Checking it out: poor casualty loss experience is driving the uptick in reinsurance underwriting audits.

For reinsurers and direct writers, the reinsurance underwriting audit is a fact of business life. Before reinsurers sign on the dotted line to provide support to insurance companies, they will pore over the priOry company's books of business to grasp the risk exposures and the extent of coverage they provide. What reinsurers conch|de from that, and their conversations with management, will shape how much reinsurance coverage they will supply.

"We are doing these reviews so we can determine how well a particular company is practicing basic principles of underwriting," said Diana Wiebers, vice president of underwriting management services at American Reinsurance Co., Princeton, N.J. "And we're a tool that is used for the benefit of the reinsurance underwriter to determine how well a company is practicing their underwriting analysis land their risk selections."

Some find that lately these audits have been cropping up with greater frequency.

"Currently, more underwriting audits are occurring, especially in the casualty area, and they are being requested on both renewals and on new business," said Joanne Moran, second vice president, ceded placement, for St. Paul Travelers Cos. "Now, if a reinsurer is interested in looking at a new program, it would tend to audit it prior to an authorization."

This is an uptick over the late 1990s and early 2000s when audits at Moran's company certainly occurred, but less often, she said. Based on what reinsurers are studying in these audits, Moran thinks the present pace is a reaction to some poor casualty loss experience during those years. "They're reviewing our guidelines, our pricing, our file construction completeness. They verify that we're writing the classes that we say that we're writing," Moran said."I believe it's also their opportunity to verify what we've put into our underwriting proposal. It's very similar to what we do when we underwrite direct risks."

Cheryl Murray, senior vice president in contract writing at reinsurance intermediary Benfield, also has noted increased audit activity recently and links it to greater due diligence on the part of reinsurers. "There's probably more movement of accounts so that if you're new on the accounts as a reinsurer, you want to go in and take a look at things and become comfortable with the company, the management, the underwriting practices and criteria," she said.

It's an exercise for reinsurers in validating the assumptions they've made about a particular company, as well as confirming and supplementing the information they received from the broker in the reinsurance submission, Murray said. "They're trying to differentiate the insurance company from others they do business with and see what's unique about this company and its practices," she said.

A Typical Scenario

American Re refers to this practice as a review, not an audit, because audit, in their view, conveys the sense of acting as certified public accountants, actuaries or consulting firms, which they do not do. They also do not give any legal advice and are not warranting any compliance to regulatory issues.

In performing their reviews, American Re's team will schedule their onsite visit to the cedent company weeks in advance. "We work with the reinsurance underwriter to determine the focus of the review,' Wiebers said. The team takes a thorough look at the cedent company's quality of underwriting, information development, exposure development and underwriting analysis, she said.

Typically, the review can take from two to four days, depending upon its scope. "We review a representative number of underwriting files and then we spend time talking with both the underwriter and the managers so we can fully understand their operation and their underwriting philosophy," Wiebers said.

How often American Re arranges these reviews depends on the nature of the ceding company's book of business, said Gerry Skalka, senior vice president, American Re Direct Treaty. "Generally speaking, from an underwriting standpoint, we would request a review on an annual basis to every three years," he said. "The more complex or extensive the exposures are in the book of business--that would lead us to request a review on an annual basis. The less complex the book of business, the less frequently we would request an underwriting review."

In Murray's experience, if a given book of business is volatile or growing rapidly, reinsurers might come in for a review as often as every quarter.

Many insurance companies have coverage with more than one reinsurer. In these cases, direct writers may ask their reinsurers to conduct their reviews on the premises at the same time. St. Paul Travelers, for example, will set aside one week a year for reinsurers to assemble at one of its two main sites, St. Paul, Minn., or Hartford, Conn., Moran said. During that week, separate rooms would be assigned to the different reinsurance companies. "We would have all the files available," she said. "We would also possibly combine that with presentations. Reinsurers would be coming and going on different days so we would coordinate that. And some of them would request individual meetings with management."

Combining the review and meetings with business unit management gives managers at St. Paul Travelers an opportunity to discuss underwriting issues with the reinsurers. "Over time," Moran said, "I think you develop some relationships."

This kind of scheduling does cause less disruption for the insurance company because it means that its underwriters won't have to relinquish their files for weeks on end for a succession of separate audits, Moran said.

If a cedent requests this sort of arrangement, American Re is willing to oblige. But Wiebers stated that her company does not share information with other reinsurers. "American ReInsurance has always been very concerned about anti-trust issues," she said. "Also, our position is that we approach our reviews in a very proprietary manner."

Legal Issues

While most contracts give reinsurers the right to audit, they are not obligated to do so, said attorney David Silva, a partner at Mound Cotton Wollan & Greengrass, NewYork. "One of the things that cedents sometimes do in disputes is say that if the reinsurer had only audited, the insurer could have avoided this problem," Silva said. "While that may be true, it really is not an excuse for a cedent company's nonperformance."

Silva has represented both reinsurers and cedents in litigation and arbitration. These conflicts are increasing, fueled especially by 1980s toxic loss issues including asbestos, which continue to reach the marketplace, he said.

He also handles litigation in reinsurance cases where auditing invariably comes into play. "Auditing sometimes reveals problems and sometimes it doesn't," Silva said. "There are times when reinsurers may get an inkling that something is not quite right with the underlying business. But some reinsurers--maybe because of cost concerns, manpower or something else--don't go out and do an investigation when it may be prudent to do so. Sometimes it's just simple blind faith."

In fact, auditing has become more of a litigation tool for a large segment of the players and markets, he said. "Some cedents complain that they're getting death by audit as sort of a prelude to litigation before a reinsurer will pay."

Gone is the long-established, informal reinsurance pact when a handshake was enough to seal the deal. That's given way to a far more contentious relationship, Silva said. "The level of trust that was in the historical markets is no longer there," he said.

Other Benefits

If audits or reviews benefit the reinsurance company, they also can be a plus for the direct writer. "The better we understand the client and their book of business, the better we are able to tailor an effective reinsurance program for that company," Skalka said.

St. Paul Travelers views the audits as a valuable service provided by its professional reinsurers. "It's very helpful for our underwriting management," Moran said. "We would prefer a candid audit report coming from a reinsurer. And this really supplements the internal audits and management reports that our underwriting management does."

She calls it a positive experience that either validates what the insurer has done or offers suggestions. "Because we do have very high underwriting standards, we actually like having that separate set of eyes looking at our business and giving us feedback," she said.

Like primary underwriters, reinsurance underwriters draw on numerous sources of information to decide if they will write a risk. So if the review raises some questions, reinsurance underwriters have to determine if the problem can be fixed and how confident they are that the ceding company can follow through on the solution, Wiebers said."With all the other means of information that the underwriter has available, ultimately they have to weigh it and make their decision on how they're going to proceed," she said."As you have a wide range of situations, obviously you can have a wide range of decisions."

Of course, reinsurers can always pull their support from ceding companies if they don't like the risk. But that's the extreme. More often than not, it will come down to altering the reinsurance contract to add exclusions, sublimits or more restrictive warranties or conditions so that the reinsurers are protecting themselves, Murray said.

Moran believes that once reinsurers have examined the cedent's Fries, seen the quality of the underwriting and management, and feel that they've gotten fair terms on their treaties, they're likely to stay on "just as we would feel motivated to continue writing business for an insured we had for 20 years," she said. "We would have monitored them over that whole period of time and just because they had one loss one year wouldn't mean we would remove ourselves. I think reinsurers have that same loyalty and part of it is keeping disclosure open."

Key Points

* Reinsurers perform underwriting audits to determine how well a cedent is practicing basic principles of underwriting.

* Some observers say that lately these audits have become more frequent because of greater due diligence on the parts of reinsurers.

* Auditing has become more of a litigation tool for a large segment of the players and markets.

Learn More

American Re-Insurance Co. (Member of the Munich Re Group)

A. M. Best Company # 00149

Distribution: Direct and brokers

For ratings and other financial strength information about this company, visit www.ambest.com.

Leading U.S. Property/Casualty
Reinsurers

Gross Premiums Written 2003 ($ Billions)

Swiss Reins America Corp [03263]
Amer Re-Ins Co [00149]
Everest Reins Co [03519]
XL Reins America Inc [02104]
Employers Reins Corp [00347]
Transatlantic Reins Co [03126]
General Reins Corp [02198]
Natl Indemnity Co [02429]
Odyssey America Reins Corp [00539]
Berkeley Ins Co [03630]

Source: A.M. Best Statistical Study: Leading Reinsurers/Buyers of
Reinsurance, United States--2003 (Published 12/13/2004)

Leading U.S. Property/Casualty
Reinsurance Buyers

Premiums ceded to nonaffiliates in 2003 ($ Billions)

Zurich/Farmers Group [18549]
American Intl Group Inc [18540]
CNA Ins Cos [18313]
Liberty Mutual Ins Cos [00060]
ACE INA Group [18498]
Royal & SunAlliance USA [18371]
Travelers P&C Group [18358]
St Paul Cos [00080]
Hartford Ins Group [00048]
Great American P&C Ins Group [04835]

Source: A.M. Best Statistical Study: Underwriting Losses Narrow:
Combined Ratio Improves for U.S. Reinsurers (Published 12/13/2004)

RELATED ARTICLE: Before and after.

Reinsurance underwriting audits come in two forms: pre-binding or post-binding. A pre-binding underwriting audit or review comes about after a reinsurer receives detailed information about a particular risk, goes out to the cedent and makes an evaluation based upon a review of that company's books and records, along with conversations with management. Then the reinsurer will decide if it wants to go with this particular risk, said David Silva, a partner at law firm Mound Cotton Wollan & Greengrass, NewYork.

"This is fairly costly and it's not done a lot" he said. "It would depend on the risk of exposure"

On the other hand, a post-binding underwriting audit is far more common, Silva said. In this situation, the risk is already bound and the reinsurer has agreed to be bound to the risk. The reinsurer will then go out periodically to the cedent to review the situation "to see that the ceding company is complying with the original disclosures as to exactly how it was going to operate and underwrite the business,' he said.

In traditional London market practice, it was unusual for reinsurers to conduct audits, Silva said.

"There was this duty of utmost good faith and it was assumed that that is how the cedent is operating," he said. "Therefore, there was no reason to go in and look at what a ceding company was doing because the presumption was that everything they were doing was fine. And if they failed to do what they disclosed, they did it at theft own peril, putting into jeopardy theft reinsurance:

Also, the pricing of the reinsurance was such that it probably didn't allow a lot of room for reinsurers to undergo the expense of hiring entities or having dedicated staff to do underwriting reviews, he noted.

But the "more American view, the more modern view, is that it is probably a wise strategy for a reinsurer to have in place periodic auditing of how the business is going, especially as markets get soft" Silva said, "because you worry that ceding companies may tend to accept risks that they may otherwise not have accepted in harder markets or have priced risks a little more thinly than they would have priced in other markets"

Therefore, conducting periodic reinsurance underwriting audits or reviews is probably a prudent idea, he said.

"When you have a ceding company that competently executes its obligations, and a reinsurer that confirms that through auditing, it can only strengthen and reinforce the relationship," Silva said.