Who Owes Whom? Understanding Setoffs in Reinsurance

Defining Setoff

The right of setoff was created to settle the issue of competing obligations, and to avoid what has been called the "absurdity of making A pay B when B owes A." Over time, what began as basic principle of fairness in courts of equity has evolved into a basic legal right common to nearly all contracts, including reinsurance agreements. This commentary will briefly explore this important right, and discuss the ways in which it can be secured for the benefit of the parties to a reinsurance relationship.

The Origins of Setoff

Setoff or offset is an equitable right that allows parties to cancel or offset mutual debts to each other by asserting the amounts owed, subtracting one from the other, and paying only the balance. The right originated in 17th century English common law and was later applied by English equity courts to bankruptcy cases. Setoff generally was not permitted in tort actions or in contract actions arising out of torts. The right of setoff has been used since Roman times as a procedural device that saves parties from the inequity of having to repay debts without simultaneously having the right to claim debts owed them by their creditors.

Early cases in the United States applying the right of setoff did so in the bankruptcy or the liquidation context. Today, the right of setoff continues to be applied most often in the context of bankruptcy or insurance insolvency, although it applies in other contractual relationships as well.

Applying Setoff in a Reinsurance Relationship

The right of setoff is used in day-to-day business transactions between reinsurers and reinsureds and their brokers in the form of standard net accounting. Balances due the reinsured for paid losses and earned premiums due from the reinsured to the reinsurer are netted out between the reinsured and its reinsurer or by the broker through the monthly or quarterly accounting reports. Besides net accounting, the right of setoff can be secured as an express contractual right, through state law, and by application of case law.

Contractual Right of Setoff. Reinsurance agreements will often contain setoff clauses that allow the parties to offset debts owed under the reinsurance agreement. For example, in Prudential Reinsurance Co. v Garamendi, 842 P2d 48 (Ca 1992), a setoff clause provided that the parties could offset any and all reinsurance debts owed by or to them under the same or any other reinsurance agreement between them. Offset clauses may express a right of offset broadly as in Prudential, narrowly, or may provide that in the event of the insolvency of a party a particular state's insurance laws will govern any right of setoff.

The clause described in Prudential is typical of setoff provisions in reinsurance contracts. As described in that clause, setoff is a broad right that can be expanded or limited as the parties see fit. Setoff rights may be limited to one reinsurance agreement between the parties, the various layers of the same reinsurance program, or all reinsurance agreements between the parties regardless of whether the reinsurance relationship is treaty or facultative.

Statutory Right of Setoff. Statutory rights of setoff are found in insolvency-related laws such as the Federal Bankruptcy Code and many state insurance and insolvency laws. See, e.g., 11 U.S.C. §101 et seq.; Cal. Ins. Code § 1031. Outside of the insolvency or insurance liquidation context, the only state having a general statutory provision governing rights of setoff in civil actions is Connecticut. See Conn. Gen. Stat. 52-139 (1999) (stating that "[i]n any action brought for the recovery of a debt, if there are mutual debts between the plaintiff or plaintiffs, or any of them, and the defendant or defendants, or any of them, one debt may be set off against the other").

When it comes to the setoff provisions in state insurance codes, 37 states have adopted the pre-1990 version of the National Association of Insurance Commissioners (NAIC) Insurers Rehabilitation and Liquidation Model Act (the "Model Act"). Courts have interpreted the Model Act as providing a broad right of setoff to creditors. In 1990, the NAIC changed the Model Act to limit setoffs where the reinsurer of an insolvent insurer was also reinsured by the insolvent insured (assumed/ceded setoffs). Some state legislatures have enacted statutes in reaction to a perceived lack of risk transfer to the reinsurer. See e.g., Fla. Stat. § 624.610(1). No state, however, has adopted the post-1990 Model Act for property and casualty, and only New Jersey has adopted it for life and health.

The National Conference of Insurance Legislators (NCOIL) endorsed the Interstate Insurance Receivership Compact Uniform Receivership Law (URL). URL allows the right of setoff under assumed/ceded reinsurance agreements, but not in "circular" arrangements where the reinsurer cedes the same business back to the original insurer. The setoff provision of the URL represents a compromise between the pre-1990 NAIC Model Law and the current NAIC Model Law.

For a practical example of the importance and use of setoffs in an insolvency context, we can look to the Reliance insolvency experience in Pennsylvania. Reliance's liquidator has issued offset guidelines that follow the principles of the pre-1990 act. The Reliance guidelines permit broad offsets within the same contracts, across multiple contracts, and across multiple contracts where Reliance is the cedent in some contracts and assuming reinsurer in others.

Because Reliance had so many reinsurance relationships, the issue of setoff was an important issue to resolve as quickly as possible. In issuing these guidelines, the liquidator pointed out that they do not create new policy, but merely implement how the liquidator planned to apply the statutory and common law setoff rules under Pennsylvania law in common setoff situations.

Common Law Right of Setoff. In the absence of express contractual or statutory setoff rights, courts apply the common law right of setoff for that jurisdiction in appropriate circumstances. Generally, the common law right of setoff acknowledges the principle that debtors and creditors may offset their obligations to each other where there is mutuality. The concept of mutuality has been defined in various ways by different courts, but essentially it means that the debts must be due to and from the same persons in the same capacity. The cases show that the courts look for three factors in determining mutuality: 1) same persons or entities, 2) mutuality of time, and 3) mutuality of capacity.

To be considered the same persons or entities, the obligations must exist between the same parties unless the contract allows for broader application. Unless provided for by contract or agreed upon by the parties, debts owed to an affiliated company generally cannot be offset against premiums due from another affiliated company. Thus, in insurance groups with multiple companies, reinsurance recoverables owed to a reinsured by one member of the group cannot be offset against reinsurance recoverables owed by another affiliate to the reinsured.

The mutuality of time requirement applies to insolvency situations. The parties must owe the debts prior to or contemporaneously with the receivership order. In insolvency cases, debts are divided into preliquidation and post-liquidation debts. Preliquidation credits may be set off against preliquidation debts, but a preliquidation credit may not be set off against a post-liquidation debt.

Mutuality may be found when a reinsured claims a setoff for losses or unearned premiums against the reinsurer's premiums. For example, in one case the liquidator asserted that the debts for reinsurance proceeds were not due at the time the insurer was liquidated. O'Connor v Insurance Co. of N. Am., 622 F Supp 611 (ND Ill 1985). The court held that all debts were due and all claims were filed pursuant to the contract at the time the insurer was liquidated. Although the claims were not paid prior to liquidation, they were susceptible of liquidation and became payable on the date of liquidation in the amount that was set. Accordingly, mutuality existed and the setoff was permitted. If mutuality is found and other requirements are met, the reinsured will be allowed to set off losses or unearned premiums against the reinsurer's premiums.

Finally, the setoff can occur only between persons or entities of equal capacity. Therefore, debts owed in a fiduciary, agency, trustee, or partnership capacity are not subject to setoff unless the credits are owed in the same capacity. For example, courts generally will not allow setoffs where the funds owed to the liquidator are being held in trust.

Because the right of setoff is an equitable principle, courts may order setoff where there is no adequate remedy at law. A court's discretion to allow an offset in equity, however, likely will be limited by any other rights applicable, such as those created by an express agreement between the parties. For example, in the bank-depositor relationship, it is a general rule that a bank may apply the deposit to a payment of the debt due it by the depositor so long as "there is no express agreement to the contrary and the deposit is not specifically applicable to some other purpose."

States may differ in the extent to which they will allow common law rights of setoff. See, e.g., Hubley Mfg. & Supply Co. v Ives, 70 A 615, 616 (Conn 1908) (noting that in Connecticut "[e]quity recognizes rights of set-off which go far beyond those which the early legislation of England and of Connecticut introduced in actions at common law."). A reinsurance agreement containing an insolvency clause will not preclude a party from availing itself of common law rights to setoff provided no statutory prohibition exists. See, e.g., Commissioner of Ins. v Munich Am. Reinsurance Co., 706 NE2d 694, 697 (Mass 1999) (noting that an insolvency clause which provides that in the "event of the ceding insurer's insolvency, reinsurance will be paid directly to the ceding insurer or its receiver without diminution because of the insolvency of the company" is intended to "increase the reinsured company's capacity to write insurance and is not designed to destroy a reinsurer's right of setoff.").

Conclusion

The right of setoff is readily available in insurance and reinsurance relationships. Like all rights, it should be carefully planned for and built into the contractual relationships that are established between parties. In today's difficult economic environment, knowing your setoff rights may help protect you if your business partner finds itself in insolvency.

The author gratefully acknowledges the assistance of William P. Bodkin, an attorney in LeBoeuf's New York office, in the preparation and research for this Commentary.