1.          Terminology

C1        Article 7.2 addresses the consequences of early termination of a contract of reinsurance before the expiration of the reinsurance period. For the sake of clarity, the Principles refer to “termination” when the contract of reinsurance becomes non-existent ex nunc (prospectively) and use the term “avoidance” when the contract becomes non-existent ex tunc (retrospectively). Termination therefore includes cancellation as well as other reasons for the contract to terminate ex nunc.

2.          Relationship to the PICC

C2        Notwithstanding special rules on the effects of termination for contracts of reinsurance set out in Article 7.2, the underlying concept of termination is in line with Article 7.3.5(1) PICC according to which “termination of the contract releases both parties from their obligation to effect and to receive future performance”.

C3        Article 7.2 focuses exclusively on the effects of termination. Whereas the PICC contains rules on the consequences of termination of long-term contracts, the general rules set out in Article 7.3.7 PICC may not adequately address all the issues specific to reinsurance. This is especially true with regard to restitution (Article 7.3.7(2) in conjunction with Article 7.3.6 PICC) and the fate of the parties’ obligations under the contract of reinsurance (cf. Swiss Re Ins Co & Ors v United India Ins Co Ltd [2005] EWHC 237 (Comm)). This is why Article 7.2 provides for a special rule on the effects of termination.

3.          Preliminary remarks

a.          Termination in general: Fixed-term and continuous contracts

C4        Where the parties to a contract of reinsurance agree on a predefined end date, the contract ends on that date. The date is usually aligned with the reinsurance period (e.g. 12 months). The parties to a contract of reinsurance initially written for a definite period are, of course, free to renew their contract or to include an automatic renewal clause, thereby creating a continuous contract (Lamy Assurances, para. 5209, 5211; O’Neill, Woloniecki & Arnold-Dwyer 3-044).

C5        Continuous contracts of reinsurance typically stipulate a contractual right to terminate subject to a notice period, i.e. a specified number of days or weeks between serving notice of termination and its effective date (e.g. “with 90 days’ notice of cancellation at anniversary date”; see Commercial Union Assurance Co Plc v Sun Alliance Insurance Group Plc [1992] 1 Lloyd’s Rep 475, QBD (Comm Ct); O’Neill, Woloniecki & Arnold-Dwyer 3-044).

C6        In either case, the contract of reinsurance will terminate by the end of the reinsurance period. There are, however, situations where the contract of reinsurance will terminate before than the contractually defined reinsurance period expires. These cases are dealt with under Article 7.2.

b.     Grounds for early termination before expiry of the reinsurance period

C7        In certain circumstances, contracts of reinsurance may be terminated before the reinsurance period expires. Beyond termination by mutual contractual agreement at any time (contrarius consensus, see Gerathewohl (1976) 899), a party may be entitled to exercise a contractual right to, or invoke a remedy for, early or special termination.

i. Termination as a remedy for breach of contract (Article 3.1(2))

C8        Article 3.1(2) provides that, in the event of a breach of contract, the aggrieved party may terminate the contract of reinsurance if it cannot reasonably be expected to uphold the contract. The right to terminate under Article 3.1(2) is available as a remedy to both parties. Termination takes effect from the date of receipt of the notice and is not retroactive (see Comments 25 to Article 3.1 and LMA5139).

ii. Contractual right to special termination

C9        Reinsured and reinsurer are free to stipulate contractual rights to terminate the contract in specific circumstances that materially impair one or both parties’ ability to perform their obligations under the contract of reinsurance. The continued performance of the contract of reinsurance may be called into question by internal or external events such as insolvency, loss of license, change of control, war, embargos, sanctions, or similar restrictions. The parties may therefore choose to include a special termination clause in their contract of reinsurance that provides for a right to terminate the contract if one of these events occurs (Lamy Assurances, para. 5210; Gerathewohl (1976) 916 et seq.). The effects of special termination on premiums, outstanding settlements and losses that occurred prior to the date of termination may vary.

C10     While some clauses are multilateral, others grant the right of special termination exclusively to the reinsured. The latter approach recognizes that it is primarily the reinsured who must be able to terminate and make alternative reinsurance arrangements in circumstances where the reinsurer appears unable or unlikely to meet its contractual obligations. The reinsurer does not necessarily need the same level of protection given that premium is frequently paid in advance. Furthermore, even where the reinsured fails to meet with its premium payment obligations, various remedies are available to the reinsurer (see Articles 3.1 et seq.).

C11     Moreover, the reinsured may wish to have a contractual right to terminate the contract if the reinsurer’s credit rating is downgraded. The reinsured is exposed to the reinsurer’s credit risk: the latter’s financial strength is crucial to the reinsured and its solvency capital requirements, as it guarantees performance under the contract of reinsurance. It is therefore well-established market practice to provide for a special right of termination that is triggered by a rating downgrade.

C12     The content, scope and consequences of special termination clauses may differ considerably, as the clauses must take into account the regulatory environment of the relevant jurisdictions, e.g. with regard to insolvency proceedings and creditor rights. With no universally accepted market standard, special termination clauses remain highly individualized and subject to negotiations. The Principles therefore do not provide a model rule but instead leave it to the parties to draft a special termination clause that meets their individual needs.

4.          Paragraph (1): Consequences for the reinsurer’s liability

a.          Change of the cut-off date

C13     Termination will bring the contract of reinsurance to its end ex nunc. Consequently, no further rights and obligations will arise under the contract after the date on which termination takes effect (the “effective date of termination”). The reinsurance period will be shortened to expire on that date.

C14     The effective date of termination becomes the cut-off date for risks for which the reinsurer remains liable to cover losses and make payments under the terms of the contract of reinsurance. Provided that the reinsurer was “on risk” during the ongoing reinsurance period and that risks attached, losses occurred or claims were made on or before the effective date of early termination, the reinsurer remains liable to settle these claims even after the contract of reinsurance expire (see O’Neill, Woloniecki & Arnold-Dwyer 3-048 and 5-126–5-129). The termination does not affect any liabilities of either party subsisting on the effective date of termination.

C15     Irrespective of paragraph (1), the parties are free to commute the reinsurer’s outstanding liabilities (commutation agreement). For example, the parties may agree to discharge the reinsurer from all liabilities in exchange for the payment of a lump sum.

b.          Corresponding duties of the reinsured relating to claims in respect of outstanding liabilities

C16     For claims in respect of outstanding liabilities, the reinsured’s duties and obligations relating to, inter alia, the claims process and reporting shall also remain in full force (see the duties of the reinsured as set out in Chapter 2, Section 4). Correspondingly, the reinsurer retains the right to inspect records of the reinsured in respect of outstanding liabilities (see Article 2.3.3).

5.          Paragraph (2): Effects on premium

C17     Article 2.3.1 provides that premiums shall be paid by the reinsured in accordance with the terms of the contract. Where the contract of reinsurance terminates before the date originally specified, the premium due by the reinsured should be adjusted to reflect the shortened period during which the reinsurer was on risk. On this point, paragraph (2) departs from English law. Under English common law, the full premium is deemed earned at the inception of the risk (see Swiss Re Ins Co & Ors v United India Ins Co Ltd [2005] EWHC 237 (Comm); see also O’Neill, Woloniecki & Arnold-Dwyer 4-045), although it should be noted that the parties frequently contract out of this position (e.g. by using clauses LMA5139 and LMA5140).

C18     Paragraph (2) provides for a more flexible solution by departing from the English common law rule. It establishes a presumption of pro-rata calculation, subject to adjustment based on particular facts and circumstances.

C19     The presumption of pro-rata calculation as the default rule is justified on mathematical grounds. As the length of the reinsurance period is a factor in calculating the premium, a change of reinsurance period logically supports the adjustment of the premium. This is also reflected in reinsurance practice, where clauses that reference pro-rata premium returns, such as LMA5139 and LMA5140, are in common use.

C20     On the other hand, particular circumstances may justify a departure from a strict application of the presumption of pro-rata calculation in individual cases. One decisive factor in determining whether the presumption of pro-rata calculation can be rebutted is the extent of claims payments already made by the reinsurer. If, for example, the agreed limits are nearly exhausted even before termination takes effect, the premium would not be reduced and the reinsured would owe the full amount (second sentence of paragraph (2)). The pro-rata rule should also be disregarded or adjusted where the covered risk is front-loaded or concentrated in the period preceding early termination.

Illustrations

I1.         A 12-month contract of reinsurance covering marine risks forms in January. It contains a liability limit of USD 10 million. An annual premium of USD 100,000 is paid at formation. In February, a major loss occurs and a reinsurance claim of USD 9.5 million is paid. The contract is terminated early in March. Under these circumstances, the pro-rata allocation of premium would not be fair.

I2.         A 12-month contract of reinsurance covering hurricane risks forms in August with an annual premium payable at formation. The hurricane season runs from August to October. The contract of reinsurance is terminated early at the end of October. In this situation, the pro-rata allocation of premium would not reflect the risk.

C21     Article 7.2 refers to the premium as the gross premium. The rule, therefore, also applies to administrative costs included in the premium. Where fees and charges are owed under separate service agreements, it is a matter of construction of the relevant agreement as to whether these costs can be returned or apportioned. Brokerage arrangements are not part of the contract of reinsurance and therefore fall outside the scope of the Principles and, consequently, outside Article 7.2.