A reinsurance agreement is a contract of indemnity between a ceding insurer
and a reinsurer. The reinsurer and the ceding insurer enjoy privity of contract—a
contractual relationship between two parties that is recognized by law. Normally,
entities that are not parties to the reinsurance agreement may not enforce rights
under the agreement because these non-parties do not enjoy privity of contract.
Even the insured may not enforce any portion of the reinsurance agreement because
it does not enjoy privity of contract with the reinsurer or the ceding insurer
under the agreement. A "cut-through" provision, however, changes this relationship.
A cut-through provision allows a party not in privity with the reinsurer
to have rights against the reinsurer under the reinsurance agreement. These
cut-through rights generally are limited and are triggered only by specific
events enumerated in the cut-through provision. Cut-through provisions may take
the form of a specific clause or an endorsement attached to the reinsurance
agreement. A cut-through clause is usually employed where the ceding company
has an insufficient financial rating to attract large commercial policyholders.
The clause applies when the ceding company becomes insolvent, a time when the
direct insured most needs the security. It is triggered on the ceding insurer's
default in payment, insolvency, or upon entry of a liquidation or rehabilitation
A cut-through endorsement is a separate agreement between the reinsurer and
the direct insured that becomes a part of the original reinsurance agreement.
Like the cut-through clause, a cut-through endorsement usually applies when
the ceding insurer becomes insolvent. It can be used in other situations, however,
such as in a fronting arrangement, where the reinsurer is not licensed in a
particular jurisdiction and intends to retain all of the risk from the original
Whether the reinsurance agreement contains a cut-through clause or endorsement,
a reinsurer may be subjected to duplicate liability. A cut-through provision
often makes the underlying insured a beneficiary under the contract. Thus, a
reinsurer usually will draft the cut-through provision so that when the reinsurer
makes payments to a third-party, it will not be required to make payments to
the reinsured or to a statutory receiver.
Why Use a Cut-Through Provision?
From an insured's perspective, a cut-through provision provides security
and comfort where the only available insurer is not as financially sound as
one would like. It avoids the risks associated with insurance insolvency (assuming
the reinsurer remains solvent), including having to file claims with state guarantee
funds and/or with the insurer's insolvent estate. It also allows the insured
to have more control over the real insurer in interest in cases where the administration
and claims handling is provided by the reinsurer.
From a ceding insurer's perspective, a cut-through provision is useful where
the ceding insurer lacks the financial standing to attract large commercial
customers. The reinsurer bolsters the ceding insurer by providing a guaranty
of payment, which enables the ceding insurer to market itself to large commercial
risks. The reinsurer benefits from the increased ceded premiums, fees, and market
penetration. The insured benefits by gaining a primary right to the reinsurance
upon the triggering event, most often the cedent's insolvency, without which
the insured becomes just another policyholder creditor of the ceding insurer's
From a reinsurer's perspective, a cut-through provision allows a reinsurer
to do business with its clients in markets where it is not licensed. The ceding
insurer acts on the reinsurer's behalf by issuing the underlying insurance policies
consistent with local regulatory requirements, but the reinsurer administers
the insurance program, including the handling and payment of claims. A cut-through
provision also gives a reinsurer the opportunity to assist a new ceding company
that has not yet developed a sufficient financial rating to do business, thereby
developing a client relationship for future reinsurance business.
Why Avoid a Cut-Through Provision?
There are several reasons why a ceding insurer or reinsurer may want to avoid
a cut-through provision. Cut-through provisions infringe upon privity of contract,
may adversely affect financial credit for reinsurance recoverables, run afoul
of insurance and liquidation statutes, and be considered unfair discrimination
under insurance statutes.
Cut-through provisions infringe on the privity of contract created by a reinsurance
agreement. The insured is brought directly into the reinsurance agreement by
giving the insured a right against the reinsurer. A court can enforce this right
based on the third-party beneficiary theory. [Bruckner-Michell,
Inc. v Sun Indemnity Co., 82 F2d 434 (DC Cir 1936).] This infringement
on privity of contract made cut-through provisions unenforceable in England
until 1999. That year, the Contract (Rights of Third Parties) Act 1999 came
into effect, which allowed parties to a contract to confer on a specific third-party
rights to enforce certain terms of the contract. Thus, cut-through provisions
generally are now enforceable in the United States and England.
From a financial perspective, a reinsurance agreement containing a cut-through
clause may preclude a cedent from taking annual statement credit for reinsurance
recoverables under that agreement. Reinsurance agreements commonly contain an
insolvency clause. Although each state's statute varies somewhat, most require
the insolvency clause to provide that, in the event of the cedent's insolvency,
the reinsurance proceeds must be paid to the receiver without diminution because
of the insolvency. Cut-through provisions alter this requirement by diverting
funds away from the insolvent's estate to the insured. [See Ainsworth v General Reinsurance Corp., 751 F2d
962 (8th Cir 1985).] Some state statutes that specifically address credit for
reinsurance appear to allow the ceding insurer to take credit for reinsurance
proceeds even where the agreement specifies another payee in the event of insolvency.
See, e.g., N.Y. Ins. Law § 1308. Other state statutes may not permit the credit.
Some courts also have held that cut-through provisions create an unfair preference
in insolvency proceedings. [See, e.g., Cummings Wholesale
Electric Co. v Home Owners Ins. Co., 492 F2d 268 (7th Cir 1974).] One
court has held that the insured's direct right of action under a cut-through
provision was not a preferred claim in the ceding insurer's liquidation proceeding
under the Uniform Insurers Liquidation Act in Puerto Rico. [Warranty
Assn. of Ins. of All Kinds v Commonwealth Ins. Co., R-80-334 (PR Sup
Ct 1983).] The court reasoned that allowing the cut-through distribution to
the insured would prevent fair and equitable distribution of the estate's assets.
In Louisiana, a different problem arises. The Louisiana Insurance Guaranty
Association Fund Act specifically excludes cut-though endorsements from the
definition of "Insurance Policy." [Luna v American Bldg.
Sys. Inc., 620 S2d 465 (La App 1993).] Thus, the fund will not cover
and pay claims arising under a reinsurance cut-through endorsement because it
is not within the statutory definition.
Finally, cut-through provisions have been criticized as creating unfair discrimination
among insureds. This criticism usually arises in the context of cut-through
endorsements obtained by large commercial insureds. Generally, only large commercial
insureds are in a position to bargain for and receive a cut-through endorsement.
Because of this, enforcement of a cut-through endorsement may work to discriminate
against small commercial and individual policyholders who are unable to secure
a similar endorsement. On the other hand, cut-through clauses contained in a
reinsurance agreement work to benefit all policyholders and do not discriminate
against different policyholders.
Before considering a cut-through clause, the laws of the jurisdiction where
the ceding insurer conducts business must be examined. It is important to know
if the cut-through is enforceable in that state and not considered an unauthorized
preference in liquidation. For the insured, it is important to know whether
the reinsurer has the financial stability to make a cut-through provision worthwhile
negotiating. For the ceding insurer, it is important to know if the reinsurance
recoverables from an agreement with a cut-through provision can be claimed as
a credit on its financial statement. For the reinsurer, it is important to know
if it will be subject to direct liability by the policyholder and the nature
of the cut-through trigger.
Note: See an update of this article at
Playing the Name Game—An Update on Cut-Through Clauses.
The author thanks Eva-Marie Cusack, an associate at LeBoeuf,
Lamb, Greene & MacRae, LLP, in New York, for her assistance in preparing this