To Commute or Not To Commute, that Is the Question

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To Commute or Not To Commute, that Is the Question

2000-

July 2003

The reinsurer's obligation to cede and pay claims continues many years after the
termination of the contract, unless it is commuted. A commutation allows the
reinsured to receive cash now to invest for the payment of future claims, and the
reinsurer's commitment ends. Regardless the reason for the commutation, and
there are many, care must be taken in drafting the agreement to avoid future
disputes.
by Larry P. Schiffer
Patton Boggs, LLP
Depending on the business reinsured, a reinsurance relationship may last long after the reinsurance contract
has terminated. In long-tail lines of business, it may take 20 or more years for all underlying claims to be
reported and resolved. If that business was reinsured, particularly through a quota share treaty, the
reinsurance relationship will last until the final claim is paid and the final reinsurance claim is submitted by
the reinsured to the reinsurer.
Although the reinsurance contract itself may have only existed for a year or two, the obligation to cede and
pay claims will continue for many years after the termination of the reinsurance contract. An alternative does
exist to this often long-drawn out reinsurance relationship. That alternative is the commutation.

What Is a Commutation?
A commutation is a settlement agreement reached between a reinsured and a reinsurer by which the
reinsurance obligation is terminated by an agreement by the reinsurer to pay funds at present value that are
not yet due under the reinsurance agreement. Similar to a policy buy-back with an insured, a commutation
allows the reinsured to receive cash now to invest for the payment of claims that will come due in the future.
The reinsurers obligations for future payments are terminated and the reinsurance contract is finally
terminated in its fullest sense.
A commutation also may be a term of the existing reinsurance contract. Particularly in life reinsurance,
accident, and health reinsurance, and workers compensation carve-out reinsurance agreements, sunset and
commutation clauses often exist. These provisions contractually conclude the reinsurance relationship or
provide the opportunity for the reinsurer to terminate the relationship after a certain number of years based
on an agreed upon formula or other negotiated provisions. While problems do arise if these preexisting
clauses are not drafted properly, the real issues arise with commutation agreements negotiated outside of
the terms of the underlying reinsurance agreement.

Why Commute?
The reasons for commutations differ from company to company and from line of business to line of business.
A reinsured may want to commute because it is no longer in that line of business or it wants to maximize its
reserves for transfer or sale to another entity. A reinsured also may want to commute to avoid the credit risk
associated with its reinsurer, particularly if its reinsurer has suffered recent downgrades and its long-term
viability is questionable. A reinsured may believe that its claims department will do a better job at settling
the underlying claims than the reinsurer believes so that it would rather take a present value payment from
the reinsurer now and eliminate the need to report to the reinsurer on future claims. If the reinsurance
agreement was placed through an intermediary that no longer exists or is no longer capable of handling the
reinsurance claims function, a commutation may be in order for the reinsured to avoid assuming the expense
of reinsurance collections.
A reinsurer may want to commute to terminate a relationship with a reinsured that is in run-off or one with
which it no longer does business. If a reinsured has solvency issues, a reinsurer may want to commute to

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avoid having to deal with a state guarantee fund or liquidator. Commuting with a potentially impaired
company raises other issues such as voidable preferences if the reinsured becomes insolvent shortly after the
commutation agreement is negotiated. Of course, a reinsurer would rather have a deal done with funds paid
to a reinsured then have to deal with a liquidator in the future. The flip side is that a reinsurer does not want
to find itself subject to reinsurance collection efforts from a liquidator after it commuted in good faith with a
reinsured.
A reinsurer may also want to commute where it is concerned that the reinsured has a radically different
viewpoint about the future emergence and payment patterns of the underlying claims. If the reinsurer
believes that its actuaries have it right, a properly structured commutation may save the reinsurer future
expenses.

Evaluating a Commutation
The negotiation of a commutation requires a detailed financial and actuarial analysis of the book of business
being commuted. Each party must have a clear understanding of the number and nature of the policies
issued, the value and credibility of the reserves established by the reinsured, and, most importantly, the
value of the losses anticipated to arise in the future, otherwise known as incurred but not reported (IBNR)
losses. Each party performs its own evaluations, but both sides must have general agreement on the policies
actually issued, the claim payments made to date, and the existing case reserves. While the parties may
differ on the IBNR, each sides evaluation of the IBNR will have to be within a reasonable range of each other
for agreement on a commutation payment to occur.
Present value calculations and investment income assumptions are also a crucial part of the commutation
process. The reinsured will want to receive from the reinsurer a payment that it believes will pay all future
losses and expenses based on the payout pattern for the losses and the investment income anticipated on
the commutation payment amount and its current reserves. The reinsurer will want to pay an amount at as
deep a discount as possible so that its present value payment today will enhance its bottom line by lowering
its reserves for losses and future payment obligations. Slight differences in interest rate assumptions may
make very large differences in the economic results of a commutation.
For the reinsured, the risk is greatest because the reinsured will have to pay the claims as they come due
without recourse to the commuted reinsurance agreement. If the reinsured guesses wrong, it will have lost
the original value of the reinsurance and the value of the commutation agreement.

The Commutation Agreement

Like any contract, careful drafting of a commutation agreement will avoid future disputes. There have been a
number of cases in the past few years where parties thought they commuted all the business only to learn
that other contracts existed that were not included in the commutation agreement. Other disputes have
occurred where a company commutes the business it underwrote and ceded to the reinsurer, only to learn
that the reinsurer considered business written by a managing general agent or pool manager for the
reinsured to come within the commutation. Careful drafting avoids these problems.
As in any agreement, it is crucial to properly describe and identify the exact business that is the subject of
the agreement. Sometimes a reinsurer will agree to commute all business with a reinsured. This often
happens when the reinsured is in run-off or has otherwise stopped writing business. If the reinsurer and the
reinsured had a long-standing relationship, there may be literally hundreds of reinsurance agreements that
might be subject to the commutation agreement. The importance of specifically identifying each contract
commuted cannot be over emphasized.
Some commutation agreements will include an appendix listing all contracts commuted. Others will also
include a clause that purports to incorporate all reinsurance contracts between the parties, whether listed on
the appendix or not. Obviously, it is to the reinsurers advantage to have as broad a clause as possible if the
goal is to commute every possible agreement that may exist with the reinsured. If the reinsured does not
intend to commute a certain category or class of agreement with the reinsurer, then those specific contracts
or categories of contracts must be specifically excluded from the commutation agreement. Confusion or
ambiguity on this point is a guarantee for a future dispute.
The clear identification of the parties subject to the commutation agreement is another critical point to a
successful commutation agreement. Because of the holding company structure of many, if not most,
insurance and reinsurance companies today, it is necessary to identify the correct parties to any
commutation agreement.

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Very often, reinsurance agreements will define the reinsured as a number of affiliated companies, including
any companies that it manages or which may come under its control during the term of the reinsurance
agreement. This is particularly important if the business being reinsured is business underwritten by an
underwriting manager, managing general agent, or a pool manager that writes for multiple companies. The
older, long-tail business that parties seek to commute often has these types of relationships. Proper and
unambiguous identification of the parties to the commutation is critical to avoiding future disputes.

2013

Conclusion
Commutations are a routine occurrence in reinsurance. Commutations allow both the reinsured and reinsurer
to truncate an old reinsurance relationship to the economic advantage of both parties. Care must be taken in
drafting commutation agreements to avoid disputes in the future by making sure that all the commuted
business is clearly identified and that the proper parties are named.
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employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or
other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified
adviser.
International Risk Management Institute, Inc. (IRMI). All rights reserved.

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