Insurer Insolvency and Reinsurance*
July 2004
What happens to the reinsurance covering insurance
policies when the insurer goes insolvent? This is a question that many a risk
manager has asked following the insolvencies of Reliance and Legion. This commentary
will briefly discuss some of the reinsurance issues that arise when the reinsured
becomes insolvent and goes into receivership.
by Larry
P. Schiffer
LeBoeuf,
Lamb, Greene & MacRae, L.L.P.
A reinsurer's obligation to make payments to the reinsured does not diminish
if the reinsured becomes insolvent and goes into receivership (typically liquidation).
Payments due the reinsured under the reinsurance agreement must be made to the
receiver (often called the Liquidator). The payments become part of the insolvent
reinsured's estate, subject to the claims of all of its creditors. Policyholders
seeking compensation for a loss generally will have no grounds for a direct
claim against the reinsurer unless they have negotiated that right beforehand.
Recent case law has allowed a direct claim against a reinsurer where no right
had been explicitly agreed to in advance, but time will tell whether situations
to which this approach will apply are more than few and far between.
Given the number of insurer insolvencies in recent years, risk managers and
other purchasers of insurance may justifiably wonder how the role of their insurer's
reinsurer may change if their insurer became insolvent. In most cases, the reinsurer's
role will remain the same. When an insurer enters receivership, its reinsurer's
obligations do not change dramatically. The reinsurer must continue to make
payments to the insurer as the receiver allows claims, even though the insurer
is no longer making payments to policyholders. This obligation is spelled out
in the insolvency clause, which is part of most reinsurance agreements. Although
statutes governing reinsurance vary from state to state, generally each state's
insurance law requires some form of insolvency clause.
Insurance Insolvency
State insurance law governs insurer insolvencies. This is contrary to insolvencies
in most industries, which are subject to the federal Bankruptcy Code. Nearly
all states follow either the Uniform Insurers Liquidation Act, promulgated in
1939, or the more comprehensive Insurers Rehabilitation and Liquidation Model
Act, revised most recently in 1977 by the National Association of Insurance
Commissioners (NAIC).
The NAIC considers an insurer insolvent if a state insurance commissioner
has taken legal action to place the insurer into liquidation, rehabilitation,
or conservatorship. In most states, when an insurer is placed into receivership,
the state commissioner of insurance is appointed its statutory receiver.
The Insolvency Clause
Under normal circumstances, the reinsured must first pay a loss and then
seek reimbursement for that loss from its reinsurer. In an insolvency, the insolvent
reinsured does not pay claims, but "allows" claims against the assets of the
estate for future distribution to policyholders and creditors in priority order
set by the insurance law. Because reinsurance policies are contracts of indemnity,
an argument arose that reinsurers did not have to pay if the insolvent reinsured
could not pay its underlying claims obligations. After a U.S. Supreme Court
decision upholding this argument was announced, the insolvency clause was born.
The insolvency clause contained in most reinsurance contracts clarifies that
if the reinsured stops making payments for losses because of its insolvency,
the reinsurer must continue to make payments to the reinsured or to its receiver
as if the insolvency had not occurred. While the insolvency clause is not necessarily
statutorily required for every purchase of reinsurance, every state requires
that, if a reinsured intends to take the reinsurance as a credit on its balance
sheet, the reinsurance agreement must include an insolvency clause.
The exact language required for the insolvency clause varies, but generally
the clause provides that, should the reinsured become insolvent, reinsurance
proceeds will be paid to the receiver without diminution because of the insolvency.
These proceeds are not earmarked to pay policyholders. Instead, the reinsurance
recoverables paid under the insolvency clause become assets of the insolvent
reinsured's estate. Policyholders must get in line with other creditors asserting
claims against the estate according to statutory priority.
Insurance Guaranty Funds
Each state has a guaranty fund or association, which takes over the claim
payment responsibilities for insolvent insurance companies. The guaranty funds
generally are triggered either by a finding of insolvency or an order of liquidation
(reinsurers are not backed by guaranty funds). Some states have specific funds
for property and casualty claims and other funds for life and health claims.
But policyholders who have had significant losses will have good reason to look
hungrily past guaranty funds and toward the potential of reinsurance proceeds.
Guaranty funds are designed to protect smaller insureds. They typically include
a cap on the amount payable per individual claim. In the majority of states
the cap is $300,000. Many funds also feature a net worth exclusion, which excludes
claims by companies whose net worth exceeds a statutory limit. The net worth
caps range from $3 million in Georgia to $50 million in the Model Act. In addition,
most property and casualty guaranty funds exclude coverage for disability, fidelity
and surety, financial guaranty, and assumed reinsurance.
An insured whose claims cannot be satisfied by the guaranty fund may make
a claim against the insolvent reinsured's estate. If there are assets at the
end of the day, the claim may be paid in whole or in part. And in certain limited
instances, an insured may be able to pursue a claim directly against the reinsurer.
Direct Causes of Action by a Policyholder Against a Reinsurer
The general rule is that policyholders cannot directly seek reinsurance proceeds
because there is no contractual privity between the insured and the reinsurer.
While it is not unusual to see direct claims advanced, they have generally encountered
two obstacles. First, an action seeking reinsurance proceeds must be based on
the reinsurer's obligations under the reinsurance agreement. Because typically
the policyholder is not a party to that agreement, courts will not allow the
policyholder to sue under the reinsurance agreement. Second, the insolvency
clause typically specifies that the reinsurance proceeds must be paid to the
receiver for the benefit of all creditors of the insolvent reinsured.
The most significant exception to this rule arises where the reinsurance
agreement includes a cut-through provision. As discussed in our March 2001 Commentary, cut-throughs give
an insured a contractual right to seek recovery directly from the reinsurer.
Cut-through provisions alter the reinsurer's obligations in the case of insurer
insolvency, permitting funds to pass directly to the insured, rather than to
the estate of the insolvent reinsured. Cut-through provisions are typically
seen where a reinsured has a financial rating insufficient to attract large
commercial policyholders. Generally only large commercial insureds are in a
position to bargain for and receive a cut-through endorsement.
The insolvency clause usually contains language allowing the payment of reinsurance
proceeds under cut-throughs and guarantees. Most state insurance insolvency
laws effectively authorize cut-through arrangements. Nevertheless, cut-through
agreements and guarantees may still conflict with receivership policy and case
law in some jurisdictions, creating the possibility that a reinsurer might owe
payment to both a policyholder and the receiver for the same claim.
Recent Case Law
An additional basis for an insured to make a direct claim against a reinsurer
has been suggested by a 2003 Pennsylvania state court opinion. In Koken v Legion, 831 A2d 1196 (Pa Commw Ct 2003),
the court held that certain policyholders had a contract right under the reinsurance
agreement as third-party beneficiaries. This was so despite the policyholders
having no cut-through provision to rely on. The court in Legion ruled that the:
determination of whether an original insured may sue a reinsurer directly
must be made on a case-by-case basis … where the agreement itself, or the
relationship among the reinsurer, the reinsured and the original insured,
extend beyond the realm of traditional reinsurance and evidence an intent
to create third-party beneficiary status for the original insured. Koken v Legion Ins. Co., 831 A2d at 1236
(citing Mellon v Security Mut. Cas. Co.,
5 Phila Co Rptr 400, 407–08 (1981)).
In essence the court determined that the parties intended that the reinsurer
would function as direct insurer for the policyholder-plaintiffs. The insolvent
reinsured, a fronting company, bore none of the risk, conducted no due diligence,
and neither handled nor funded claims. The reinsurer assumed responsibility
for all of these functions. The court held that direct access to the reinsurance
proceeds was not an impermissible preference of the policyholder-plaintiffs
over other creditors.
It is worth noting, however, that Legion involved
an unusual situation in which the reinsured, though insolvent as a result of
cash flow difficulties, had a positive net worth. Because of this, between the
insolvent reinsured's assets and the state guaranty funds, those policyholders
who were not plaintiffs in the direct action would likely be fully satisfied
even if the plaintiffs were allowed to siphon off these reinsurance proceeds.
Of course, this assumes that the evaluation of the reinsured's net worth will
hold up as more claims come through. Nevertheless, other courts may be reluctant
to follow Legion's approach in cases in which
other creditors would suffer in proportion to any award of reinsurance proceeds.
While the Pennsylvania opinion has drawn the most attention, a similar direction
has been suggested by decisions in New York, New Jersey, and Texas courts. It
is possible that, where no cut-through has been agreed to, reinsurers will now
include language in their reinsurance agreements explicitly disavowing any kind
of cut-through relationship with the reinsured.
Setoffs
Another general rule governing the relationship between insurers and reinsurers
allows the reinsurer to offset its obligations to the insurer against anything
the insurer owes. Thus a reinsurer may subtract the value of any payment of
premium currently owed by the insurer to the reinsurer from any payment due
an insurer under a reinsurance agreement (see March 2003 Expert Commentary). Where a reinsured
becomes insolvent, the offset provisions of the relevant state's insurance law
and any regulatory rules or guidelines for offsets must be reviewed. Generally,
where mutuality exists, a reinsurer will be able to exercise its offset rights
even against an insolvent reinsured.
Estimating Claims
Some jurisdictions have sought to expedite the liquidation process by estimating
future claims and seeking payments from reinsurers based on those estimates.
“Long-tail" claims (such as for asbestos or environmental losses) may take many
years to become fixed. Illinois, Missouri, and Utah now allow estimation of
the value of contingent claims, triggering a reinsurers' obligation to the estate
of the reinsured. This approach permits an estate to be closed more quickly,
but is a recipe for litigation between receiver and reinsurer as has been the
case in New Jersey and California.
Claims estimation is a radical departure from the normal relationship between
a reinsured and its reinsurer. Under a typical reinsurance contract, the reinsurer
is obligated to reimburse the reinsured for claims payments until all the underlying
claims have been adjusted. Yet, many reinsurance contracts include sunset and
commutation clauses and, of course, parties may always negotiate a commutation
of ongoing and future liabilities under any reinsurance agreement.
Arbitration
Reinsurance agreements typically contain arbitration clauses. But once a
reinsured becomes insolvent, the state liquidation court is granted exclusive
jurisdiction over the affairs of the insolvent company. While traditionally,
the receiver stands in the shoes of the insolvent company and must abide by
its contracts, the right to arbitrate under reinsurance contracts once a reinsured
has gone into receivership has been hotly disputed.
Whether disputes between the insolvent reinsured and the reinsurer remain
subject to arbitration or whether those disputes must be addressed in the liquidation
court varies by state. In New York, for example, the Court of Appeals has held
that the arbitration clause is abrogated by the reinsured's insolvency and that
all disputes must come before the liquidation court. New Jersey, on the other
hand, has enforced the Liquidator's right to arbitrate outside of the liquidation
court.
Conclusion
A reinsurer's obligation to make payments to the reinsured for losses incurred
on the reinsured policies is not diminished by a reinsured's insolvency. From
the insured's point of view, however, funds flowing from the reinsurer into
the insolvent reinsured's estate may be beyond reach if the estate's assets
are insufficient to fund all policyholder claims along with other priority claimants,
unless the insured had negotiated a cut-through arrangement. New case law has
raised the possibility that, under certain circumstances, an insured may go
after reinsurance recoverables in spite of the absence of a cut-through provision.
It remains to be seen how broadly courts will apply this third-party beneficiary
theory.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does 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.