Insurance Industry Developments for Spring 2011

21 March 2011 Publication
Author(s): Jeffery R. Atkin Ethan D. Lenz Richard F. Riley Jr

Legal News: Insurance

IRS Is Aggressively Challenging P&C Loss Reserve Deductions: Companies Should Be Prepared
By Dick Riley

Starting in 2008 and continuing today, the IRS has ramped up challenges to loss reserve deductions taken by property and casualty insurance companies in computing taxable income. P&C insurers need to understand the IRS audit position, how to prepare for a loss reserve audit in light of the current IRS position, and what to do once the IRS makes a challenge.

The reserve for unpaid losses is typically the largest deduction on a P&C insurer’s tax return, so challenges to the reserve represent the IRS “hunting where the ducks are.” A successful challenge to the reserve deduction can generate substantial additional tax revenue from an insurance company taxpayer. However, from the IRS’s perspective, there is more to the issue than that. IRS insurance experts believe that many insurers have been systematically overstating loss reserves in recent years, and the current audit effort is designed as a pushback.

IRS Issues Paper on Excessive Loss Reserves

The IRS position on P&C loss reserves is explained in a Coordinated Issue Paper published by the IRS Large & Mid Size Business (LMSB) Division (since renamed Large Business & International or LB&I) in November 2009, entitled, Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims. As the title suggests, the IRS asserts that many insurers are adding unjustified “margins” to their loss reserves, resulting in excessive tax deductions.

The general rule for tax purposes, stated in longstanding IRS regulations, is that the end-of-year reserve for unpaid losses, on which a P&C insurer’s tax deduction is based, must represent the company’s “actual unpaid losses as nearly as it is possible to ascertain them.” According to the regulations, “These losses must be stated in amounts which, based upon the facts in each case and the company's experience with similar cases, represent a fair and reasonable estimate of the amount the company will be required to pay.”

According to the IRS, there are two ways in which a “margin” can make a company’s loss reserve exceed the “fair and reasonable estimate” allowed by tax regulations. First is an explicit margin, representing a dollar amount simply added on top of an actuarially determined estimate of unpaid losses. Some court cases have disapproved such explicit additions to loss reserves, unsupported by professional actuarial analysis. To the extent the IRS Coordinated Issue Paper is raising questions about explicit add-ons to loss reserves, made by company management without sufficient actuarial support, the IRS has some legal basis for its position.

The second kind of margin is what the Coordinated Issue Paper calls an implicit margin, or the supposedly improper use of “implicit conservatism” in developing a company’s loss reserves. This is the more troubling and aggressive aspect of the IRS position, and potentially harder for companies to defend against. The IRS argues that, even when P&C loss reserves are developed by credentialed actuaries and are fully consistent with professional actuarial standards, the reserves are still subject to tax challenge if they are based on some inappropriate — and unspecified — degree of “conservatism” in the company’s estimation of its unpaid losses.

There is little legal precedent to support this IRS rejection of any degree of “conservatism” in developing loss reserves. In some ways, the estimation of unpaid losses seems inevitably conservative, taking into account the many risks generated by a company’s insurance business, given that companies are necessarily averse to driving themselves out of business by ignoring the array of risks they might encounter. Professional actuarial standards and NAIC accounting standards are consistent with this kind of “conservatism.” Be that as it may, however, companies must be aware that the current IRS audit position is to reject any perceived “conservatism” in loss reserves. IRS agents and in-house IRS actuaries are on the lookout for reserves to challenge, and companies should be prepared.

Companies also should understand that the IRS does not agree that the loss reserve number reported on the annual statement should control for tax purposes. This is despite important court decisions that have confirmed the crucial importance of annual statement loss reserves in determining tax deductions.

What Is the IRS Looking for in Loss Reserves?

What will IRS agents look for in deciding whether to claim that a company’s loss reserves include an “explicit margin” or reflect “inherent conservatism,” making the reserves subject to challenge?

  • An “explicit” margin could be any kind of managerial addition to what a company’s in-house or external professional actuarial consultants have estimated as the company’s unpaid losses. In reported court cases, such “explicit” margins have included “bulk” reserves not developed in accord with actuarial standards, and a 10-percent “add-on” included in the reserve by a company’s financial managers without consultation with or support from actuaries.
  • “Implicit conservatism” raising questions in the mind of the IRS could be evidenced by company management’s statements to the financial community or other outside audiences that refer to “conservative” reserving practices. The IRS also searches for a consistent pattern of favorable development of reserves (that is, reserve take-downs) during subsequent years. We have seen IRS agents claim that companies are purposefully “stuffing” their reserves to increase tax deductions, with the idea of writing them down in later years as the actual losses develop more favorably than estimated.

IRS agents following the Coordinated Issue Paper have proposed, and continue to propose, some very substantial reductions in P&C insurance companies’ loss reserve deductions. We have worked with multiple companies recently facing these IRS audits. Our experience is that IRS Appeals, the independent office within the IRS that hears administrative challenges to IRS audits, has serious questions about at least some aspects of the LMSB Coordinated Issue Paper on loss reserves. Nevertheless, IRS Appeals believes it has to take all loss reserve adjustments proposed by IRS agents seriously, so companies must be prepared to respond to these substantial proposed adjustments.

Insurance Company Strategy for IRS Audits


  • Assure the company has a well-documented internal loss reserving process in place, performed by or under the supervision of trained and credentialed actuaries implementing professional actuarial standards.
  • Assure qualitative input from underwriting and claims during the reserving process.
  • Actuarial recommendations should be discussed at regular meetings throughout the year.
  • Obtain an opinion or “reality check” from outside actuarial consultants and/or auditors.
  • Know what company executives are saying to the investment community, regulators, A.M. Best, and others. Make sure executives understand the potential sensitivities of a focus on “conservatism.”

Once the IRS audit has begun:

  • Involve outside tax professionals at an appropriate stage.
  • Have a process for careful preparation and pre-submission review of all responses to IRS information document requests.
  • Consider engagement of independent outside actuarial consultants to support the company’s booked reserve. Take account of confidentiality and privilege concerns: consider possible engagement of outside actuaries by counsel to help the attorneys frame their legal advice.
  • Look ahead to IRS Appeals and possible litigation, and plan your strategy accordingly.

Solvent Run-Off Schemes in the United States: The Rhode Island Statute and Current Challenges
By Brian Kaas and Mike Davis

On March 16, 2011, a Rhode Island Superior Court heard arguments on whether Rhode Island’s solvent restructuring statute violates the Contracts Clause of the U.S. Constitution. The case stems from a global commutation plan developed pursuant to this statute by GTE Reinsurance Company Limited in order to settle all of its obligations under various property and casualty risks reinsured by GTE Re decades ago. Critics contend that the Rhode Island law enables policies and contracts to be modified without policyholder consent in violation of the U.S. Constitution.

Enacted in 2002, Rhode Island’s solvent restructuring statute created a first of its kind, expedited process for solvent insurers to enter a solvent arrangement in the U.S. See Voluntary Restructuring of Solvent Insurers, R.I. Gen. Laws § 27-14.5-1 et seq. More commonly used in the United Kingdom, a solvent arrangement1 is a legally binding compromise between the insurer and its policyholders and creditors to pay the insurer’s obligations via a global settlement as opposed to paying those obligations as they arise over the course of the runoff. This article, the first in a three-part series, will provide an introduction to solvent arrangements and Rhode Island’s solvent restructuring law.

Insurance runoff in the United States is a large and growing industry. In 2006, PriceWaterhouseCoopers estimated that the runoff market in the United States alone had an estimated $150 billion to $200 billion in reserves. Solvent arrangements are designed to significantly expedite the runoff process by settling all claims between the insurer and its policyholders pursuant to a global settlement. This often includes claims of undetermined, or disputed, value as well as claims that may not yet be known by the policyholder.

From the policyholder’s perspective, one might argue that a solvent arrangement guarantees payment on its claims, which could be a significant benefit if there is uncertainty regarding the long-term solvency of the insurer and its ability to pay future claims. At the same time, a solvent arrangement might be viewed by others as detrimental to some policyholders who believe they lose the benefit of the insurance protection they had purchased. This might be especially the case if a policyholder believes that it may have significant future claims that are not fully developed or known at the time of settlement.

From the insurer’s perspective, solvent arrangements could significantly reduce the long-term administrative expenses associated with runoff, which could result in more money being available for the payment of claims. A solvent run-off may also offer finality to all claims covered by the arrangement. Such finality might be achieved at a cost that is lower than other alternatives to runoff, such as selling or reinsuring the block of business or seeking to individually buy back policies or commute obligations.

U.K.Schemes of Arrangement

Schemes of arrangement have become fairly commonplace in the United Kingdom. The enabling legislation for these schemes was first contained in Section 425 of the Companies Act of 1985, which was subsequently amended in full by Section 895 of the Companies Act of 2006. Under this law, schemes of arrangement are available to solvent and insolvent companies, insurance and non-insurance companies, and U.K. and non-U.K. companies with a substantial connection to the United Kingdom. Schemes of arrangement first emerged in insolvency proceedings as a means to avoid paying substantial levies to the U.K. Department of Trade and Industry that were triggered under a traditional liquidation proceeding. Schemes of arrangement were later used by solvent insurers to access excess capital that would not be available in a traditional runoff. PriceWaterhouseCoopers reports that more than 60 companies have used solvent schemes of arrangement as of November 2010.

Rhode Island’s Solvent Restructuring Law

Modeled after the U.K. legislation and responding to a lack of alternatives to run-off, the Rhode Island Legislature passed a voluntary solvent restructuring statute in 2002. To be eligible under the statute, an insurer must meet certain requirements. First, the insurer must be domiciled in Rhode Island. GTE Re, for example, re-domesticated from New Hampshire to Rhode Island to meet this requirement. Through its favorable Port of Entry statute, Rhode Island also enables foreign insurers to re-domesticate so long as the insurer becomes subject to the jurisdiction and regulation of Rhode Island. Second, the insurer may have only “commercial” business on its books. This means, for example, that an insurer that has reserves attributable to life, workers’ compensation, or personal lines insurance would not be eligible to pursue a solvent arrangement. Third, the insurer must be solvent. Fourth, the entire insurer (and not just a block of its business) must enter the solvent arrangement and be bound by the commutation plan.

At year-end 2009, the Rhode Island Department of Business Regulation (Department) issued Regulation 68, which set forth certain procedural requirements for insurers to effectuate a solvent arrangement. Following are some of the details of the Rhode Island law.

  • Departmental approval of commutation plan. As an initial step, the insurer must allow the Department to comment upon the proposed commutation plan and resolve any comments that the Department has to the Department’s satisfaction. The insurer also is required to pay the Department a $125,000 fee.
  • Filing of plan with court. Upon receiving Department approval, the insurer must file its proposed commutation plan with the Rhode Island Superior Court of Providence County. GTE Re started the process by filing a Petition for Implementation of Commutation Plan in the Providence County Superior Court. On July 21, 2010, the Superior Court granted GTE Re’s motion for a meeting of the creditors to vote on the commutation plan.
  • Notice and provision of information. With the Superior Court’s approval, the insurer must then provide notice of the plan to affected parties. It is not necessary that each policyholder actually receive notice. Instead, notice must be provided to all insurance agents and/or producers of the insurer and all persons known or reasonably expected to have claims against the insurer, including all policyholders, at their last known address in the insurer’s records. In addition, notice must be printed in a newspaper of general circulation. The notice has to provide policyholders, creditors, reinsurers, and guaranty associations access to the same information relating to the proposed plan.
  • Vote. To become effective, the commutation plan must be approved by more than 50 percent by number and 75 percent by value of creditors voting, in person or by proxy, at the meeting. GTE Re had representation of 79 percent of GTE Re’s Composite Reserve vote at its creditors’ meeting. More than 87 percent by number and 97 percent by value of those voting approved of its commutation plan.
  • Court confirmation. The court must provide an order to implement the commutation plan if the required vote was achieved and it determines the commutation plan would not materially adversely affect either the interests of objecting creditors or policyholders. In determining whether the interests are not materially adversely affected, the court may consider the objections of creditors.

Status of the GTE Re Plan

Certain creditors of GTE Re have filed objections to the commutation plan premised on a violation of the Contracts Clause of the U.S. Constitution, which provides that no state shall pass a law impairing the obligation of contracts. The basis for the creditors’ argument is that their insurance contracts will be substantially modified, without their consent, as a result of the state law. The Rhode Island Attorney General submitted a brief in the GTE Re hearing arguing that the law was constitutional. Separately, on January 11, 2011, a creditor objected to the commutation plan stating that its reserve methodology does not adequately address its latent exposures.

The Superior Court split the confirmation of the vote and the implementation of the commutation plan into separate issues. On January 13, 2011, the Superior Court granted the motion to confirm the vote of the meeting of creditors. The Court will next take up the objections to the plan itself. It is unknown whether the Superior Court will approve the implementation of the plan, which will allow payments to the creditors and provide a release of the insurer by all parties upon the completion of the commutation plan. A discussion of the disposition of the hearing and an analysis of the principal arguments made by both parties in briefs will be discussed in the next edition of our newsletter.

1 In the United Kingdom and Bermuda, solvent arrangements are called “schemes of arrangement.” In Rhode Island, solvent arrangements are called commutation plans.

Insuring Renewable Energy Projects
By Ethan Lenz, Jeff Atkin, Trevor Stiles, Ben Sykes

Increased Governmental Financing Options in the Face of Strict Lending Requirements Opens a New Insurance Market

Over the past decade federal, state, and local governments have made available (and continue to make available) billions of dollars of funding for solar photovoltaic and other renewable energy projects (Solar PV Projects) across the nation. These dollars typically come in the form of tax credits, cash grants, accelerated depreciation, and other incentives. Even with all the available funding, however, the financial crisis has made it difficult for many Solar PV Project developers to obtain the financing needed to complete megawatt-scale renewable energy projects. This disconnect has resulted in the underutilization of the available governmental incentives designed to increase the installed capacity of renewable energy.

Reacting to the difficulties involved with obtaining financing, some innovative insurers are beginning to create and offer products to address those risks, allowing Solar PV Project developers to meet the financing market’s risk requirements and develop their projects. To offer these products effectively, however, the insurance industry must understand and address the relevant regulatory issues and other risks that inherently attach to such products.

How Large-Scale PV Projects Are Financed

Traditionally, most Solar PV Projects have been financed using long-term, fixed-price energy contracts called power purchase agreements (PPAs) or similar purchase agreements for the renewable attributes. Many Solar PV Projects are often collaborations between a governmental entity (such as a municipality or county) and third-party Solar PV Project developer, whereby the governmental entity provides the space for the Solar PV Project installation, and the developer provides the upfront capital for the installation. The governmental entity then enters into a PPA with the developer at rates that are often competitive with traditional local utilities.

The third-party development model provides certain advantages for both parties. For instance, governmental entities, which have no tax liability, cannot take advantage of the many types of Solar PV Project incentives made available to private parties/businesses. Additionally, governmental entities may not have the capability or desire to finance the high upfront capital costs of Solar PV Project installations and may not be willing to assume the risks associated with development, construction, and operation of a power plant with technology that is new to them. However, local governments often have significant amounts of real estate ideally situated for the Solar PV Project installation, including rooftops, schools, reservoirs, and park land. Third-party developers have the tax appetite to use the incentives and often have the ability to arrange for large-scale financing, making them excellent partners for Solar PV Project development.

One of the most important aspects of obtaining financing for a large-scale Solar PV Project is the warranty provided by the manufacturer of the PV panels to the developer, which in turn guarantees a certain level of output. A typical warranty in the industry guarantees that a panel will produce electricity for 10 years at 90 percent of its rated power output, and for the next 10 to 15 years at 80 percent of its rated power output. The declining warranty level is the result of the fact that all solar panels slowly degrade over time. Financing parties require these decades-long warranties before agreeing to any funding of a Solar PV Project. However, such a performance warranty creates a liability on a company’s balance sheet, and manufacturers must maintain hefty capital reserves for any future claims. In addition, in recent years there has been a significant increase in the number of manufacturers entering the business that might not have the track record or balance sheet necessary for the financing parties. If the financial industry does not think the manufacturer has the capacity to satisfy its potential claims, it may not provide the financing necessary for a megawatt-scale underlying project.

Solar PV Output Insurance

A handful of insurers have recently begun to respond to the undercapitalization of Solar PV Project panel manufacturers by providing an insurance product that covers potential warranty claims. The product transfers the risk of a panel’s failure to produce the guaranteed energy output from the manufacturers’ balance sheet to the insurance carrier. Not only does this free up a substantial amount of capital for the manufacturer to use on R&D and other investments, it also provides third-party development projects and their associated financial institutions the security that the output warranty is backed by an insurance carrier. By obtaining such a “backstop” insurance product, PV panel manufacturers become more competitive in their own market, and more large-scale Solar PV Projects are likely to be built. Some insurers are even exploring the possibility of providing the backstop insurance directly to Solar PV Project developers, with the coverage tied to the warranty provisions of the panel manufacturers.

One of the largest current challenges to the insurance industry in offering output guarantee products is determining the actual risk that the solar panels will not meet the terms of their warranty. Because the commercial solar panel industry is still relatively young, with new technology and manufacturing processes emerging constantly, the insurance industry must invest a significant amount of capital in analyzing the underlying market factors before it will likely be able to offer an actuarially sound product.

These costs and risks should decrease as the panel manufacturing industry matures. However, the premiums on solar output policies will likely be relatively high for the foreseeable future to offset these factors. Despite such high premiums, many see the market for such policies growing significantly as the financial industry continues to show signs of restrictive lending practices in the coming years. Moreover, manufacturers also may be able to offset the high premiums by deducting them from the manufacturer’s tax liability as a business expense.

Coverage and Regulatory Concerns Associated With Solar PV Project Policies

As discussed above, one of the primary coverage concerns for such products is determining what events constitute a loss that triggers coverage under the policy. Typically, such a policy will indemnify for a reduction in power from the solar PV panels’ warranted guaranteed energy output. However, among other things, insurers will need to determine whether a loss is based on the annual energy output or some shorter time period and whether coverage is for the entire project, each individual panel installed, or some other subpart of the project. There also will likely be other technical project specific factors that will need to be taken into account when determining the scope of the offered coverage.

In addition to the preceding, insurers need to carefully design their policies to avoid covering losses caused by damage to the panels from outside forces such as windstorms, vandalism, failure to properly maintain the panels, and so forth. All of these can, of course, cause significant reductions in the panels’ output, but are not typically included in the scope of what is essentially a contractual liability/warranty backstop cover. Furthermore, even if it is possible to exclude all non-manufacturer-based risk from the policy, the insurer must be careful to select the appropriate percentages (of reduced energy output), deductibles, and limits of liability. Because the latest solar PV panel technology is just now being installed, determining these numbers based on the success rates of the industry in meeting these 10- and 25-year guarantees will be inherently difficult.

Another underwriting challenge is that many of these policies are likely to be somewhat of a hybrid of claims-made and occurrence-based policies. For example, they may define a loss as a power underage that occurs during the policy period, and also require a claim to be made within a set period of time following policy inception. Given the typical length of the panel manufacturers’ warranties (10 – 20+ years), and depending on the size of the project and the level at which the coverage trigger and liability limits are written, the policies may trigger significant reserve requirements for many years.

Finally, there also are potential regulatory concerns that will impact policy underwriting and issuance. For example, if the coverage is written on a surplus lines basis, many of the typical surplus lines coverage form concerns will arise, including:

  • Whether the policy must comply state-specific cancellation and non-renewal requirements
  • The form of required surplus lines “notice” requirements/disclosures
  • Whether the policy is exempt from rate and form filings (See article below, “Federal Court Rules That Surplus Lines Insurers Must File Policy Forms With Commissioner Of Insurance,” addressing, Edward E. Gillen Co. v. Insurance Co. of the State of Pennsylvania, No. 10-C-564, 2010 WL 431 4266 (E.D. Wis. Nov. 2, 2010))
  • Whether the underwriting insurer must qualify for any applicable state export list

Given the rapidly evolving world of renewable energy technology, it is inevitable that the insurance industry will continue to progress and change to adapt to the needs of the renewable energy sector. As such, it is crucial for insurers to stay abreast of developments in all areas of this rapidly growing sector of the economy to ensure that new policies and products prove to be both profitable for the insurance industry and useful for the renewable energy industry.

Federal Court Rules That Surplus Lines Insurers Must File Policy Forms With Commissioner of Insurance
By Bart Reuter

On November 20, 2010, the United States District Court for the Eastern District of Wisconsin issued a decision that sent shock waves through the surplus lines community. In Edward E. Gillen Co. v. Insurance Co. of the State of Pennsylvania, No. 10-C-564, 2010 WL 431 4266 (E.D. Wis. Nov. 2, 2010), the Court ruled Wisconsin law requires surplus lines insurers to file and obtain approval from the Wisconsin Office of the Commissioner of Insurance (OCI) for all Wisconsin policies. As a general rule, surplus lines insurers doing business in Wisconsin historically have not filed their policy forms with OCI and so the surplus lines industry has been following this case very closely.

The plaintiff-insured in Gillen filed a suit for coverage under a surplus lines liability insurance policy. The defendant-surplus lines insurer sought to enforce an agreement to arbitrate in the policy and asked the Court to dismiss the lawsuit in favor of an arbitration proceeding. The Court found that the agreement to arbitrate was not enforceable because the policy had not been filed with, and approved by, OCI.

In asking the Court to enjoin the arbitration proceeding, the plaintiff-insured in Gillen relied on Wis. Stat. § 631.85, which provides that agreements to arbitrate in insurance policies are “subject to the provisions of s. 631.20.” Section 631.20, in turn, requires insurers to obtain approval of their policy forms from OCI. Because the defendant-surplus lines insurer had not obtained policy form approval from OCI, the plaintiff-insured claimed that the agreement to arbitrate was not enforceable.

In response, the defendant-surplus lines insurer argued that Wis. Stat. § 618.41 excused surplus lines insurers from Wisconsin’s form filing requirements. Section 618.41(11) provides:

(11)Form Regulation. The commissioner may by rule subject policies written under [Wisconsin’s surplus lines statute] to as much of the regulation provided by Chapters 600 to 646 and 655 for comparable policies written by authorized insurers as the commissioner finds to be necessary to protect the interests of insureds and the public in this state.

Because OCI had not issued a regulation requiring surplus lines insurers to obtain approval of their policy forms, the defendant-surplus lines insurer asserted that the requirements of sections 631.85 and 631.20 did not apply to it.

The Court rejected the defendant-surplus lines insurer’s argument. In so ruling, the Court relied heavily on the stated applicability of Chapter 631, where Wisconsin’s form filing and approval requirements are found. The applicability statute in Chapter 631 provides:

631.01 Application of statutes. (1)General. This chapter and Chapter 632 apply to all insurance policies and group certificates delivered or issued for delivery in this state, on property ordinarily located in this state, on persons residing in this state when the policy or group certificate is issued, or on business operations in this state, except:

(a) As provided in ss. 600.01 and 618.42

(b) On business operations in this state if the contract is negotiated outside this state and if the operations in this state are incidental or subordinate to operations outside this state, unless the contract is for a policy of insurance to cover a warranty, as defined in s. 100.205(1)(g), in which case the provisions set forth in sub. (4m) apply

(c) As otherwise provided in the statutes

In its final analysis, the Court found that there was no provision in Chapter 631 that excused surplus lines insurers from Wisconsin’s form filing and approval requirements. The Court stated, “[the defendant-surplus lines insurer’s argument] directly conflicts with § 631.01(1), which provides that ch. 631 applies to all insurance policies delivered or issued for delivery in this State.” (Emphasis supplied by the Court in its decision.) Accordingly, the Court denied the defendant-surplus lines insurer’s motion to dismiss and, instead, enjoined the insurer from proceeding with its demand for arbitration.

The case is currently on appeal to the Seventh Court of Appeals. As of the writing of this article, briefing has been stayed pending mediation. Regardless of the outcome of the mediation, a legislative solution appears to be one viable method to resolve the concern that the Gillen decision has cast across the surplus lines community.

Political Risk Coverage
By Bob Leventhal

The recent and ongoing political upheaval in the Middle East is like to give rise to increased demand for political risk insurance as well as increased claims being filed seeking compensation for business losses having some relationship with the political upheaval. The fact that significant political change appears to have taken place in countries like Egypt without significant violence and with a general continuity of government is likely to give rise to disputes about whether business losses resulting from the political changes currently being implemented fall within the coverage of political risk insurance policies.

Political risk insurance policies vary in what they cover. Coverage typically available includes the following:

  • Confiscation, expropriation, and nationalization coverage. This cover protects the insured if its assets are confiscated, expropriated, or nationalized by a foreign government. It also protects against unlawful of acts of the foreign government that deprive the insured fundamental rights in the insured project or investment. This cover typically does not protect from business disputes, legal difficulties, or reasonable regulatory actions. It usually only protects against politically motivated acts of the government that are contrary to international law.
  • Currency inconvertibility and exchange transfer coverage. This cover protects against acts of the host government that restrict the transfer of currency. In order to trigger this cover, the debtor may be required to transfer payment to the insurer’s local account in the country that has restricted the transfer of currency. The insurer then pays the insured in its country of residence.
  • Contract frustration cover. This cover protects against foreign government obligors arbitrarily repudiating or disavowing their contractual obligations or frustrating contractual expectations. It also can cover breach of contract by a private entity that results from an arbitrary act by the foreign government, as well as the losses arising from the nonpayment of a guarantee.
  • Political violence cover. This cover typically protects against loss caused by war civil disturbance, or terrorism. Usually the violence must be politically motivated in order the trigger cover.

There is usually a waiting period that must be exceeded before payments are made under confiscation, expropriation, and nationalization; contract frustration; and currency inconvertibility covers. One reason for a waiting period is that the insurance is not intended to pay if the confiscation or currency restrictions are temporary and cease within a reasonable period of time. Some form of political risk cover is sometimes included in trade credit insurance policies.

Political risk insurance is available from both private and from government-backed insurers, including the Overseas Private Investment Corporation (OPIC), an agency of the U.S. government, whose insurance is backed by the full faith and credit of the U.S. government. A disadvantage to government-backed insurance is that any disputes that arise may be governed by special rules that apply to bringing actions against government agencies, including limitations on the application of collateral estoppel to government entities that can make it more difficult for an insured (or reinsurer or reinsured) to prevail in a dispute with the government entity.

A side benefit of having political risk insurance is that foreign governments may be less inclined to improperly interfere with an insured transaction because of its relationship with the insurer. The foreign government might believe that it needs the insurer’s cooperation in order to obtain financing for projects and foreign investments in the country. Disrupting this relationship by actions that trigger insurance coverage could have a detrimental impact on the insurer’s willingness to insure projects in the country and on investors’ willingness to invest in and finance projects. Many people believe that purchasing insurance can actually make adverse foreign government action less likely. This potential side benefit of purchasing insurance is probably even more likely where the insurer is an agency of the U.S. government.

The claims adjudication process for many types of political risk insurance involves subjective judgments. For example, foreign governments often do not expressly state that they are wrongfully expropriating a foreign company’s property. Instead, they often provide legal justifications for their actions. An insured is likely to believe that the justifications given by the government entity are pretextual and the taking of their property is a politically motivated expropriation, while an insurer may be more likely to believe that the government’s explanation of the basis for its action is reliable and establishes that no expropriation has taken place. Likewise, there can be issues arising from creeping expropriations, where the government takes a series of actions, each one of which standing alone does not constitute an expropriation, but when taken together may. Disputes often arise regarding whether the cumulative effect of the actions is sufficient to trigger political risk cover.

The ongoing developments in the Middle East are likely to give rise to coverage disputes. For example, the overthrow of Hosni Mubarak in Egypt has lead to the arrest of former government leaders on charges of corruption. It is likely that the government will seek to recover property that it believes was acquired by these individuals (and possibly of their business partners) through corrupt acts. Insureds are likely to believe that any property that is seized as a result of the corruption charges is politically motivated government expropriation of private property. The government is likely to claim that all it has done is properly enforcing anti-corruption laws and recover property that was illegally acquired as a result of bribery, misuse of power, or theft of government property. The insurer will have to decide who is correct.

Similar issues are likely to arise under contract frustration cover. This cover is only triggered when the action of the foreign government that interferes with the contractual rights is arbitrary. There are likely to be disputes regarding whether this requirement is met where government action adversely affects contract rights with third parties or where the government repudiates government contracts because of alleged corruption in previous administrations.

Additionally, there are exclusions in political risk insurance policies that may be applicable. One common exclusion is for situations where the preponderant cause of the loss is unreasonable or provocative attributable to the insured or the foreign enterprise, including corrupt action. This exclusion involves somewhat subjective judgments and is also likely to give rise to factual disputes as to the validity of the grounds for the adverse government actions.

In summary, the political upheaval in the middle east is likely to result in governmental actions that adversely impact foreign investors and foreign projects. It is likely that disputes will arise regarding whether these government actions trigger coverage under political risk insurance policies and whether any policy exclusions are applicable.

Seventh Circuit Rules Against Disqualifying Arbitrators During an Arbitration
By Brian Keenan

The Seventh Circuit definitively rejected attempts by a party to obtain an injunction preventing an arbitrator from serving on a pending arbitration, reaching the same result as other Circuit Courts of Appeal. See Trustmark Ins. Co. v. John Hancock Life Ins. Co. (U.S.A.), --- F.3d ----, 2001 WL 285156 (Jan. 31, 2011). The decision makes it practically impossible to disqualify an arbitrator during an arbitration in the Seventh Circuit and overrules two of the main decisions relied upon by parties seeking such injunctions. See Jefferson-Pilot Life Ins. Co. v. LeafRe Reinsurance Co., No. 00-C-5257, 2000 U.S. Dist. LEXIS 22645 (N.D. Ill. Nov. 20, 2000); In re Arbitration Between Certain Underwriters at Lloyds, London, No. 97-C-3638, 1997 U.S. Dist. LEXIS 11934 (N.D. Ill. Aug. 7, 1997). The decision also established that a “disinterested” arbitrator is one that has no financial or personal stake in the outcome, citing the ARIAS U.S. Practical Guide to Reinsurance Arbitration Procedure. Under that standard, there is nothing improper in appointing the same arbitrator for consecutive arbitrations between the same parties because knowledge of a prior arbitration is not a disqualifying “interest.” Lastly, the court held that matters relating to confidentiality agreements governing arbitrations are procedural matters for arbitrators to decide without interference from the courts.

The case involved a reinsurance dispute between Trustmark Insurance Company (Trustmark) and John Hancock Life Insurance Company (Hancock). In 2004, a three-member arbitration panel ruled in Hancock’s favor on the issue of the issue of the extent of Trustmark’s reinsurance obligations and the award was confirmed the district court. Following the award, Trustmark refused to pay the bill Hancock sent it, causing Hancock to start another arbitration. Hancock named the same party-appointed arbitrator for the second arbitration that it had named in the first. The second arbitration focused on whether the ruling in the first arbitration was dispositive, with Hancock arguing that it was largely dispositive and Trustmark contending that the ruling was not controlling. With respect to the confidentiality agreement governing the first arbitration, the umpire and Hancock’s arbitrator extended that confidentiality agreement to the second arbitration and ruled that they could consider the evidence and rulings from the first arbitration.

Before the arbitration reached a hearing on the merits, Trustmark filed a lawsuit in the Northern District of Illinois alleging that the first arbitration award had been procured by “fraud” because of four documents that had not been produced in that arbitration. Trustmark requested an injunction preventing the arbitration from proceeding with Hancock’s appointed arbitrator on the grounds that Hancock’s arbitrator was not “disinterested,” as required by reinsurance agreement’s arbitration clause, because he knew what had happened in the first arbitration. Trustmark also contended that the second arbitration panel had no authority to interpret or act on the confidentiality agreement from the first arbitration because the confidentiality agreement did not have its own arbitration clause. The district court granted Trustmark an injunction preventing Hancock’s arbitrator from serving in the second arbitration.

The Seventh Circuit reversed the district court for two reasons. First, Trustmark had not suffered the irreparable harm necessary for an injunction. Trustmark could challenge the resulting award under Section 10 of the FAA after the arbitration was completed if the arbitrators had actually exceeded their authority. The only harm Trustmark would suffer in waiting until the arbitration was completed was monetary, such fees for attorneys and arbitrators, that was not irreparable. Second, the court went on to reject Trustmark’s claims on the merits because Trustmark seemed “determined to tarnish” the reputation of Hancock’s arbitrator. It held that Hancock’s arbitrator was disinterested because he was “lacking a personal or financial stake in the outcome.” An arbitrator does not gain an “interest” through knowledge about a prior proceeding between the same parties. The court noted that judges frequently decide cases that are related to prior cases and the standard to disqualify a party-appointed arbitrator is higher than that required to disqualify a federal judge. Highlighting this fact, the district court judge that granted the injunction had previously confirmed the award from the first arbitration. The court also ruled that arbitrators had authority to rule on the effect of the confidentiality agreement because this was procedural question to be decided by the arbitrators. The confidentiality agreement was closely related to the arbitration and presumptively within the scope of reinsurance agreement’s comprehensive arbitration clause.

The Seventh Circuit’s ruling supports a prior ruling from the Northern District of Illinois, in which Foley successfully defended Clarendon National Insurance Company from a similar attempt by Trustmark to disqualify an arbitrator. See Trustmark Ins. Co. v. Clarendon Nat’l Ins. Co., 2010 WL 431592 (N.D. Ill. Feb. 1, 2010). In that case, Trustmark attempted to disqualify Clarendon’s arbitrator because she was not “disinterested” due to the fact that she had served on a prior arbitration panel whose ruling would be at issue in the second arbitration and, therefore, the arbitrator would “inevitably breach” the confidentiality agreement from the first arbitration. Because Trustmark had refused to participate in choosing an umpire, Clarendon counterclaimed for a petition to compel arbitration and appoint an umpire. The district court rejected Trustmark’s claim because Trustmark could not avoid the FAA’s provision that the time to challenge an arbitrator’s bias is after an award is after it is rendered merely by re-styling its claim as one for breach of contract that required “disinterested” arbitrators. The court defined “disinterested” similarly to how the Seventh Circuit would do so one year later: free from bias, prejudice, or partiality, and not having a pecuniary interest. The court also held that Trustmark could not state a claim for breach of the confidentiality agreement when it alleged no breach had yet occurred. The court granted the motion to compel and appointed an umpire.

The two Trustmark decisions are supported by several decisions of other Circuit Courts of Appeal. The Fifth Circuit concluded that the FAA does not give a court the power to “remove an arbitrator from service.” Gulf Guar. Life Ins. Co. v. Connecticut Gen. Life Ins. Co., 304 F.3d 476, 490 (5th Cir. 2002) (emphasis in original). The case involved the allegation that a party-appointed arbitrator was ineligible to serve as an arbitrator because he was an executive of a reinsurance company and not an executive of “life insurance company” as required by the contract. The court reasoned that the “purpose of the FAA is to ‘move the parties to an arbitrable dispute out of court and into arbitration as quickly and easily as possible’” and therefore “a court may not entertain disputes over the qualifications of an arbitrator to serve merely because a party claims that enforcement of the contract by its terms is at issue.” Id. at 490-91 (quoting Moses H. Cone Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 22 (1982)). The Second Circuit also rejected a pre-hearing challenge to an arbitrator’s independence, holding that the FAA “does not provide for pre-award removal of an arbitrator” because “it is well established that a district court cannot entertain an attack upon the qualifications or partiality of an arbitrator until after the conclusion and the rendition of an award.” Aviall, Inc. v. Ryder Sys., Inc., 110 F.3d 892, 895 (2d Cir. 1997). Likewise, the Eighth Circuit decided that a party “cannot obtain judicial review of the arbitrators’ decisions about the qualifications of the arbitrators or other matters prior to the making of an award.” Cox v. Piper, Jaffray, & Hopwood, Inc., 848 F.2d 842, 843-44 (8th Cir. 1988) (per curiam).

The Seventh Circuit’s decision is a positive development for arbitration because it is now exceedingly difficult, if not impossible, for a party to frustrate an ongoing arbitration by running to court for an injunction to stop it, both on procedural and substantive grounds. The decision also helps prevent parties from using confidentiality agreements to thwart the efficient resolution of claims in arbitration, whether by using the confidentiality agreement in an attempt to hide what happened in a prior arbitration or as a way to prevent a party from using its chosen arbitrator because the arbitrator has knowledge of the prior arbitration. Furthermore, a party risks losing its chance to influence the selection of an umpire if it tries to disqualify an arbitrator instead of proceeding with arbitration, as shown by the result in the Clarendon decision. The Seventh Circuit’s decision also provides a lesson to refrain from personal attacks in litigation. Trustmark pushed the Seventh Circuit to rule on the underlying merits of its arguments by its attempt to tarnish an arbitrator’s reputation. The Seventh Circuit’s ruling on the merits effectively precludes a successful attempt to vacate the arbitration award under Section 10 of the FAA based on Trustmark’s legal theory.


Upcoming Events

On April 28, 2011, three of Foley's Insurance Industry Team professionals will be presenting a one-hour Web conference, during which they’ll expand on three topics covered in this newsletter:

  • Solvent run-off issues
  • SSAP No. 62R and its effect on run-off agreements
  • The IRS's aggressive challenges to P&C loss reserves, and how companies can prepare and respond

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