Arbitration: Intended and twisted practice in reinsurance

BRUCE D. EVANS*

I.

INTRODUCTION

Reinsurance contractual agreements are carefully crafted in order to provide ongoing relationships between participants in the property and casualty insurance business. Virtually all non-life insurance companies reinsure in order to balance their portfolio of insured risks. Exceptions noted in this industry are the very largest insurer and those selected regional companies whose risks are perceived as scattered. Exceptions aside, the typical property and casualty (hereafter P & C) insurer expects to transact reinsurance agreements. Once effected, the P & C insurer further expects to review the efficacy of those risk-shifting contracts on a regular basis.

An industry recognized source defines the participants within the P & C reinsurance arena:

Reinsurance, despite its sometimes exaggerated complexity, is simply a transaction between insurance companies by which risk exposures are redistributed. Typically in such a transaction, an insurer transfers or cedes some of its risks to a reinsurer. The reinsurer, in turn, agrees to indemnify the ceding company for all or part of the loss which it may sustain. Strictly speaking, reinsurance may be defined as the "insurance of insurance."1

The fact that reinsurance is a transaction consummated by a contract is underscored here, since various authors sometimes describe reinsurance as being defined by the contract.2 To the contrary, the contract is the expression, but not the definition, of reinsurance.

When a reinsurance agreement is transacted between a ceding company (alternatively termed a cedent, an insurer, or The Company) and a large "direct" reinsurer, the reinsurance is effected with the direct risk assumer, who normally drafts the contract for the cedent's approval. A direct reinsurer is expected to contact the cedent through an employed account executive, and then negotiate as a single uninterrupted link. It is no surprise that the reinsurers in such instances (roughly fifty percent of United States industry premium volume) create contracts that are noticeably more favorable to themselves. A vast majority of such contracts include an arbitration clause that specifies the approach to use should the participants encounter a future dispute.

If the reinsurance transaction is alternatively initiated by an intermediary, appointed by the cedent (through an official authorization letter) to find eligible reinsurers within the brokerage market, then the typical approach is to use several reinsurers who are joined by a contract created by the intermediary. Each subscribing reinsurer signs an Interests and Liabilities Agreement at the conclusion of that contract, indicating its joint but not several participation in the underlying reinsurance contract. Virtually all the broker market-created contracts contain an arbitration clause to resolve any future disputes.

The confirmation signing mechanism within the intermediary market usually involves, at the outset, a broker of record letter to recognize the intermediary's authorization to enter the marketplace to seek quotations for the principal. Upon obtaining authorizations, a cover note rendered by the broker details the initial agreement and seeks official confirmation by the indicated participants. When all of the subscribing reinsurers are secured, a cover slip is prepared to formalize the transaction. In the case of an over-subscribed placement, the intermediary will be expected to "sign down" the approved reinsurers proportionate to their original commitments to the total of reinsurance authorizations. This procedure assures no favoritism. Proportional signing down is in keeping with the market practice of "no better terms."

Within the confirming cover slip, an arbitration clause will be included to resolve future differences, together with a numerical indication of exactly which BRMA (Brokers and Reinsurance Market Association) clause is to be used. The resulting contract that links the participants should include the exact BRMA wording for each clause indicated on the cover slip. These expectations are generally satisfied.

Given the widespread use of arbitration clauses to resolve future disputes, it is appropriate to mention a companion industry expectation: the ultimate good faith principle. Although seldom mentioned per se within a reinsurance contract, the underlying philosophy that each participant expects the other to disclose all relevant facts is a cornerstone of the reinsurance business. A few contracts remain that cite an Honorable Undertaking clause to express this cornerstone principle. Some other contracts specifically include an Ultimate Good Faith clause. Most reinsurance partners, however, recognize an overwhelming residue of case law that confirms an expectation of good faith within the reinsurance contract.

The focus of this expectation (of good faith and fair dealing) falls upon the cedent, rather than the reinsurer. The initial delivery of valid underwriting information, for instance, is a legal "sine qua non." Without each partner's ability to rely on such information, the reinsurance relationship is meaningless.

Informed professionals regard reinsurance as a non-adversarial relationship for two reasons. First, the contract (no matter who creates the original draft) must be approved by the other participants. Second, the reinsurance transaction is expected to be mutually satisfactory. Behavioral expectations aside, the parties agree to seek assistance through arbitration in order to resolve disputes. In the United States, the industry procedure for arbitration cases is standardized. Both cedent and reinsurer will appoint an arbitrator; those two partyappointed arbitrators then will agree on an umpire to complete a three person panel.

II.

CONTRACT FUNDAMENTALS

In drafting a contract, it is industry practice to protect the original intent of the participants in a reinsurance relationship. Should a later disagreement arise, the three member arbitration panelists often investigate whether the parties intended to supersede the contractual terms. This determination can prove crucial because the arbitration panel has the authority to detour from the strict legal fundamentals of contract law. Thus, each participant usually keeps careful records of initial exchanges of relevant information, together with notes taken from the resulting negotiations. This paper record can substantiate any later claim regarding the parties' intent. If a dispute should arise, the contractual partners take advantage of such recall and usually dissipate the friction by confirming the original purpose. Once the original negotiations are complete, and once the drafting organization produces a proposed agreement, the participants carefully review the contract to ensure the meaning and good faith of the parties involved.

The reinsurance intermediary (involved in the remaining fifty percent of industry premium volume) typically presents the contract to his or her legal principal (the cedent). There is no doubt within the industry of this legal relationship since the issue was conclusively resolved in the case of Francis v. Midland Insurance Co. (In re Prichard & Baird, Inc.), decided in the late 1970's.3 Once approved by the insurer, the intermediary will approach the various reinsurers for approval of their subscribing share in the contract. One can imagine the stressful difficulty of a broker who attempts to gain consensus among a variety of experienced reinsurers. However, the specific language used in an arbitration clause is seldom a point of conflict since the alternative wordings sponsored by the BRMA were created. The most frequent issue is whether to expand application of the arbitration clause to each and every dispute (the broad form) or, in the alternative, to apply the clause only to disputes that do not involve performance activities.

In the case of a direct reinsurer, where the reinsurer's account executive handles the assumption, there is no need for a broker of record letter or any other intervening step. Instead, the account executive delivers a home office approved cover note to confirm the understandings that were reached. At the final step, the contract is again prepared by the reinsurer in most instances and will include an arbitration clause to resolve differences. A noted exception involves the third largest reinsurer domestically, which has traditionally preferred not to employ arbitration clauses. Otherwise, it is industry practice for both direct and brokerage market participants to cure deadlocked differences via arbitration.

Now that the contract is set, the reinsurance partners engage in the activities prescribed in the contract. Policies are underwritten in accordance with the coverage, territory and exclusions cited within the agreement. Accounting clauses confirm the financial transactions, claims clauses confirm the loss transactions, and the participants in all other ways engage in creating what was intended originally. What can go wrong?

The response to this question is legendary. Perhaps the cedent is underwriting policies that are suspected to be outside the boundaries of the reinsurance relationship. Perhaps the accounting or claims reports are flawed, late, or otherwise fail original expectations. Perhaps the original underwriting data proves to be misleading. Even more fundamental, perhaps the interpretation of a key contractual term draws different meaning. Given the variety of problems, the parties to the contract may recognize differences or attempt to resolve them, yet find that unresolved issues still remain. In these situations, the arbitration clause engages.

III.

INTENDED ARBITRATION PRACTICE

The arbitration clause used within the P & C industry specifies that each participant selects a person (but not an organization) to serve on a three person arbitration panel to resolve any subsequent dispute. In the intermediary market situation, a single arbitrator can be chosen to represent all subscribing reinsurers by applying a consolidation clause found in some contracts or simply by agreeing to a joint representation. Should any single reinsurer withdraw from the group effort, that non-participating reinsurer retains the privilege of arbitrating separately or alternatively. A separate arbitration on the same issues will create a distinct disadvantage to the cedent if a subsequent arbitration essentially repeats the same subject material.

The direct reinsurer's behavior is, by its nature, much more straight forward. Because it selects only one arbitrator, the choice is made without the need to interface with other participants or communicate through an intermediary.

The selection of a party-appointed arbitrator often takes place by reviewing lists of qualified candidates. Such lists are available through the Society of CPCU, the Reinsurance Association of America, and other sources. One of the initial problems is that certain organizations charge a fee of candidate arbitrators who wish to be included in that organization's list, but offer no qualifying review. Thus, both experienced and inexperienced candidates appear on a printed roster from a reputable industry source that is reluctant to screen applicants. Since reinsurance is a sophisticated business, it is expected that such rosters provide a list of readily-available candidates, but the list is not necessarily all-inclusive. It is industry practice to seek informal guidance from distinguished personal sources prior to choosing any panel member.

Typically, any candidate who is approached for this purpose provides experience data that can be researched for accuracy and assessment. When legal counsel is involved, the contact attorney may be asked to provide such an adequacy review. Any remaining questions are resolved, typically, through resulting interviews. Preliminary indications of bias can be sought by the prospective arbitrator at this stage. To no one's surprise, an initial leaning in the direction of either the sponsoring cedent or reinsurer will clinch or remove that candidate from continuing review. It is expected that the issues involved, the identification of the participants (in order to exclude any conflicts of interest), the location of the arbitration site, and other general concerns will be shared with candidates on the "short list." Once chosen, the cedent or reinsurer initiating the dispute resolution will advise the other party that the reinsurance contract's arbitration clause has been activated, enumerating the issues and identifying the arbitrator of choice. The remaining contractual party normally is given thirty days to respond. The response must include nomination of the second arbitrator.

Once identified, the two selected arbitrators are then asked to convene. In Lloyd's of London practice, those two people are typically invited to first attempt resolution between themselves.4 A third panelist (the umpire) may be appointed, but participates only if the two party-appointed choices cannot reach a mutual agreement. Domestic practice, by contrast, specifies the selection of a neutral umpire once the parties have selected their arbitrators. This decision is widely recognized as a very crucial ingredient because selecting an umpire who happens to lean in the direction of one participant's case could shape the outcome. Every effort is made to locate a neutral, unbiased umpire. Often the party-appointed panel members will suggest several candidates as umpire. Should the offered names be rejected, typical arbitration clauses recommend a "drawing by lots" solution, where each participant furnishes three names, each responding party strikes two, and one residual choice of each party is selected by the flip of a coin. Under these circumstances, a conniving participant might still provide three biased names, risking that two will be stricken, and then figure on a fifty percent chance of a favorable coin toss as the method of winning the argument. Thus, the choice by lot method is not favored in industry circles unless a deadlock occurs on the recommended names.

What qualities are expected of arbitration panel members as contemplated by the P & C industry? Although they may lean in the direction of their sponsoring member, the party-appointed members are expected to be disinterested.5 Given no financial incentive for "victory" in the outcome, these arbitrators, together with the umpire, are expected to remain open to the merits of either side's case. That openness should extend to their final decision, their consideration of relevant information, and the validity of the other side's expert witnesses (if any).

IV.

TWISTS IN THE PROCESS

At this juncture, it seems important to contrast the requirements of a nonadvocate arbitrator with the committed position often cited by legal authorities who enter into the debate.6 Attorney-driven writings often favor the appointment of an arbitrator-advocate whose role is similar to the advocacy role of a lawyer representing a client. An advocate is reluctant to accept the merits of the others side's position. Lawyers who have invaded the thinking on domestic arbitration issues have changed the non-biased expectation of panelists.

A related change has occurred in limited instances where the arbitrator choice is an undisclosed member of a law firm, a consulting firm, a CPA firm, and the like. Immediate research into this topic locates no reference that replaced the "person" requirement with an organization in the role of arbitrator. Some professional firms have tried to shape the impersonal choice in arbitration, knowing that the person who will serve is disguised. The rationale cited in this article seeks to reverse either the advocacy or the impersonal tendency.

With regard to the umpire, this person is expected to epitomize non-biased behavior. An umpire should never involve him or herself with just one other arbitrator while discussing arbitration issues. The term "ex parte" (one sided) would apply in that situation. The American Arbitration Association goes so far as to recommend against an elevator ride involving the umpire and just one panelist. The reinsurance industry's sensitivity may not be that rigid, but the threshold is crossed any time the unbiased expectation is tarnished.

The arbitration panel usually holds an initial meeting with the disputants. The umpire chairs the meeting, seeks agreement on procedure, and sets the hearing agenda. Each panel member declares his or her background and demonstrates relevant qualifications in the process. Routinely, each member is or was an executive of an insurance or reinsurance company, has no conflict of interest, will consider all the evidence presented, and can decide the outcome impartially. Any objections or challenges are offered, followed by the responses. The parties are then asked to authorize the panel members. Once secured, the panel's decision can be overturned only if the behavior of its members blatantly conflicts with the promises made at the initial panel meeting. The panel members commit to studying the issues and deciding an appropriate outcome. The final vote is usually two to one, with the so-called losing party's appointed arbitrator voting against the majority decision. However, an effective working panel will be able to vote unanimously on the specifics and the outcome if each member perceives that his or her views were seriously considered.

V.

TRACING THE RELATIONSHIP: ANOTHER TWIST

In the arbitration process, consideration should also attach to the specific relationship between a party-appointed arbitrator and his or her sponsoring member. Is the relationship defined as a legal agent to principal? Is it instead an independent commission whereby the chosen arbitrator has no commitment of loyalty to the sponsor? Despite a near void of evidence in existing publications, this author suggests that a legal agent-to-principal relationship would nullify the requirement of remaining open to the merits of the other party's position. However, such a viewpoint continues to clash with the lawyer-driven advocate role. Logic recommends an independent commission in this situation, which is consistent with the "disinterested" arbitrator requirement.

On a similar track, sensing that the selected arbitrator may be leaning in the other direction, could the sponsor seek to cancel the appointment by asking the original arbitrator to resign in favor of a more sympathetic representative? Similarly, could the sponsor seek a "forced" resignation by the original choice in order to meet the enhanced qualifications of another party's choice of arbitrator? If an arbitrator has indeed been named in official papers, then any later doubt by a sponsor raises an invidious issue. The doubting insurer/reinsurer wants to be represented well. But perhaps the detection of an unsympathetic viewpoint, or an under-qualified representative, causes the sponsor to seek a replacement. This appointment switching is possible; all that is required is a request to resign the appointment. These possibilities are virtually untapped after reviewing the available literature7 and bring into question the arbitral relationship.

Summarily dumping an arbitrator of original choice is not only inappropriate but violative of an arbitrator's independent commission status. And if that situation occurs, one can anticipate a day when a willing-to-resign arbitrator petitions the arbitration board to be replaced. When the opposing sponsor realizes the very distinct possibility that the dumping process will work against its interests, it will vigorously object. Regardless of the outcome (how should the arbitrator appointed by the opposite party vote on this issue?), the dynamics will be sensational. The sponsor's motive to engage in re-selecting can interject a serious ingredient into the situation.

Logistically, the doubting sponsor may chat informally with the arbitrator in question, suggesting that the tides have changed and the party's interests would best be represented by a different person. Imagine the thought process of the arbitrator. "If I agree to retire from the panel, what will be said about me if this news gets around the industry? Since being a panel member usually includes payment by the hour or by the day, am I willing to yield this flow of funds in order to comply?" Such issues may influence the decision to gracefully resign from the panel.

Given the unresolved nature of this "pressured" retirement from the panel, there is a related issue affecting the arbitrator's behavior. The expectation of panel member independence usually occurs when the appointed arbitrator is asked, during the panel's initial meeting, to conduct no business with the sponsor that would result in losing his or her unbiased status. Much discussion has occurred in trying to define behavior that is "beyond the fringe." Perhaps the panel member needs to check on a logistical issue with the sponsor. This usually creates no problem. However, should the discussion turn to strategizing the presentation of the sponsor's case to the panel, the appointed arbitrator should refuse to participate. Between logistics and strategizing there are a variety of behaviors that would threaten the arbitrator's promise to remain "ex parte" in relating to the sponsor. Some literature provides guidance on this subject. Whether these behaviors constitute "restricted communication" or ex parte communications is conjecture since the industry has no binding terminology.8

A renowned case in the northeast United States involved one arbitrator who, prior to the appointment of an umpire, negotiated with the opposite party appointed panel member while also communicating with the sponsor. This behavior is flawed. In Metropolitan Property & Casualty Co. v. J.C. Penney Casualty Co.,9 the court decided that both ex parte contact and industry practice had been violated. In the few other available cases or industry references on this subject, very little guidance is provided. In addition to a dearth of guidance, this issue is thorny because arbitrators do not keep an activity journal. Their out-of-the-panel discussions with their sponsor (if any) remain secretive, and the frequency of ex parte discussion thus remains speculative. The ex parte test seems to be: did the side conversation shape the panel's deliberations? If conversation takes place on procedure, logistics, etc., it is doubtful that any industry observer would be offended. The crossover point occurs when substance is involved because substance may bias the arbitrator in future panel deliberations.

VI.

CONCLUDING THE ARBITRATION PROCESS

Reverting once again to the arbitration procedure, the disputants are requested to provide the equivalent of legal briefs to the panel after the initial hearing. The panel expects to receive these summations at least ten working days prior to the actual hearing. In some cases, the umpire will guide the parties to deliver such initial positions to both the arbitration board and to the other disputant so that objections can be noted and registered in a second brief at least three working days prior to the panel meeting. The more that information is shared, the greater the disputants' understanding of the other's position. And, the greater their understanding, the greater the likelihood of an early resolution, thereby saving money and needless consternation among the panel members.

If no pre-hearing settlement occurs, the umpire calls the actual hearing to order once the relevant documents are exchanged. A court reporter is typically present, taking permanent notes for each side to review at a later date. The petitioner moves first and concludes the full presentation after the respondent's case is heard. Both contractual language and practice dictate that the arbitration board will not be bound by legal procedure or other predetermined behavior. Interruptions to clarify often occur. An informed and informal setting tends to produce the greatest meaningful exchange. When all the evidence is heard, the disputants are asked to leave the room. The panel then meets, and a decision is rendered. This decision binds the participants. If one party does not perform, the other enforces the arbitral award through legal action. Hopefully, the reinsurance partners can return to business as usual when their previous differences are resolved.

The traditional arbitration process has afforded permanent solutions to disputes in the property and casualty reinsurance industry. Its contribution is well recognized. This author believes that identifying each arbitrator as an independently commissioned person will strengthen this dispute-resolving process.

1 A CONTEMPORARY GUIDE TO REINSURANCE (2d ed. 1994). 2REINSURANCE 5 (R. W. Strain, ed. 1980).

3No. B-75-3202 (D.N.J. filed March 1, 1979); see John M. Sheffey, Reinsurance Intermediaries: Their Relationship to Reinsured and Reinsurer, 16 THE FORUM 922 ( 1981).

"See generally Sheffey, supra note 3.

5Bruce D. Evans, A Disinterested Party-Appointed Arbitrator, RISE, Summer 1993 at 2. 6 See, e.g., Eugene Wo]lan & Lawrence Greenglass, Reinsurance Arbitration, U. S. REINSURANCE REPORT, Jan/Feb. 1986 at 19; see also Harold Tract's discussion of "Super advocates" in Arbitration: The Bloom is Off the Rose, BEST'S REVIEW, Aug. 1987, at 32.

'See, e.g., Some Guidelines for Resolving Reinsurance Related Disputes, REINSURANCE ASS'N. OF AMERICA (1988).

8 See, e.g., American Arbitration Association, THE CODE OF ETHICS FOR ARBITRATORS, Canon V (1977).

9780 F. Supp. 885 (D. Conn. 1991).

*The author gratefully acknowledges Robert G. Lynch, Margaret V. Evans and a reader who wishes to remain anonymous for their helpful suggestions in reviewing an earlier draft of this manuscript.

Bruce D. Evans, CPCU, ARe, * is a nationally known educator in reinsurance matters. Professor Evans has directed seminars in property/casualty reinsurance for over 25 years. He is a court-recognized industry expert and also serves as an arbitrator or umpire in insurance matters. Professor Evans is a member of the full-time faculty at the University of Dallas, Graduate School of Management. He previously served as V.P. - Reinsurance for the Transport Insurance Group.

Copyright Federation of Insurance & Corporate Counsel Spring 1998
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