Reinsurance commutations play a critical role in successful insurance company run offs. They may allow a reinsurer in run off to remove itself from entire lines of business, and may provide a ceding company with a welcome infusion of cash; in the case of setoffs, both sides may share in such results. The key to commutations is the finality they achieve. All parties are released with respect to any further obligations to their counter-parties, and a company in run off can move on to its next transaction. However, that cherished finality is threatened in many commutations by the possibility that a party subsequently becomes insolvent and is put into rehabilitation or liquidation, and the liquidator or rehabilitator attempts to recover the commutation payment, asserting that it was made as a voidable preference or fraudulent conveyance, and that the time in which to make a claim has passed. As a result, a party to the commutation could find itself returning the funds it received, and, having released the paying party, could be left without an option to pursue collection.
This article discusses two ways of addressing this problem: (i) New York Insurance Regulation 141, as an example of a regulatory measure designed to minimize the number of liquidations to begin with; and (ii) drafting techniques that the parties to a commutation can use to attempt to mitigate their losses if a commutation is voided.
Background: Voidable Preferences and Fraudulent Transfers
Most U.S. states allow their superintendent or commissioner of insurance, as the statutory liquidator of insolvent insurers domiciled in the state, to void transactions made by an insolvent insurer within one year of a liquidation petition under certain conditions. This is reflected in the NAIC (National Association of Insurance Commissioners) Rehabilitation and Liquidation Model Act, §§ 29 (c)(1)(2) (fraudulent transfers) and 32(a) (voidable preferences). Each of the states has either followed the Model Act, with some variations, or adopted related legislation.
The relevant New York statute principally provides that "any transfer of, or lien created upon, the property of an insurer within twelve months prior to the granting of an order to show cause under this article with the intent of giving to any creditor or enabling him to obtain a greater percentage of his debt than any other creditor of the same class and which is accepted by the creditor having reasonable cause to believe that such a preference will occur, shall be voidable." N.Y. Ins. Law § 7425(a).
For many years, the New York Department of Insurance was hostile towards allowing financially impaired insurers to enter into commutations. The Superintendent could (and often did) challenge these agreements as voidable transfers pursuant to Section 7425 of the New York Insurance Law if the company was subsequently placed into rehabilitation or liquidation. For example, In re Dominion Insurance Company of America, No. 86-40924 (Sup. Ct., N.Y. County, Aug. 7, 1986), involved a situation in which the reinsurer, Dominion, entered into multiple commutations with its insurers that would eliminate its financial troubles and enable it to resume writing new business. Notwithstanding this positive business result, the Superintendent successfully voided the commutations and placed Dominion into liquidation.
Regulatory Prophylaxis – New York Regulation 141
In reaction to arguably inefficient results such as in the Dominion case, in 1989 New York amended its insurance law to permit certain commutations that would otherwise be subject to voidance as preferential transfers. See N.Y. Ins. Law §§ 7425(d) 1321. New Section 1321 empowered the Superintendent to approve commutations between a reinsurer and an impaired or insolvent insurer, and Regulation 141 was issued to set forth the applicable standards that the Superintendent would use in determining whether such commutations should be approved.
Regulation 141 permits financially distressed (re)insurers to enter into approved commutations, in an attempt to avoid the time and expense of liquidation. The impaired or insolvent insurer can submit a "Regulation 141 Plan" to the Superintendent for approval. A Regulation 141 Plan is subject to restrictions and conditions, including the following:
- It must be extended to "each and every" ceding insurer to which the company has obligations.
- The terms of the commutation agreement to be offered to each and every ceding insurer must be the same, except that the percentages by which the impaired or insolvent company proposes to discount obligations due to each ceding insurer may vary based on different lines of business.
- It must provide for a stipulation from the company (usually its board of directors) consenting to an order of rehabilitation or liquidation if the plan fails.
The Superintendent cannot consider a Regulation 141 Plan unless it eliminates the insurer’s impairment or insolvency and restores its surplus to policyholders to the greater of either (a) the minimum amount required to be maintained or (b) the amount the Superintendent determines is adequate in relation to the insurer’s outstanding liabilities or financial needs. Life insurers may not participate in a Regulation 141 commutation.
Regulation 141 provides the New York Insurance Department with a mechanism to limit the number of insurers in liquidation, hence decreasing the odds that a given commutation agreement will become subject to voidance as a preferential or fraudulent transfer. We are aware of five "successful" Regulation 141 Plans, as well as one proposed Plan currently under consideration by the New York Insurance Department.
Damage Control: Drafting the Commutation Agreement to Mitigate Losses arising from the Future Insolvency of a Party
To provide a company with an opportunity to recover a portion of returned funds if a commutation payment to it is later reversed due to the paying party’s insolvency, the commutation agreement should be drafted to include a provision that reinstates the status quo prior to commutation in the event of a voidance, so that the release to the insolvent party is voided along with the payment. A sample "reinstatement" clause might look like this:
Reinstatement: In the event that the insurance department of the State of _________, or a court of competent jurisdiction in connection with the liquidation, receivership or rehabilitation of the reinsurer, or otherwise, requires return by reinsured of any portion of the payment made pursuant to paragraph _ of this Agreement, the releases given by the parties in paragraph _ of this Agreement shall be null and void, and the parties shall be returned to their original status as though this Agreement had not existed.
However, there are more complex situations in which such a clause is insufficient. For example, in connection with a quota share treaty, common (or "joint") account excess of loss reinsurance may have been purchased to protect both the ceding company and its quota share reinsurers. If the business were commuted, the common account reinsurers would likely be parties to the agreement. One or more of the parties, for example a quota share reinsurer in run off, may have solvency issues. Suppose, then, that a quota share reinsurer becomes insolvent and goes into liquidation during the preference period, and the liquidator succeeds in recovering the insolvent reinsurer’s commutation payment to the ceding company. In these circumstances, aside from the ceding company’s loss, the common account reinsurers also become exposed to further potential losses. Prudent drafting can provide some level of comfort, although draftsmanship alone cannot fully protect all parties.
First, the commutation agreement should include a clause providing that, if any payment to the ceding company is voided as a preferential transfer, fraudulent conveyance or otherwise by a liquidator, rehabilitator or statutory successor, that voidance would not affect the validity of the releases granted by the ceding company to the other (solvent) reinsurers. Next, the ceding company would be permitted to void the commutation agreement as between it and the insolvent reinsurer only, provided that: (i) this would not otherwise affect the validity of the commutation agreement; (ii) the quota share treaty would be in full force and effect only as between the insolvent reinsurer and the ceding company; and (iii) the releases in the commutation agreement between the ceding company and the solvent reinsurers would remain in full force and effect.
If the insolvent quota share reinsurer were no longer bound to the commutation agreement, and the quota share agreement were revived as between the ceding company and the insolvent quota share reinsurer, the common account treaty would also likely be revived with respect to the insolvent quota share reinsurer. Thus, the common account reinsurers would be exposed to further payments to the insolvent quota share reinsurer if the ceding company recovered against the latter. To protect themselves, the common account reinsurers, as part of the consideration provided for their payments to the ceding company, should attempt to negotiate concessions from the ceding company in the event of a voidance. One such concession would be the ceding company’s agreement not to file a claim against the estate in an amount in excess of the amount initially paid to it by the insolvent quota share reinsurer under the commutation agreement.
Most importantly, the common account reinsurers should seek an indemnification from the ceding company for any amounts they have to pay to the insolvent quota share reinsurer. Although a ceding company may not be willing to provide a complete indemnification, it may be willing to indemnify up to the amount of the portion of the common account reinsurers’ commutation payments to the ceding company that is attributable to the reinsurance provided to the insolvent quota share reinsurer under the common account treaty, plus the amount of the insolvent party’s commutation payments to the ceding company.