Reinsurance Arbitration Clause Pitfalls for Captive Insurers

In nearly all cases, captive insurers procure some form of reinsurance. Both the issuing reinsurer and the captive insurer typically enter this relationship with positive intentions. While many captives may never encounter claims that lead to disputes with reinsurers, such disagreements would typically be addressed under the reinsurance contract's arbitration clause.

Standard arbitration clauses are generally similar across reinsurers. However, despite the familiarity of captive boards and management with these clauses, they often dedicate little time to reviewing the arbitration clause section of their reinsurance contracts. As with any contractual agreement, potential pitfalls may arise. Captive insurers should strive to understand these pitfalls within arbitration clauses and explore how additional contractual language can help mitigate them.

Below is an example of a standard arbitration clause found in reinsurance contracts. For the sake of this article, sections of the contract deemed free from potential pitfalls are omitted. However, captive insurers, in collaboration with their legal counsel, should thoroughly scrutinize each section of their reinsurance agreements to identify potential 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 examine each of the clauses above to pinpoint 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 of two arbitrators and an umpire, meeting in Dallas, Texas, unless otherwise agreed.

The first vulnerability pertains to the composition of the arbitration board. As outlined in the clause, three individuals are involved: two arbitrators and one umpire. While this may seem straightforward, it's crucial to have an odd number of members on the arbitration board to ensure a definitive decision. A potential issue with a single arbitrator is the risk of indecision. We've encountered cases where the arbitrator was inclined to rule in favor of the captive insurer but refrained from doing so due to potential political consequences. Additionally, costs come into play, as a three-person board incurs higher expenses compared to a single-person board.

The second vulnerability concerns the location of the arbitration. Most clauses specify that the arbitration will take place in the reinsurer's domicile, not the captive insurer's. This could entail unfamiliar foreign venues with different rules and regulations, along with additional travel expenses for the captive. Whenever feasible, the captive insurer should strive to have the arbitration conducted in its own political jurisdiction 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.

Regarding the composition of the arbitration board, the clause stipulates that its members must be active or retired disinterested officials of insurance or reinsurance companies. This condition could pose challenges for captive insurers. Firstly, it restricts the use of other professionals with insurance expertise, such as brokers, actuaries, or captive managers. Secondly, there have been instances where a retired executive from a captive insurer was deemed ineligible because captives are often categorized as alternative insurance and may not meet the strict criteria of an insurance or reinsurance company.

Every captive insurer should acquaint itself with the Association Internationale de Droit des Assurances (AIDA) Reinsurance and Insurance Arbitration Society (ARIAS). Most reinsurers appoint their arbitrators from this association and often seek an ARIAS umpire. However, this practice presents several disadvantages for captive insurers. Firstly, upon closer examination of the professional arbitrators and umpires within ARIAS, it becomes apparent that many of them come from very large primary insurance or reinsurance companies. Secondly, even though the contract language may not explicitly require the use of ARIAS arbitration rules, if at least two members of the arbitration board are ARIAS members, there is a tendency toward employing the ARIAS rules introducing a potential bias.

When selecting an umpire, the ARIAS guidelines recommend creating and sending a questionnaire to potential candidates. Captive insurers should note that the language used in the questionnaire might lead to issues. A more effective approach would be for two arbitrators to propose three candidates for evaluation by the other party. Each party could reject two candidates, and the umpire could be chosen by drawing lots. However, even in this scenario, if the umpire and one arbitrator are both affiliated with ARIAS, they may be acquainted due to the relatively small size of the ARIAS group. It's important to acknowledge that ARIAS is a highly professional organization with robust arbitration rules. However, captives should be mindful that many members of the group are either current or former general counsels for insurers and reinsurers.

The third area of potential conflict involves 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 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 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" may seem innocuous, it may cause concern for individuals with legal backgrounds. Caution should be exercised to avoid prolonged debates over the extent of flexibility allowed in presenting evidence under this clause.

Additionally, while arbitration is often seen as a cheaper alternative to litigation, it still incurs costs. In some cases, litigation may ensue even after arbitration, nullifying the cost-saving advantage. Although rare, this scenario can occur. Therefore, captive insurers should carefully review the arbitration clause in their reinsurance contracts and ensure they fully comprehend all its implications. It's advisable to seek clarification before the need for the clause arises.