In our March 2001 article, Cut-Through Provisions in Reinsurance Agreements, we described the nature of cut-through clauses and some of the business reasons why cut-through clauses exist. In this commentary, we take another look at cut-through clauses and how they have been interpreted by the courts since 2001.
Because a reinsurance agreement is a contract of indemnity between a ceding insurer and a reinsurer, a contractual relationship exists only between those two parties. Generally, no privity of contract is enjoyed by the original insured (or reinsured in a retrocessional relationship), as it has no contract with the reinsurer.
The exception to this general rule occurs when the reinsurer and the ceding insurer contract around the lack of privity between the original insured and the reinsurer by express language in the reinsurance contract. This language in a reinsurance contract is known as a "cut-through" clause. A cut-through clause allows a party that is not in privity with the reinsurer to have rights against the reinsurer as a part of the agreement between reinsurer and ceding insurer.
The Cut-Through Clause
A cut-through clause is generally tailored to respond to specific events written into the reinsurance contract. It allows the original insured to take direct action against the reinsurer where these specified events prevent the original insurer from paying the claims of its policyholder (the original insured). Cut-through clauses can be particularly useful in situations where, to secure business, the ceding insurer needs to provide extra assurance to its policyholders. Many large commercial insureds may not engage an insurer unless they have some assurance that the reinsurer standing behind the insurer will be liable to the original insured in the event the ceding insurer is unable fulfill its policy obligations.
Additionally, certain insurance programs are structured in such a way that the reinsurer is, for all intents and purposes, the real insurer-in-interest and the ceding insurer is merely fronting the deal. This may happen because of licensing issues affecting the reinsurer's ability to issue policies in a given territory, capital constraints, or brand recognition and penetration.
Recent Court Rulings Involving Cut-Through Clauses
While most states recognize the validity of cut-through clauses, recent case law suggests that cut-through clauses must be precisely tailored in order to be effective. Indeed, if any language proffered as a cut-through clause is not precisely worded, courts have shown a clear preference against finding the clause to be a valid cut-through clause.
An excellent example of how the courts interpret cut-through clauses is the recent decision in Jurupa Valley Spectrum, LLC v. National Indem. Co., 555 F.3d 87 (2d Cir. 2009). In Jurupa, the obligee of surety bonds sued the surety's reinsurer to collect on the bonds after the surety became insolvent. The claim arose out of the following language in the reinsurance contract:
[T]he parties to this Reinsurance intend that Reinsurer, through the Claims Administrator, shall pay all amounts ... due Insureds and other persons as and when due directly on behalf of the Reinsured....
The obligee argued that this wording necessarily implied that the reinsurer had granted cut-through rights to all original insureds against the reinsurer. In affirming the district court, the Second Circuit Court of Appeals ruled that this clause did not constitute a cut-through clause. The court stated that "New York law recognizes an exception if the reinsurance agreement contains a so-called 'cut-through' provision granting policyholders a direct right of action against reinsurers, which is apparent on its face." Despite the apparent provision for payment to the original insured, the court found that the provision needed to specifically name those insureds to which payments would be made.
This seemingly minor difference was determined to be the distinguishing factor between the contract in this case and the contract containing substantively similar language that the court found to be a cut-through clause in Trans-Resources, Inc. v. Nausch Hogan & Murray, 298 A.D.2d 27 (1st Dept. 2002). The court said the language in Trans-Resources included the agreement of the reinsurer "to pay directly to the named insured," while the language above provided that the reinsurer "shall pay all amounts due Insureds." This latter language, the court held, did not specify to whom the payments will be made.
Moreover, Article 14 of the reinsurance contract provided expressly that:
[n]othing ... expressed or implied,... shall be construed to confer upon ... any person [other than the parties] ... any rights or remedies under ... this reinsurance.
This language, said the court, further supported the view that the reinsurance contract did not provide for a cut-through.
The specificity the Second Circuit sought, which required the reinsurance contract to name the direct insured to be paid via a cut-through clause, is an example of the type of detailed construction required for any cut-through clause to be effective. While there are differences between the clauses in Jurupa and Trans Resources, this should not take away from the importance of careful construction of cut-through clauses to assure their effectiveness. The court's message in Jurupa is clear: particular phrasing of any clause creating additional rights for third parties in reinsurance contracts is crucial for the validity of the clause, especially if the wording is to be construed to overcome additional language in the agreement stating that:
[n]othing [herein], express or implied, ... shall be construed to confer upon ... any person ... (other than the parties hereto or their permitted assigns or successors) any rights or remedies under ... this reinsurance.
Thus, the issue of specifically naming the insured to be paid in the event of insolvency, and not the disclaimer language, was the primary issue resulting in the court's finding that no cut-through clause existed in Jurupa.
Yet, courts have not backed away from the general rule that reinsurance contracts can still effectively contract around the traditional tenet that there is no right of the original insured against the reinsurer. Rather, the decision in Jurupa serves to advance the idea that, to allow the original insured rights against a reinsurer, a clear intent must be manifest in the specific language of the contract itself.
In Trans-Resources, the reinsurer attempted to use fairly standard language to avoid an alleged cut-through clause. The reinsurance contract had a provision stating that the reinsurer "shall have no obligation to the original insured or anyone claiming under the policy(ies) reinsured." The court, however, refused to overlook language in the contract's cover note obliging the reinsurer "to pay directly to the named insured ... with respect to any claim under said policy" and stating that this clause "stipulates direct liability and creates a direct procedural privity as between the original insured and the reinsurer."
When you compare Trans-Resources to Jurupa, it becomes clear that the major difference between the wordings of the purported cut-through clauses in both cases is the specificity in which the party receiving the reinsurance payments was named. The court in Trans-Resources found that a cut-through clause existed because the policyholder (the named insured) was clearly named as the recipient of direct payments from the reinsurer if the ceding insurer could not pay. Although this clause represented a fairly standard "insolvency clause" that is found in many reinsurance contracts, the decision in Trans Resources indicates the importance of specific construction of cut-through clauses by expressly naming the policyholder that will be paid upon the ceding insurer's default.
The specificity of naming the party to whom direct payments will be made is often based on statutory requirements. For example, in Pennsylvania, the statute provides that:
The amount recoverable by the liquidator from reinsurers shall not be reduced as a result of delinquency proceedings, regardless of any provision in the reinsurance contract or any other agreement. Payment made directly to and insured or other creditor shall not diminish the reinsurer's obligation to the insurer's estate except where the reinsurance contract provided for direct coverage of an individual named insured and the payment was made in discharge of that obligation.
40 P.S. § 221.34.
This statute formed the basis for the guidelines established by the court supervising the Reliance Insurance Company liquidation in Pennsylvania. See Koken v. Reliance Ins. Co., No. 269 M.D. 2001 (Apr. 26, 2002). These guidelines set forth the circumstances under which direct payments by reinsurers to insureds would be allowed—essentially the rules for determining the validity of cut-through clauses for reinsurers of Reliance.
In Koken v. Legion Ins. Co., 831 A.2d 1196 (Pa. Commw. 2003), the court noted the Reliance guidelines were instructive in considering cut-through clauses in the Legion Insurance Company insolvency, but were not binding. In Koken v. Legion, the court addressed several claims by several insureds claiming direct access to reinsurance proceeds. One insured claimed that the reinsurance contract between the ceding insurer and the reinsurer had an express cut-through right. The insolvency clause in the reinsurance contract provided as follows:
... The reinsurance will be payable by the Reinsurers directly to [the cedent], its liquidator, receiver, ... except (a) where this Agreement specifically provides another payee of such reinsurance in the event of ... insolvency or (b) where the Reinsurers, with the consent of the direct insured or insureds, have assumed such policy obligations of [the cedent] as direct obligations of themselves to the payees under such policies in substitution for [the cedent's] obligation to such payees. Then, and in that event only, [the cedent] ... is entirely released from its obligation and the Reinsurers will pay any loss directly to the payees under such policies.
The court found that the reinsurer functioned as the direct insurer (it was a fronting situation) and that provision (b) was included in the reinsurance contract to provide the insureds direct access to the reinsurers in the event of the ceding insurer's insolvency. The rationale behind the cut-through provision in the insolvency clause, as expressed by the court, was to give the insureds comfort that if something happened to the insurer, the insureds would be able to obtain coverage directly from the reinsurers.
In rejecting the rehabilitator's attempt to give very narrow meaning to the exception provision in § 221.34, the court in Koken v. Legion stated that it is difficult to make any generalizations about cut-through endorsements and how they ought to appear. Expert testimony cited by the court acknowledged that cut-through clauses are distinctive and vary depending on the jurisdiction and the intent of the parties.
Conclusion
It is clear from the ruling in Jurupa that the precise wording of a cut-through provision must clearly indicate its function in allowing a third party to the reinsurance contract the right to direct access to the reinsurance, as well as sufficiently naming the party to who payment will be made. Yet, jurisdictional differences, statutory distinctions, and the intent of the parties may allow for enforcement of a cut-through clause that does not meet the Jurupa standards. If what the parties intend is that the underlying insured should have direct access to the reinsurance should the ceding insurer become insolvent, then the provision should be drafted precisely and clearly to effect that intent.
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