Commutations are generally a good thing. However, you have to get the drafting right. There are two issues which must be thought through. First, does the agreement reflect what the parties want? Second, if you are a reinsurer, does it take account of the recovery of the commuted balances from retrocessionaires?

As to the first issue, you must be clear about:

  • Who are the parties?
  • What are the contracts?
  • How much will be settled?
  • What happens if it is not paid?

The industry has undergone myriad mergers and acquisitions. Many companies once gave their pens away to agents. Unless you are absolutely clear what is involved, some contracts might escape the commutation; or you might even commute away contracts you did not realise existed!

It is best if the commutation balance is settled in one go. If it is paid in instalments you need to provide for the possibility of them not being met. A right to sue on the contract with interest may be useless. Perhaps you could stipulate that the agreement is automatically discharged with the commuted reinsurances reinstated if there is default. Alternatively, require the paying party to establish reserves against which future obligations could be drawn down.

This second issue is a legal difficulty. Commutations generally comprise:

(i) Paid balances: amounts notified by the cedant as being due, and payable under the treaty but which the reinsurer has not paid.

(ii) Outstandings: generally reserves advised to the reinsurer by the cedant in respect of known losses.

(iii) Losses incurred but not reported,

("IBNR"): estimates (generally estimated actuarially) of the value of possible future liabilities but which are not referable to any known loss.

Ordinarily, a retrocessionaire protects against the legal liabilities which the reinsurer incurs to his cedant under contract(s) of reinsurance. However:

(i) a commutation might involve terminating a reinsurance contract and replacing it with another agreement by which a sum certain is paid in exchange for a release; the retrocessionaire might say; "I don’t reinsure this obligation. I only reinsure obligations under the underlying reinsurances";

(ii) alternatively, the commutation payment cannot be attributed to any known obligation; the reinsurer therefore finds it impossible to prove liability to his cedant. This is particularly so with outstandings and IBNR, where the losses have not necessarily crystallised.

The problem was demonstrated in the Singaporean decision, Overseas Union -v- Home, (2000 4 SLR 104). Overseas Union entered a commutation at a figure which had been ascertained by an actuarial report. They claimed a proportionate share of the commutation from their reinsurers, Home. The treaty loss settlements clause provided that "all loss settlements made by Overseas Union, including compromise settlements, shall be unconditionally binding upon reinsurers".

The commutation did not qualify as a "loss settlement" and therefore Overseas Union could not claim for it!

An extreme position perhaps, which may not be followed here. However at present, there is no compelling UK authority and only a vague notion that the position is rather unfair.

There is no magic solution, although you can help by avoiding terminology which suggests the "termination" or "release" of the commuted contracts. Also, ensure that paid balances are clearly identified and referable to a figure comprising the settlement.

The problem in relation to outstandings and IBNR is more deeply rooted. However, one way through is to persuade the cedant to continue accounting to you, but subject to your obligation being capped at the commutation figure, that figure is then "advanced" to the cedant. That way, the commuted reinsurances and the obligations under them maintain every appearance of continuing to exist.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.