two arbitrators fail to agree upon the appointment of an umpire within four weeks after their nominations, each of them shall name three, of whom the other shall decline two, and the decision shall be made by drawing lots.

The condition in the clause "shall be active or retired disinterested officials of insurance or reinsurance companies" can be particularly troublesome for captive insurers. First, it makes no allowance for using the variety of other professionals with insurance expertise, including brokers, actuaries, or captive managers. Second, there have been instances where a retired executive from a "captive insurer" is disqualified because captives are viewed as "alternative" insurance and do not meet a strict interpretation of an insurance or reinsurance company.

Every captive insurer should familiarize itself with Association Internationale de Droit des Assurances (AIDA) Reinsurance and Insurance Arbitration Society (ARIAS). Most reinsurers select their arbitrators from this association and also seek an ARIAS umpire. This creates several disadvantages for a captive insurer. First, a careful look at the professional arbitrators and umpires in ARIAS reveals the majority of them hail from very large primary insurance or reinsurance companies. Second, while the contract language does not stipulate the use of ARIAS arbitration rules, if at least two of the arbitration board members are ARIAS members, there is a bias toward using the ARIAS rules.

When choosing an umpire, the ARIAS guidelines again call for a questionnaire to be developed and sent to prospective candidates. Captives should be aware that the questionnaire verbiage may cause problems. A better alternative to this would be for two arbitrators to submit three candidates for vetting by the other party. Each party may decline two of the candidates and draw lots to select the umpire. Even with this, if the umpire and one arbitrator are both part of ARIAS, they are likely familiar with each other given the small size of the ARIAS group.

It should be noted that (we believe) ARIAS is a very professional organization with sound arbitration rules. Nonetheless, captives should be cognizant of the fact that many of the professionals in the group are current or former general counsels for insurers and reinsurers.

The third area of potential conflict encompasses rules of evidence.

The board shall make its decision with regard to the custom and usage of the insurance and reinsurance business. The board shall issue its decision in writing based on a hearing inwhich evidence may be introduced without following strict rules of evidence but in which cross-examination and rebuttal shall be allowed. The board shall make its decision within 60 days following the termination of the hearings unless the parties consent to an extension. The majority decision of the board shall be final and binding on all parties to the proceeding. Judgment may be entered upon the award of the board in any court having jurisdiction thereof.

While the phrase "without following strict rules of evidence" sounds harmless enough, it does engender some level of trepidation in individuals with legal training. Beware of getting tied up in an extensive debate about how much leeway the introduction of certain evidence is granted under this clause.

Finally, arbitration is often touted as being a less costly alternative to litigation, but it is not cost free. Even when arbitration is employed, at times litigation follows thus negating the cost differential. While rare, it does happen. Therefore, captive insurers will be well served to pay close attention to the arbitration clause in their reinsurance contracts and make sure they understand all of the ramifications of the existing language. Clarification should always be obtained before the need for the clause arises.