Caution over commerciality

European reinsurers have found themselves at the centre of an unusual legal debate in recent months, which appears to have opened a potential can of worms for some global players. Some in-house counsel might argue that this particular can of worms has been developing for some time—it is just that only now are those outside claims and legal departments aware of it.

The problem involves the willingness—or lack of it—of European reinsurers to provide coverage to Indian insurers that are underwriting Indian refineries processing Iranian crude oil. They have backed away from the business because of increasingly stringent sanctions imposed by the EU and the US that apply to Iranian products.

The EU imposed sanctions against Iran in 2010 following concerns about the country’s nuclear programme. These sanctions were strengthened in October of that year and apparently prohibited reinsurers from providing reinsurance to an Iranian person, entity or body, or any person acting on their behalf. Further restrictions have been introduced since.

The matter started to make headlines when the Indian government unveiled a plan to create a reinsurance pool that would cover these risks. Meanwhile, Indian refineries Essar Oil and MRPL, two of the biggest consumers of Iranian crude, sought a legal opinion clarifying the position, which also made headlines. According to that, reinsurers are not legally obliged to uphold European sanctions in this way but they have chosen to do so anyway.

Regardless of the legal interpretation, it is easy to understand why. No global company would want to risk the possible negative publicity should they appear to ignore the political and diplomatic reasons behind the imposition of such sanctions. But the issue has brought to light that this is an increasingly difficult issue for reinsurers, and it is soaking up an increasing amount of time and costs for their legal departments and hindering their ability to compete for and secure business in some parts of the world.

And should a firm get it wrong legally, disobeying sanctions can also mean heavy penalties including huge fines and imprisonment. Why risk it?

Old issue, new problems

Compliance with sanctions regulations has been an issue for re/insurers for as long as trade sanctions have been applied by governments or regulators.

According to Jamie Rogers, senior associate at law firm Hogan Lovells, however, the recent increase in their use is adding to re/insurers’ concerns.

“Sanctions are certainly not a new tool,” he says, “but in recent years the increase in their use has been dramatic, which has added to the compliance burden that reinsurers already face.

“We lawyers are constantly being asked to scrutinise compliance policies and procedures, specific placements and the terms of exclusions to ensure that they are compliant with the law.”

Chris Jones, head of market services at the International Underwriting Association (IUA), explains that sanctions have gone right up the compliance agenda for members over the last five years. “They are now in the top three issues that we are asked about by our members,” he says.

Viewed by governments as a peaceful way of imposing pressure on a state or government, sanctions are being used more and more by the EU, US and United Nations—and reinsurers must take heed.

Such is the sensitive and highly political nature of sanctions that reinsurers are perhaps understandably wary of commenting on the growth in their use and what it means for the industry. One of the few willing to comment was Munich Re.

The world’s biggest reinsurer admits that sanctions are having a growing impact on business. “It is quite obvious that there is an increasing use of sanctions in the EU and the US,” a spokesperson from the Munich Re compliance department told Intelligent Insurer.

“This is evident from the increase in the dimensions of the EU rules: the EU regulation on Iran of December 2012 has about 120 pages. Just like any other company in the EU or in the US, Munich Re is becoming more affected by sanctions, and they have a considerable impact on our business.”

Others agree with Munich Re’s perspective on this issue. Lindsay McQuillian, a partner in the insurance and reinsurance practice at law firm Mayer Brown, says that it would be easy to assume that sanctions have not caused any significant problems as they are often associated with countries that are themselves problematic, therefore it might follow that there would be a reluctance to write business connected with those countries regardless. But that is not always true.

“We’re being told that the sanctions relating to Iran have had a real impact on reinsurers because people were writing business with a nexus to that jurisdiction,” she says. “I am told by my clients that sanction restrictions have materially and detrimentally affected them. They now have to turn away business which they would previously have written as a consequence of the sanctions that are in place.”

Concern is growing that, as reinsurers based in Europe and the US become increasingly limited by sanction regulations, industry expertise and business may be lost to other jurisdictions less concerned about such matters.

“The final challenge from an insurance perspective is the competitive one,” says Neil Smith, head of underwriting at the Lloyd’s Market Association.

“The more strict application of sanctions, particularly in Europe and the US, means that insurers not subject to regulation under these jurisdictions may have a commercial opportunity to write business for clients without the restrictions applied by US/European insurers. This makes these alternative markets potentially more attractive particularly for clients who, themselves, may also not be EU or US-based.”

Others, however, are not so convinced. Jones says the government-backed reinsurance pool in India is evidence that there is not the appetite or skills in reinsurers elsewhere to step in.

“Take Iran as an example: they cannot buy reinsurance from Western countries, but there is not the market in other jurisdictions to supply it as there are few reinsurers and far less competition. This is why you end up with government-backed pools,” says Jones.

A heavy price to pay

Sanctions are deemed by many to be an effective way of exerting political pressure when needed. According to Rogers, compliance by re/insurers is not only important to ensure that they do not breach the criminal law, but from the FCA’s perspective, compliance “promotes market confidence as it stops the financial sector being used for financial crime”.

Meanwhile, there are other very tangible reasons why reinsurers err on the side of caution when it comes to compliance.

“It is quite obvious that there is an increasing use of sanctions in the EU and the US. Just like any other company in the EU or in the US, Munich Re is becoming more affected by sanctions; they have a considerable impact on our business.” Munich Re

“Failure to comply with sanctions is not an option; if you do not comply you will be exposed to heavy fines, possible imprisonment and there can be significant reputational damage,” says McQuillian. “And it should not be forgotten that the US regime is designed to have extra-territorial reach in certain circumstances. For example, if a foreign entity engages in activities which the US considers supportive of Iran’s petroleum and refined petroleum sectors, then the US Government can impose a number of sanctions on the foreign entity, including effectively cutting it off from the US financial system or blocking transactions in respect of any US property in which the foreign entity has an interest.”

In the UK, two government bodies—HM Treasury and the Export Control Organisation—are responsible for sanctions law. The former concentrates on financial sanctions—the main concern for reinsurers—while the latter looks after trade laws and export controls. The US relies on OFAC.

These bodies have the power to grant exemption licences but this can be an arduous process—often too slow for the efficiency demanded by underwriting practices and often rejected unless the cause is humanitarian aid.

Re/insurers have a range of support—including complex software—to enable effective compliance, leaving negligent parties to be found guilty of violation.

“The FCA can find that a company’s systems and controls are defective, even if they can’t prove that the company in question has breached the criminal law,” says Rogers. “If they find that your systems are not appropriate, you can be fined very significant sums of money.”

As the number and range of sanctions increase, the market is reviewing the situation. Lloyd’s of London announced earlier this year that it was piloting a review programme with the assistance of Deloitte, Hogan Lovells and three managing agents to find an effective solution to unify sanction compliance in the Market.

The pilot phase will enable Lloyd’s to test the proposed review approach, to ensure it is “effective and proportionate” before it is implemented across the Market. The review will take place in the final three quarters of 2013.

Jones believes that industry concerns do not derive from the implication or enforcement of sanction regimes, but the ‘type’ of sanctions being introduced.

“In some ways it’s no different from any other change in legislation,” he says. “The greater impact has been the kind of sanctions being brought into force. Historically sanctions were linked to individual people and governments; now, however, the types of sanctions are different.”

The US has had broad trading and financial restrictions, which prevent US persons and entities from conducting business with Iran, in place for years. However, recently, the US has extended sanctions to include non-US companies that have sufficient dealings with the US.

The proof is in the policy

Regulations on sanctions usually enter into force on the day of their publication in the Official Journal of the European Union and re/insurers are alerted of these changes in a variety of ways, including publication on EU and national authority websites. Despite the strict compliance routines and scrutiny of policies, accidents, while rare, are not unheard of.

“We have offered sanctions training to a number of different managing agents which has been extremely well received. Historically, the level of knowledge of sanctions issues within managing agencies differed though there is now a much more level playing field,” says McQuillian. “For example, one issue which caused some surprise, related to US dollar denominated policies. If a policy is denominated in US dollars there is a presumption that those funds will clear through the US banking system, and all related transactions must be US sanctions compliant. So, an entirely UK based reinsurer could fall foul of the US sanctions regime by reinsuring a Cuban risk if the policy is in US dollars, even though to do so would not be in breach of UK sanctions. Many didn’t realise this.”

Due to the nature of their risk, marine and transport insurers may face the highest exposure to compliance challenges.

“The broad issue of sanctions compliance is challenging from the insurers’ perspective, particularly in terms of maritime and transport insurance, because the wholesale nature of much of the business written means that insurers may not become aware of potential problems until such time as a loss arises and investigation shows that the activity is in breach of a particular sanction,” says Smith.

“This situation is further heightened because the scope and application of sanctions will vary from insurer to insurer dependant on a number of factors which may include the domicile of the insurer, the composition of the board, and sometimes even the nationality of the individual broker or underwriter placing or writing the risk.”

McQuillian agrees that marine and aviation cover can be problematic. "There are certain areas that can be tricky,” she says. “Re/insurers involved with open marine cover may have no idea where the vessel is going, the type of cargo that’s on board or who it belongs to. In those situations it’s hard to know what to do for the best. Should you examine every single contract under treaty insurance? It’s very difficult to do that."

While feelings and attitudes towards international sanctions remain mixed, the general perception within the industry is one of caution.

“Increased focus is being placed on incorporating exclusionary language into contracts —that was far less common several years ago,” says Rogers. “Insurers and reinsurers are also conducting a lot more up-front compliance due diligence, where this is possible, looking at specific risks by reference to the applicable rules. Policies can then be written in compliance within those laws to ensure that contract wording adequately reflects what they can and cannot do.”

Smith agrees. “From a Lloyd’s/London Market perspective our response to these challenges has been to encourage regulators to engage with us so that we can assist in drafting and framing appropriate sanctions language which will meet the needs of those regulators in limiting/prohibiting illegal activity while recognising the commercial and competitive aspects of the industry,” he says.

“It is strongly recommended that insurers undertake additional due diligence in asking questions relating to activities and trading partners, particularly in areas where there is potential for some areas of activity to fall foul of the relevant regulations.”

Rogers agrees. “It is very important for insurers to look beyond their own compliance needs and consider the effect of sanctions on their outwards reinsurance needs too. What may be legal for the insurer may not be for the reinsurer, which can give rise to the prospect of unreinsured exposures.”