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.
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.
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.
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.
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.
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.
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.
The author wishes to acknowledge the significant contribution of Benjamin Sahl, a summer clerk at LeBoeuf, Lamb, Greene & MacRae, L.L.P. in the research and drafting of this Commentary.