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An evolving essay on certain solvency issues faced by P&I Clubs

Three insurance products sold as one

The Clubs in the International Group provide their member-insureds with very high limits of cover, in addition to extremely broad primary coverage and a high level of service.  The Clubs have sufficient assets to provide the primary coverage, but they have to purchase reinsurance in order to provide the coverage in excess of $5 million per occurrence.  The working layer is provided at cost, by the Clubs themselves, who pool all of their losses in the layer $45 million excess of $5 million.  For losses above $50 million, the Clubs buy reinsurance from the market.
In effect, the Clubs are providing their members with three insurance products:

  • primary cover up to $5 million any one occurrence
  • working layer reinsurance above $5 million
  • excess of loss reinsurance above $50 million

One remarkable feature of this arrangement is the extent to which the Clubs take on the risk that some or all of their reinsurance recoverables may be uncollectible.

In other industries, insurance buyers assume that risk by purchasing primary insurance from one insurer, and excess insurance from another.  The primary insurer rarely assumes its assured's business risk that some of its excess insurers may become insolvent.

Securing reinsurance recoverables

While this additional risk may not worry the directors and managers of the Clubs, it does worry insurance regulators, especially when the reinsurance is provided by companies the regulators have not personally examined.  In New York, the American Club must show the regulators that it has collateral for each reinsurance recoverable from companies who are not authorized to do business in New York.  Lloyd's is authorized, but most of the Clubs and the member companies of the Institute of London Underwriters are not.

The oil spill by the TASMAN SPIRIT off Karachi in August 2003 presented the American Club and the New York Insurance Department with their first opportunity to come to grips with the Clubs' unique arrangement and the constraints imposed by domestic insurance regulation. It would be interesting to know what they made of it. The loss may have to be reserved at more than $30 million, judging solely from accounts in the press, and the American Club will have to show that liability on its balance sheet, offset by reinsurance recoverables.  The question for the regulators will be whether, and to what extent, they should give the Club credit for reinsurance recoverables from subscribers to the Group's reinsurance program who do not do business in New York and who may have no assets in New York.  A further question is whether the American Club can even show recoverables from Lloyd's et al, because the Group's contract is a reinsurance of the Pool.  Accordingly, the American Club may have to show recoverables from the other members of the Pool, almost none of whom are authorized to do business in New York.

The traditional means of securing reinsurance recoverables is to obtain a letter of credit from the reinsurer.  Lloyd's and the London market are very familiar with this procedure.  The other members of the Pool are not familiar with it, and it is highly doubtful that they would agree to provide the American Club with ellcees.

The American Club for many years claimed that its recoverables from the Pool are secured by the amounts it owes to the Pool, i.e., its reserves for other Clubs' Pool claims and other reinsurance payables.  This accounting practice, referred to by the regulators as "funds withheld under reinsurance treaties", was first used by the Club when its participation in the Pool was, technically speaking, an aspect of its reinsurance contract with Bilbroughs ("LSSO"). Then, it was easy to persuade the auditors that amounts set aside to pay Pool claims were "premium" as opposed to "claims" because the Club's obligation to pay those claims stemmed from a written reinsurance contract.  When the Club became a member of the Pool in its own right in 1998, however, it became less clear to the auditors that Pool claims payable should be accounted for as "premium" and not as losses incurred from assumed reinsurance, although they continued to permit the Club to follow its practice.

Sadly, at least to this author, the Club's practice was disallowed in the most recent examination by the New York State Insurance Department; it remains to be seen what long term effect this will have on the Club.  I understand that the managers are currently taking the position that the other Clubs' designated reserves are a form of collateral for the American Club's recoverables, but those funds are earmarked for specific purposes and are not held in the United States, so I wonder whether this practice would withstand  scrutiny by the Insurance Department.

In this era when the press equates Maurice Greenberg of AIG with the thieves at Enron for violating FASB 113, it is difficult to defend creative accounting practices , but I think the classification of Pool claims payable as reinsurance expense was entirely correct . First, in practical terms, it is a reinsurance expense, because a Club pays other Club's Pool claims in order to obtain  reinsurance for its own losses, and not for any other reason.   Second, if other Clubs' Pool claims are to be classified as  "losses", there should be a corresponding "premium" for all "losses" incurred, and. a Club does not earn any additional or identifiable premium for "assuming the reinsurance" of other Clubs. Third, the amounts that Clubs reserve for Pool claims are based on the constantly changing ratios that their premiums, tonnage, and claims bear to the Group as a whole, and cannot be estimated solely with regard to actuarial principles as a Club's own losses are.  Actuaries can project the development of the total claims on the Pool in any given year, but only the Club's underwriters can estimate how the Club's tonnage and premium will compare to the Group totals in 2-3 years' time.  Finally, Pool claims did not magically change character when the document obligating the Club to pay them became an agreement among thirteen Clubs as opposed to two Clubs. For all of those reasons, the Insurance Department should reconsider its position that Pool claims payable should be treated as "losses" as opposed to "reinsurance expense".

To learn more about the New York Insurance Department's views of reinsurance, look at