Demand for cut-throughs is high, although availability is scant

Although the hard re/insurance market has made cut-throughs more difficult to get, the demand for them continues to grow in parallel with the continuing tendency of rating agencies to downgrade insurers to below 'A'. But a court case in Pennsylvania has circumvented the need for a cut-through endorsement in a reinsurance contract altogether, yet still entitled the policyholder access to reinsurance benefits.

A cut-through is an endorsement to a reinsurance agreement that means that if the ceding company becomes insolvent, the reinsurer is required to pay any loss covered under the reinsurance agreement directly to the insured or third-party beneficiary. The endorsement gets its name because reinsurance claim payments 'cut through' the usual route of payment from reinsured company to policyholder, and then reinsurer to reinsured company, substituting instead payment of reinsurer to policyholder. A cut-through affects the path of payment only, and does not increase the risk to the reinsurer.

Usually, cut-throughs are granted by a reinsurer to an insurance company that has been downgraded by a rating agency ' to a level beneath that demanded by certain clients - usually to below 'A. Most cut-throughs are provided only for property, and almost never for casualty unless the cut-through can be limited to claims on a yearly basis.

Riding on cut-throughs

Insurance companies with a cut-through from reinsurers are, in effect, borrowing the size and rating of the reinsurers. A cut-through allows the insured or a third-party beneficiary to collect the reinsurance recoverables directly from the reinsurer in the event that the insurer becomes insolvent, and not wait for the liquidator of the insolvent insurer to pay claims, usually at a discount, which could take years. A cut-through can be written on a blanket basis, where the reinsurer assumes liability for a complete line, or for specific policies. The fee or surcharge paid to the reinsurer can vary considerably, depending on how urgently the primary insurance company needs the cut-through and how willing the reinsurer is to consent to the plea.

Kathryn Baker, associate general counsel at Employers Reinsurance Corp, Overland Park, Kansas, acknowledged that Employers Re has a couple of clients that are traditionally provided with cut-throughs on property treaties. "When we make a cut-through for an individual client," she said, "we are most thorough in determining why we should give the client this accommodation. It is almost always because the insurer's rating has been lowered." The reason for the downgrade is fully investigated and if there are no negative indications, a cut-through is given. "This is the only time we furnish them," she affirmed.

Sean Mooney, vice president, Guy Carpenter, New York, said: "It is nearly impossible to get a cut-through in today's market. Reinsurers are very reluctant to get involved with having to deal directly with adjusting losses if the primary insurer should go broke."

Employers Re echoes this reluctance for providing cut-throughs because of the possible adjusting demands. "We don't have a facility to do this," said Ms Baker. "We would have to hire a third party to do the adjusting - not something we want to get involved with." In addition, if one or more reinsurers gave cut-throughs to a specific insurer, and other reinsurers did not, payment of the claims of that insolvent company would be further complicated, delaying resolution, she said.

Cut-throughs needed now

The availability of cut-throughs has varied with the fortunes of the market and the vagaries of the cycle. A former CEO of a major reinsurance company, who asked not to be identified, said: "In the old days, reinsurers were giving cut-throughs right and left, and insurance companies were abusing them. Primary insurers were attaching cut-throughs to all their important insurance policies, and this became an administrative nightmare.

Reinsurers stopped doing this a few years ago when the market turned hard.

Some reinsurers still provide a cut-through to an insurer that they have extreme confidence in, one they have an arrangement with as to how compensation will be paid in the event of an insolvency. Reinsurers also sometimes use it as leverage to gain more of the primary insurer's reinsurance program."

According to Ms Baker, though, Employers Re has not followed this pattern of fluctuation. "I'd say the number of cut-throughs has been consistent," she said.

"I have been with Employers Re for 27 years, and the number has not varied much over that time. At the most, fewer than ten clients a year get cut-throughs, and that number fluctuates from year to year; sometimes there are only one or none." Once a client has the go-ahead to offer cut-throughs, it can issue as many policies with the endorsement as it wants "with approval of Employers Re, of course," she quickly declared.

Ironically, the CEO said cut-throughs are needed more now than a decade ago because of the increased prevalence of rating agency downgrades, leading policyholders to look for an assurance their claims will be paid. So these dropped companies pay, sometimes dearly, to have reinsurers provide cut-throughs - if they can find a reinsurer that will do it.

An example of a frantic yet fruitless attempt to maintain its life by using cut-throughs was the case of Kemper Insurance Cos. After being downgraded to 'B+' from 'A' in December 2002, Kemper obtained a cut-through from National Indemnity Co, an insurance subsidiary of behemoth Berkshire Hathaway.

All policies issued by Kemper after 23 December 2002 that have a cut-through endorsement carry the AM Best 'A ' rating of National Indemnity. The price for this agreement with National Indemnity was not disclosed.

In November 2003, facing continued capital constraints and additional downgrades from various rating agencies, Kemper substantially ceased its underwriting operations and voluntarily entered into run-off. If the cut-through is triggered, National Indemnity will pay in full, from dollar one, all first and third party claims that Kemper has not already paid.

Since it is unlikely that Kemper will be declared insolvent, National Indemnity will probably not be required to respond.

Regulatory resistance

State insurance regulators are opposed to cut-throughs, arguing they give an unfair preference to sophisticated insurers and third parties at the expense of consumers and thus should not be enforced. The officials contend that reinsurers have a statutory obligation to pay reinsurance proceeds to the receiver of an insolvent insurance company.

Further complicating the cut-through provision is the problem of determining which policies have the cut-through and which do not. Sometimes, records of the insolvent primary insurer can be incomplete or missing, and the reinsurer with the cut-through must go to considerable expense to determine which claims are to be paid to the receiver and which to the beneficiary of a cut-through. If the accounting is not carefully undertaken, the reinsurer may pay the same claim twice.

Virtually every US state requires that reinsurance contracts contain an insolvency clause if the cedant is to receive financial statement credit for the reinsurance. This clause obligates the reinsurer to pay claims to the receiver without diminution due to the cendant's insolvency. A guiding principle of receiverships of insolvent insurers is that all creditors of the same class are treated equally. Ordinarily, this means that all policyholders and loss payees would be paid the same proportion of their allowed losses. But in some states, the 'insolvency clause' contains language that allows the payment of reinsurance proceeds directly to the insured if there are cut-through provisions. This difference can cause conflicts between contractual cut-throughs and receivership policy on the one hand, and case law on the other.

Clear-cut case?

The decision in June 2003 by a judge in a Pennsylvania court to grant certain policyholders direct access to reinsurance proceeds in the Legion Insurance and Villanova Insurance insolvency case even without cut-through provisions evident in the policies has caused the reinsurance community to take notice. Few observers, however, feel the case, because of its unusual circumstances, will ever become a ruling precedent.

The case involved Legion Insurance Co and Villanova Insurance Co, both of which were placed in liquidation by the Commonwealth of Pennsylvania towards the end of 2002. During the court proceedings, four of the companies' policyholders - Pulte Homes Inc, Psychiatrists' Purchasing Group Inc, Rural/Metro Corp and American Airlines Inc - sought direct access to reinsurance funds to pay claims.

The policyholders became involved with Legion when they wanted to purchase reinsurance that would cover any losses exceeding their self-insured retention.

Since they could not go straight to a reinsurer, they used Legion and Villanova as 'fronting' or 'pass through' companies to act as a middleman between them and reinsurers in exchange for an annual fronting fee.

Legion issued an insurance policy solely to meet regulatory requirements, and bore no claims responsibility. When declared insolvent, however, it said reinsurance proceeds should be paid to it and not to the four policyholders.

None of the four companies had clear cut-through endorsements in their final policies with the reinsurers, which included Lloyd's of London syndicate 271.

This syndicate had reinsured American Airlines, which involved coverage for American Flight 11 which was flown into the North Tower of the World Trade Center; American Flight 77 which was flown into the Pentagon the same day; and the loss of American Flight 587 which crashed in Queens, New York, on 12 November 2001. The claims from the estates of passengers on board the planes, from persons on the ground who were injured or killed, for property damage to buildings and for loss of income would run into billions of dollars.

Judge Mary Hannah Leavitt concluded that Legion "has no right to the proceeds of the reinsurance agreements that cover the liability claims of Pulte Homes Inc, Psychiatrists' Purchasing Group Inc, Rural/Metro Corp and American Airlines Inc." She said that direct access to a reinsurer is "constant with the equitable purpose of a liquidation," and noted the relevant factors presented by the four policyholders. These were the absence of any underwriting risk by Legion or Villanova, absence of adjustment responsibility or activity by Legion or Villanova, and the reinsurance was placed by policyholders, not Legion or Villanova, for the policyholders' benefit. Further, the four named policyholders waive claims against state guaranty funds.

She went further, however, and ordered that other policyholders of Legion and Villanova could also collect directly from their reinsurers if they could show similar causative relationships to those of the four main policyholders.

"Broadly, the court's decision in the Legion insolvency proceedings provides hope that courts will look more often to the realities of insurance and reinsurance transactions with an eye toward fulfilling the reasonable expectations of policyholders," said John N Ellison, managing shareholder of the Philadelphia, Penn, office of Anderson Kill & Olick, which represented Pulte Homes in the Legion insolvency proceedings. "The decision provides ample precedent for policyholders to recover directly against reinsurance companies whenever the policyholder is the intended beneficiary of the reinsurance."

Employers Re's Ms Baker said she was not worried that the Legion and Villanova case would affect the reinsurance industry as it involved a fronting operation. "I find it hard to imagine that this case will be expanded to become anything like a precedent. It deals with a very specific set of circumstances that rarely reflect usual reinsurance operations."

Seeing that billions may be lost for payment of claims from the two failed fronting companies, as well as requiring the Pennsylvania guaranty funds to make large payments to policyholders, the Pennsylvania Insurance Commissioner filed a post-trial motion for reconsideration of the Legion/Villanova case.

The commissioner's contention is that reinsurance relates directly to underlying insurance policies, and that "reinsurance proceeds reimburse a direct insurer for claims payments made on behalf of its insureds and does not somehow grant the insureds the right to direct funding from reinsurers." Timothy P Law, attorney with Anderson Kill & Olick's Philadelphia office, said that motions for reconsideration are usually unsuccessful. "The court's decision was so well thought out," said Mr Law, "that the state's motion brings up nothing new."