General points
A binding authority is an agreement whereby the "cover holder", often a broker but sometimes an underwriting agency, is authorised in accordance with the terms of the authority to accept risks on behalf of an insurer and to issue documents that evidence the insurance without the need for any further approval on behalf of the insurer. Coverholder arrangements are an intrinsic part of the London Insurance market (there are estimated to be over 5,000 such arrangements at Lloyd's).
A binding authority should be distinguished between:
1. "lineslips" – under a lineslip one or more underwriting participants only are supposed to agree to each risk acceptance, with business often produced from one particular broker. Bordereau listings are usually supplied for all risks that are bound.
2. "open covers" – a facility that enables declarations of insurance to be made to an insurer provided that the insurance being declared falls within the limits which had been agreed. Premium is paid as and when declarations are made. Open covers can be given to an agent or a broker or even directly to an insured. Some open covers can be immediately binding on the insurer without the need for its approval. These are otherwise known as obligatory open covers.
3. "brokers pools" - these are based upon a formal written agreement between a broker and (re)insurer to the effect that the broker will bind business on behalf of the (re)insurer within defined terms of conditions. These agreements are similar to underwriting agency agreements. Some arrangements may be effected by a simple exchange of correspondence. Most are operated in a similar manner to a binding authority or a lineslip.
Effectively a binding authority is a facility to which the coverholder/broker can allocate or bind contracts of insurance or reinsurance knowing that these will be accepted automatically by the (re)insurers or are otherwise bound to those (re)insurers.
A word about "Limited Binders", as the market call them. On their face these may appear to be in a form identical to the "usual" binding authority arrangements that are as described above, but in practice it is always intended that specific risks must still be individually broked to an underwriter, who will have the final decision on whether to write the business or not. The advantages of such arrangement are in terms of administration and cost.
It must be remembered that a binding authority is not a contract of insurance, and the duty of utmost good faith (uberrimae fidei) does not apply to the formation of that contract (see Sail v Fairex 1995 upheld in HIH Casualty and General Insurance Ltd v Chase Manhattan Bank (2001)). However, the individual contracts of (re)insurance that are subsequently created pursuant to the binding authority arrangement will be subject of the duty of utmost good faith. A party may however have potential common law rights of rescission if, in the lead up to the formation of the binder, there have been misrepresentations of fact that have induced an underwriter to enter into the contract with the coverholder and that has caused that party to suffer loss.
Risk awareness issues
The terms of a binding authority define the scope of a coverholder's duties. They may include obligations to provide information and access to documentation and records in terms that go beyond ordinary market practice or agency principles (for example extending inspection obligations to brokers' own papers). The broker coverholder will also potentially owe duties to those on whose behalf he "arranges" or procures any insurance.
It is necessary to understand that whilst well run binders can be profitable for all concerned, binders with problems or which are loss making just simply generate complaints (and claims) by insurers against brokers, particularly broker/ coverholders. These can include complaints that:
(a) the business bound was of a perceived lower quality than would be the case if business was placed in the open market;
(b) risks were written outside the scope of the delegated authority conferred and/or an unlawful sub delegation of underwriting authority has occurred;
(c) deductions/commissions were excessive and should be repaid;
(d) the broker has placed itself in a position of legal conflict by reason of its different duties owed to policyholders and underwriters.
The broker/coverholder must understand the potential for conflict of interest. If there is a problem regarding a particular cover or piece of business that has been written then the broker/coverholder could find itself in a very difficult position: if there is any dispute about the cover granted to a particular assured then potentially the broker faces a breach of duty claim brought by the assured, on whose behalf he agreed to arrange cover. Conversely, if cover is written contrary to a binding authority underwriter's expectations then the broker/coverholder could in turn be faced with a potential breach of duty action in respect of claims that underwriting may be legally obliged to disburse to assureds.
Some horror stories
The recent case of Hiscox Underwriting Limited v Dickson Manchester (2004) highlights the importance of any broker involved in a coverholder arrangement understanding the true extent of its duties under such an arrangement.
In February 2004 Houston Casualty ("HCC") announced its intention to merge the operations of Dickson Manchester ("DM") into its other broking operations. Henceforth a significant amount of DM's professional indemnity business would be underwritten by HCC. At that time Hiscox had a coverholder arrangement with DM, as binding authority agents.
Hiscox, requested that DM produce for inspection all records created or received by DM as its agent. The purpose was so as to enable Hiscox to identify its potential renewal market so it could quote renewal terms to them. DM agreed to produce certain categories of documents but refused to provide documents identifying the producing brokers so effectively hindering Hiscox's attempts at fully identifying its existing book of business under the coverholder arrangements. DM argued that such documents were confidential to it.
The inspection of records clause stated:
"We [Hiscox], ... have the right without restriction or limitation to inspect and audit any of your records relating to insurances bound at any time during reasonable business hours and have the right to make copies of or take extracts from any such records."
DM argued the clause only allowed Hiscox access to records to satisfy itself that the binder was being operated according to its terms. Also, DM argued, it did not allow Hiscox access to confidential information that DM alleged belonged to it and would allow Hiscox to "compete" with it.
Upon an application to the Court by Hiscox for an emergency injunction delivering up documents, the Court decided there was no foundation for DM's refusal to comply with Hiscox's request and to deny Hiscox information about the producing brokers. The clause permitted Hiscox unfettered access to the records, which, being records created by DM or received by it as agent for Hiscox, were in the court's view owned by Hiscox. Cooke J concluded that if there was any confidentiality in the information contained in the records held by DM, such confidentiality was in favour of Hiscox as DM's principal. Both the records and information contained therein were owned by Hiscox.
Cooke J stressed that as agent for Hiscox, DM owed Hiscox as its principal a duty to act in its best interests regarding renewals, but recognising that DM could freely place business with any insurer once the agency was terminated. The issue of whether a coverholder must, in the absence of special circumstances, write to a binder the renewals of policies written under that binder in a previous year was however not decided by the Court; in essence the case was decided by reference to the contractual provisions of the inspection clause, pursuant to which DM agreed to give its principal significant rights of documentary access and inspection, including rights post termination. The case certainly signposts the potential for any broker/coverholder to be in breach of duty if business is diverted from a binder without renewals being offered.
Those who have delegated their underwriting authority are also quick to look to put the broker in the frame, even if the broker is not the coverholder, but merely a broker of business to a coverholder. This is illustrated in the recent case Sphere Drake Insurance & Anr v Euro International Underwriting Ltd [2003] EWHC 1636.
The background to this case is not straightforward. Euro International Underwriting Ltd ("EIU") were granted an underwriting authority by Sphere Drake in early 1997. Sphere Drake expected EIU to underwrite traditional personal accident business. In fact, they wrote a large volume of "workers' compensation carveout" reinsurance, a product developed in the late 1980s and 1990s, which enabled a large part of the exposure arising from US workers' compensation risks, traditionally written in the Property & Casualty market, to be underwritten instead by the Life and Personal Accident markets.
Most of the business written by EIU was placed by Stirling Cooke Brown ("SCB"). SCB were a major broker in this area of the market. They also had interests in underwriting agencies and licensed carriers who were involved in underwriting workers' compensation carveout (or other similar product) at a direct or first tier reinsurance level in the United States.
In late 1998 Sphere Drake imposed a moratorium on EIU's underwriting. In 1999 it initiated proceedings against various companies and individuals in New York. Those proceedings were dismissed on the basis that New York was not the appropriate forum, leading to the action in London. EIU, SCB and named principal directors of those companies were sued by Sphere Drake.
In the London proceedings, Sphere Drake alleged that EIU and SCB had dishonestly colluded to defraud them in a number of ways:
1. The underwriting: EIU wrote contracts with huge exposures, often including unlimited reinstatements, with little or no information, or when information was available it demonstrated a high likelihood of substantial losses.
2. The terminology "gross loss-making business" was adopted in the trial to define business that was almost certain to make losses, but which was underwritten with the intention of recovering those losses from retrocessionaires. The Defendants accepted that many of the risks could only be accepted on that basis.
3. Sphere Drake were misled as to the business being written. As well as the general nature of the business, there were examples of attempts to manipulate the period of contracts to fit within the authority when in truth EIU was not permitted to write the contracts.
4. There were also a number of ancillary allegations of fraudulent misrepresentations about the personnel involved in EIU and their history in the market.
Although EIU and SCB did not always agree with one another in their defences, they both said that the placing and writing of risks "below the burn" was a normal and legitimate incident of a soft market, that passing losses on to reinsurers was acceptable because reinsurers were "in the know", and that spirals were a naturally occurring and not improper feature of the market. It was alleged that Sphere Drake's own underwriter knew the business that was being written and had not been misled.
In his judgment Thomas J agreed that the gross loss making business with which the trial was concerned was improperly underwritten, that EIU were dishonest to have written it, and that EIU colluded with SCB in a whole series of ways and had become subservient to SCB's interests. The structure of the business was intended to advance SCB's interest and to generate commissions. Such business could only be written by those in the know because others were likely to be misled.
EIU recklessly endangered Sphere Drake's capital because they did not always have outwards reinsurance in place, and when they did losses could spiral back to Sphere Drake. In addition, there were substantial solvency, cashflow and legal risks in seeking to rely on reinsurance recoveries.
Sphere Drake had been serially misled as to the nature of the business being underwritten and a number of other matters. However, Sphere Drake's underwriter had been grossly negligent for failing to supervise the binder properly.
Thomas J made findings of dishonesty against named defendants.
Whilst, for underwriting agents and their principals generally, the case highlights (perhaps in an extreme way) the massive damage that can be done in a very short period of time if an agent fails to act in his principal's best interests in connection with a binding authority, and how brokers can end up being sued even when they do not have the 'pen' for the underwriter, the case is also interesting from a legal perspective because of the way arguments about lack of authority and brokers knowledge of the same were used to support findings that no contact of reinsurance were legally created. Obviously similar findings in any broking scenario will almost automatically trigger a brokers' e&o exposure.
The new Lloyd's regime
Historically, Lloyd's exercised relatively little effective control over the coverholder business written in its market place. Following the Sasse affair and the Fisher Report Lloyd's began to focus more upon binders an their potential for problems. In 1990 the Binding Authorities Byelaw was introduced. In October 2001, the Underwriting Byelaw. (No. 2 of 2003) was introduced which provided that application had to be made to the Lloyd's Franchise Board for permission for any party to act as an underwriting agent. Those who have attended the previous years seminars may recall how I have tracked through a consultation process initiated by Lloyd's, following topical issues that are out of the Travel Insurance Litigation in 2001. Ultimately this led to the passage, on 4 February 2004, of the Delegated Underwriting Byelaw ("the Byelaw") and also in particular a new Managing Agents Code of Practice for Delegated Underwriting ("the Code").
The Byelaw and Code taken together signposted a whole new regulatory regime of significance to all parties involved in binding authorities, but also brokers.
Under this regime Lloyd's will only permit "authorised" coverholders and registered coverholder arrangements within its market place. It also specifies to whom and how a syndicate might delegate its underwriting authority and, more pertinently for broker/coverholders, specifies the criteria for coverholder approval. Approval may be revoked in certain circumstances.
Significant obligations and responsibilities are also imposed upon those who are concerned with Lloyd's coverholder arrangements, all designed to help police such arrangements. The daily burden of monitoring coverholder business is clearly placed on the shoulders of the relevant syndicate managing agents, particularly the lead syndicate's agencies who must assess the suitability of a coverholder, set any limits of coverholder authority and monitor the coverholder contract, but burdens are also imposed upon the Lloyd's broking community.
Provisions include:
(a) Broadly, with only limited exceptions, all new coverholder arrangements must be approved by the Lloyd's Franchise Board using a new standard application form. No binding authority arrangement may be approved by Lloyd's until the coverholder provides written confirmation of its terms.
(b) For all new coverholder arrangements, the lead syndicate must declare to Lloyd's that:
- it has taken all reasonable steps to ensure the coverholder complies with all relevant laws,
- it supports the application and is prepared to lead the binding authority concerned,
- to the best of its knowledge and belief it considers the applicant suitable to become an approved coverholder, and
- it has carried out an assessment of the applicant in accordance with the requirements of the Code.
A lead syndicate's managing agents must assess a coverholder's reputation and financial standing. They are expected to visit the coverholder's offices and to meet staff (or to hire coverholder review specialists to undertake this function). The suitability of existing approved coverholders must be reassessed whenever new coverholder arrangements with them are proposed. Generally, managing agents must demonstrate that all existing arrangements are being monitored sufficiently.
(c) Potentially, the Franchise Board has wide powers of approval or not: in making its assessment of any prospective coverholder status, it may have regard to "all other relevant matters" (including whether a coverholder will "add value" to the Lloyd's franchise). Prospective new coverholders (including broker coverholders) should submit an underwriting plan to the Franchise Board, who will also review the adequacy of that coverholder's professional indemnity arrangements. The Franchise Board may require an applicant coverholder who is not a Lloyd's broker to be formally sponsored by the Lloyd's community, and specifically a Lloyd's broker. This is significant because, as sponsor, the Lloyd's broker may be required to furnish documentary or other information (including answering questions) to the Franchise Board or to provide funds or other security (see Part C of the Byelaw). As an applicant for approved coverholder status, a broker may be required to submit to similar conditions.
(d) Review. The Franchise Board also has powers of review. If such powers of review are exercised then a Lloyd's broker – whether as coverholder or sponsoring broker, or as a party who has arranged, broked or is a party to a binding authority arrangement - may be required to provide documentary or other information to the Franchise Board, as well as attending before the Franchise Board.
(e) Specifically in relation to binding authorities:
(i) the Franchise Board has power under Part E of the Byelaw to prescribe conditions and requirements with which such arrangements must comply;
(ii) no coverholder may enter into a contract of insurance pursuant to a binding authority unless all conditions as set in (i) above are met or until a binding authority has been registered; and
(iii) the person who registers a binding authority must ensure that all information contained in the register to that binder is kept up to date.
Core principles for underwriting agent
These arrangements are also about modernising Lloyd's business practices - all binding authority placement slips must comply with London Market Principles standards from early 200 - but they are clearly directed at the protection of the "Lloyd's brand" as well as the protection of the public. Lloyd's can be expected to police the regime firmly: coverholders who do not make the grade will not be allowed to become part of the Lloyd's franchise. Expect stiff regulatory penalties to be imposed on those who fail in their monitoring and sponsoring obligations. Broker/coverholders will do well to note and observe the Core principles for underwriting agents that Lloyd's has published. Some of the statements may seem somewhat trite but they do chart a course that the law would also demand ie:
(a) Integrity
An agent should observe high standards of integrity and deal openly and fairly.
(b) Skill, care and diligence
An agent should act with due skill, care and diligence.
(c) Market conduct
An agent should observe high standards of conduct and should take all reasonable steps to avoid causing harm to the standing or reputation of Lloyd's.
(d) Conduct towards Members
An agent should conduct the affairs of each of the members for whom it acts in a manner which does not unfairly prejudice the interests of any such member.
(e) Information
An agent should seek from members it advises any information about their circumstances and objectives which might reasonably be expected to be relevant in enabling it to fulfil its responsibilities to them. An agent should also take all reasonable steps to give members it advises or for whom it exercises discretion, in a comprehensible and timely way, any information needed to enable them to make balanced and informed decisions. An agent should also be ready to provide members with a full and fair account of the fulfilment of its responsibilities to them.
(f) Conflicts of interest
An agent should seek to avoid any conflict of interest arising, but where a conflict does arise, should make comprehensible and timely disclosure of that conflict and of the steps to be taken to ensure the fair treatment of any members affected. An agent should not unfairly put its own interest above its duty to any members for whom it acts.
(g) Assets
An agent should deal with assets and rights received or held on behalf of a member prudently and in accordance with the terms of any applicable trust deed or agreement with the member.
(h) Financial resources
An agent should maintain adequate financial resources to meet its commitments and to withstand the normal risks to which it is subject.
(i) Internal organisation
An agent should organise and control its internal affairs in a responsible manner, maintaining proper records and systems for the conduct of its business and the management or risk. It should have adequate arrangements to ensure that staff and others whom it employs are suitable, adequately trained and properly supervised and that it has well-defined compliance procedures.
(j) Relations with Lloyd's
An agent should deal with Lloyd's in an open and co-operative manner and keep Lloyd's promptly informed of anything concerning the agent which Lloyd's might reasonably be expect to be disclosed to it.
Lloyd's clearly hopes that this new regime will sweep away the potential for future problems arising with binding authorities, major or otherwise. No doubt problems will arise in the future, but the new regime should at least ensure that they are spotted much earlier, with a better chance of avoiding the large-scale market wide problems that, historically, has bedevilled this market.
For further information, please contact Stephen Netherway on +44 (0) 20 7367 3015 or by email at stephen.netherway@cms-cmck.com
