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Cut-Through Provisions in Reinsurance Agreements

March 2001

A cut-through provision allows a party not in privity with the reinsurer to have rights against the reinsurer under the reinsurance agreement. Learn how cut-through endorsements are attached, triggered, and employed, and how they may be unenforceable in some jurisdictions.

by Larry P. Schiffer
Squire Patton Boggs (US) LLP

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 order.

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 policy.

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 estate.

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.

Conclusion

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 article.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do 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.

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