Shane Gleghorn and Liz Williams look at how cut-through clauses can provide more protection for fronting companies than standard market wordings

Cut-through clauses are designed to protect commercial policyholders in major transactions against the consequences of insolvency or cash flow risk by giving a directly enforceable right of action against retrocessionaires.The clause or endorsement purports to allow an insured or a reinsured to compel payment from a reinsurer or retrocessionaire higher up the chain.A cut-through clause is typically used in fronting arrangements where, for example, an insured with a captive insurance program interposes a fronting company between itself and an offshore captive. Invariably, the fronting company enters into the relationship for a fee and does not intend to assume any ultimate risk of loss. The fronting arrangement is designed to ensure that the captive covers all losses, and the fronting company is quarantined from the profits and losses of the underlying business.Typically, the fronting company and the original insured (often a large commercial business) will enter into an initial insurance agreement. A fronting establishment is then completed by the arrangement of a simultaneous 'back-to-back' reinsurance agreement between the fronting company and the (often) offshore captive reinsurer. It has become quite common for the fronting company to insist that it is the beneficiary of a 'cut-through' clause which enables it to claim directly against the retrocessionaires of the captive in the event that the captive is affected by an act of insolvency.Parties entering into these types of deals should be aware that, in the event of the captive's insolvency, there is a risk that the fronting reinsurer may be left without a recovery mechanism against the retrocessionaires of the captive. The cut-through clause may well contravene the relevant insolvency law (normally the law of the country where the captive is incorporated).Thus, a fronting company may be liable to indemnify an underlying insured, but be left without a recovery mechanism against the retrocessionaires of a captive because the cut-through clause is void under the insolvency law of the jurisdiction in which the captive is incorporated. Accordingly, serious consideration must be given to the insolvency law of the relevant offshore jurisdiction before entering into a reinsurance arrangement that purports to protect a fronting reinsurer by the use of a cut-through clause.The Contract (Rights of Third Parties) Act 1999 (effective as at 10 May 2000) (CRTP) makes it possible under English law to include a cut-through clause in a reinsurance contract so that a ceding company and a reinsurer can agree that the reinsurer shall pay any amounts due to the ceding company to a specified third party. Before the CRTP came into force, English law did not necessarily recognise the rights of third-party beneficiaries and, accordingly, cut-through clauses were considered to be unenforceable because of the lack of privity between the underlying insured and the reinsurer. However, the doctrine of privity has not been statutorily modified in some offshore jurisdictions (e.g. Guernsey and the Cayman Islands), with the result that a cut-through clause in a reinsurance agreement (governed by the law of such an offshore jurisdiction) may be unenforceable.If English law governs a reinsurance or retrocession agreement, it will be possible for the parties to specify that the insured or the fronting company is a beneficiary. The CRTP provides that a third party can enforce a contract if the contract identifies the third party as a beneficiary, either by name or by reference to a particular class or description. This makes it possible to fashion a cut-through clause for either facultative or treaty reinsurance in a way which does not give rise to privity issues.

InsolvencyAlthough it is now possible under English law to include a cut-through clause in a reinsurance contract without causing privity problems, there is a great deal of uncertainty as to whether such a clause contravenes the Insolvency Act 1986. The statute requires equality of treatment of all unsecured creditors, so that, in the event of an insolvency, the debtors' assets can be distributed amongst unsecured creditors on a pari passu basis. This general principle is common to most offshore jurisdictions such as Bermuda, Guernsey, the Cayman Islands and the Isle of Man.The general principle of equality of treatment is reinforced by a number of provisions designed to protect an insolvent company's assets against any form of distribution which prejudices creditors. In particular, section 239 of the Insolvency Act voids any transaction by a company that prefers one creditor over another which takes place within the six months prior to the commencement of insolvency proceedings. Thus, under English law there is a risk of a court determining that a liquidator is entitled to prevent any payment being made pursuant to a cut-through clause on the basis that the insolvent company's creditors are disadvantaged by a direct payment which results in a reduction of the pool of assets available for distribution. Depending on how the cut-through clause is worded and the chronology of events, the 'transaction' which is voided may be the granting of the cut-through clause itself, or a notional assignment of the ceding company's claim against the reinsurer at the time of the insolvency, or a substitution of the insured as loss payee at the time of the insolvency.Furthermore, irrespective of whether the reinsurance contract specifies English law as the governing law, there remains the risk that the liquidator of an offshore captive could apply to the courts of the foreign jurisdiction for an order preventing the captive's retrocessionaires from making a payment directly to the fronting company. For example, a common form of captive program involves an English fronting company entering into a reinsurance agreement with a protected cell company in Guernsey. The Guernsey Protected Cell Companies Ordinance 1997 (PCC Ordinance) provides a statutory framework for a protected cell company to 'ring fence' the assets (e.g. reinsurance contracts) of each cell in the event the company is put into insolvency.This ring fencing mechanism is designed to ensure that the creditors of one cell do not have recourse to the assets of the other cell. However, this mechanism is of no assistance to a fronting company if it is a creditor of a cell that has been put into insolvency.Under section 14 of the PCC Ordinance, no transfer of cellular assets of a particular cell of a cell company may be made except under the authority of the Guernsey Court, and authorisation will not be granted unless the court is satisfied that the creditors of the cell will not be unfairly prejudiced by the transfer. Section 108 of the Companies (Guernsey) Act includes provisions similar to section 239 of the English Insolvency Act.Accordingly, it is possible that a liquidator of a Guernsey-based captive could contend that the fronting company is precluded from relying upon a cut-through clause because the relevant reinsurance contract is an asset of the cell company which cannot be transferred without unfairly prejudicing the other creditors of the cell company.There are arguments under English law to counter the intervention of a liquidator. As payment under a cut-through clause is not made directly by the insolvent company to the specified third party, it is difficult to see how the liquidator could contend that such a payment qualifies as an act done by the insolvent company in breach of section 239. The 1997 case of McMahon v AGF also suggests that the courts are willing to countenance arrangements whereby policyholders are paid by a third party in the event of the insurer's insolvency, even if this possibly disadvantages other creditors. Equally, however, it is at least arguable that the granting of a cut-through clause is itself liable to be set aside if it occurs within the statutory 'claw back' period of six months. Moreover, McMahon involved a takeover scenario rather than a cut-through clause, and therefore there is no authoritative case law that can be relied on to categorically rule out the possibility of a liquidator successfully intervening to claim such reinsurance proceeds.

Credit riskThe problems associated with cut-through clauses highlight the importance of a detailed assessment of the credit risk of the participants when entering into a fronting arrangement. Fronting companies should not rely on a cut-through clause to make good any deficiencies in the captive's credit rating.Its fronting fee is likely to pale into insignificance if it is liable to indemnify an underlying insured for large claims, but unable to recover corresponding payments from the captive in respect of those claims.If, however, the fronting company is satisfied that the captive is solvent (and will continue to remain so), but wishes to have the added protection of a cut-through clause, it will be prudent for the fronting company to:- ensure that the reinsurance agreement between the captive and its retrocessionaire does not contain a blanket exclusion of the provisions of the CRTP without a 'carve out' for the provisions of the cut-through clause; and- have regard to the insolvency law of the jurisdiction in which the captive is incorporated to determine (to the extent it is possible) whether the cut-through clause will be enforceable in the event that the captive is put into insolvency.The lesson for fronting companies is that it will be prudent to give serious consideration to the drafting of a bespoke cut-through clause that is informed by the insolvency law of the relevant jurisdiction. Mere reliance on standard market wordings may not offer the fronting company sufficient protection.