In an article in our June 2011 Insurance and Reinsurance Update we looked at certain issues that impact upon the enforceability of cut-through clauses contained in reinsurance contracts. With the coming into operational effect of the PPSA the question arises whether a cut-through clause may be a PPSA security interest that requires perfection by being registered on the PPS register to ensure priority over competing security interests.


The Personal Property Securities Act 2009 of Australia (PPSA) establishes a national system for the registration of security interests in personal property, together with new rules for the creation, priority and enforcement of security interests in personal property. The PPSA came into effect on 15 December 2009, and commenced operational effect on 30 January 2012, with a two year transitional period.

Whether or not a cut-through clause is void or voidable as against a liquidator or administrator of the reinsured is not considered in this note. For example, for the reason that because the right of the original insured to receive payment springs up at the time the reinsured becomes financially “impaired”, it may constitute a distribution of the reinsured’s property in a manner inconsistent with applicable priority rules under relevant insolvency law. The Corporations Act 2001 (Cth) (s562A) requires the liquidator of an Australian insurer, unless the Court orders otherwise, to pay the net proceeds of reinsurance received by him or her to certain of the reinsured’s insureds in priority to other creditors - including those having preference under the general priority regime under that Act (s556). This note solely considers whether a cut-through is a PPSA security interest for which registration on the PPS register is necessary if it is to have priority over competing interests (if it is not otherwise void or voidable under insolvency law).

Approach taken

In this note I:

  • Provide a re-cap of what a cut-through clause is and the types of cut-through clauses commonly encountered in practice;
  • Consider the basis on which a cut-through clause may be a PPSA security interest; and
  • A potential exception to the registration requirement.  

Overview and Summary

Inclusion of a cut-through clause as a term of a reinsurance contract is a function of an anterior or subsisting relationship between the original insured (the beneficiary of the cut-through) and the reinsured (as insurer under the reinsured contract). From the stand point of the original insured and the reinsured, a cut-through serves as security for the reinsured’s indemnity obligations under the reinsured contract. At a minimum, the clause will entitle the original insured to obtain payment of the proceeds of a claim under the reinsurance contract (to which it is responsive). Depending on its terms, it may or may not entitle the original insured to have direct recourse to the reinsurance itself to discharge the reinsured’s indemnity obligation under the reinsured contract.

A mortgage or charge over an insurance policy is a PPSA security interest. However, the PPSA contains an exception for certain transfers of interests in, or a claim under, an insurance policy.

Subject to a question regarding the breadth of a carve back to that exception, a cut-through clause that constitutes a mortgage over the reinsurance should come within the exception. A charge over the reinsurance similarly may come within the exception though this is more contestable (and is also subject to a similar question regarding the carve back to the exception). Some cut-through clauses, upon their terms, are not, however, dispositive and do not give the original insured a proprietary interest in the reinsurance proceeds. Depending on their terms, these provisions may not constitute PPSA security interests. If they do, however, the question then again arises whether they are also outside the scope of the PPSA by the exception for a transfer of an interest or claim in or under a policy of insurance.

Recap

A cut-through clause is a term of a reinsurance contract between a primary insurer (the reinsured) and its insurer (reinsurer) which confers upon the original insured under a reinsured policy a right of action directly against the reinsurer to recover the proceeds payable to the reinsured under the reinsured policy upon the occurrence of certain prescribed events – usually related to the insolvency, or other financial impairment (eg material rating downgrade), of the reinsured.

Cut-through clauses come in various formulations. Some are, or are analogous to, directions to pay the reinsurance proceeds to the original insured upon insolvency of, or other defined financial impairment event in relation to, the reinsured, but do not give rise to a separate indemnity obligation in favour of the original insured i.e. direct indemnification by the reinsurer of the original insured in respect of the latter’s loss (as covered by the reinsured contract). In effect, they are “loss payee” clauses (or directions to pay) that are triggered upon occurrence of the prescribed event. They are not dispositive of the reinsured’s chose in action under the reinsurance contract nor do they create separate and independent indemnity obligations in favour of the original insured. Notwithstanding this being the case, they do give the original insured the right to obtain payment of the proceeds of the reinsured’s claim upon the reinsurance.

On the other hand, some cut-through clauses do give rise to a separate indemnity obligation in favour of the original insured. Upon occurrence of a prescribed financial impairment event, the reinsured’s chose in action and the reinsurer’s indemnity obligation to the reinsured may terminate or expire and at the same time an indemnity in favour of the original insured (who may or may not also be a party to the reinsurance contract) is enlivened – possibly subject to a condition precedent that the reinsured irrevocably withdraws its claim for indemnity upon the reinsurer. As noted in our June 2011 Article, as a related term it would be usual for the reinsurance contract to also stipulate that any payment the reinsurer makes under the cut-through to the original insured provides a discharge to the reinsurer in respect of its liability to its reinsured, and to any liquidator, receiver or other controller of the reinsured, in respect of the claim upon the reinsured policy or occurrence that triggered the response of the reinsurance contract.

Scope of the PPSA

The PPSA is extremely broad in its scope. It applies to security interests in personal property granted by all entities (ie companies and individuals). Personal property is any form of property (including a licence) other than land and certain statutory rights that are declared not to be personal property for the purposes of the PPSA. The notion, as defined, therefore encompasses intangible property such as an insurance policy and a “chose in action” (rights to sue) under it.

Security interest

A security interest under the PPSA is defined as an “interest in personal property provided for by a transaction, that in substance, secures payment or performance of an obligation”. Security interests for the purposes of the PPSA of course include traditional securities such as charges and mortgages. The notion would thus include a fixed and floating charge taken over an insurer’s outwards reinsurance assets. However, security interests for the PPSA also include transactions that, in substance, secure payment or performance of an obligation but which may not be traditionally classified as security interests. A clause which requires the reinsured to pay proceeds under the reinsurance to the original insured under a reinsured contract may create an “in substance” security interest for the purposes of the PPSA. A clause which requires the reinsurer to pay the proceeds under the reinsurance to the original insured under a reinsured contract by extinguishing the reinsured’s indemnity entitlement and substituting an indemnity entitlement of the original insured, similarly may create an “in substance” PPSA security interest.

A person who holds a security interest under the PPSA needs to “perfect” the security interest to ensure that it has priority over competing interests (and in some cases, to ensure that the security interest survives the insolvency of the grantor). Failure to do so may have the following consequences: (a) another security interest may take priority; or (b) another person may acquire an interest in the property that is subject to the security interest free of the security interest; or (c) the holder may not be able to enforce the security interest against a grantor who becomes insolvent.

Potential exception?

The PPSA does not apply to certain interests. Amongst the interests excepted from the PPSA’s ambit is “a transfer of an interest or claim in, or under a ……policy of insurance, except a transfer of a right to an insurance payment or other payment as indemnity or compensation for loss of, or damage to, collateral (or proceeds of collateral)”. The expression “policy of insurance” is not defined. A reinsurance contract is a type of insurance contract. There is no reason in principle to except from the expression “policy of insurance” a reinsurance contract.

Whether or not a cut-through clause involves a “transfer of an interest or claim in, or under” the reinsurance contract of which it is a term so as to come within the exception, is a question of fact and law to be determined having regard to the precise terms of the relevant clause. The PPSA does not define “transfer”. “Transfer” has a broad meaning at general law.

An assignment of the reinsured’s interests in its outwards reinsurance, whether absolutely or by way of security, should come within the exception as should an agreement (for value) to assign future reinsurance proceeds. However, a cut-through that falls short of an assignment or charge of present or future proceeds, whilst it may, in some cases at least, have an analogous commercial effect to an assignment nevertheless may not come within the exception.

The example has been given of a clause, which extinguishes the reinsured’s right of indemnity and substitute a corresponding right of indemnity in favour of the original insured and provides that the parties agree and acknowledge this satisfies the liability of the reinsurer to the reinsured. In an economic sense such provisions may be equivalent to an agreement to “transfer” the proceeds of the reinsurance (upon occurrence of the contingency which enlivens the cut-through)" but technically not constitute a transfer of an interest - as these are not dispositive of the reinsured’s proprietary interest to the original insured. That is, the provisions may, in combination, qualify as an “in substance” PPSA security interest but not come within the exception - because the creation of a right of indemnity in favour of the original insured contingent upon extinguishment of the reinsured’s right, does not fit within the nexus of a transfer at general law. A cut-through which operates by extinguishing the reinsured’s chose in action and substituting a right of indemnity in favour of the original insured or which requires the reinsured to withdraw its claim, does not involve a transfer of the reinsured’s interest to claim against the reinsurer other than in a loose, non-technical sense. The original insured is not a legal or equitable assignee of the reinsurance proceeds. A separate indemnity right is created in its favour – albeit one that springs up contingent upon extinguishment of the reinsured’s chose in action.

A cut-through drafted as a direction to pay the reinsurance proceeds to the original insured upon occurrence of the prescribed financial impairment event similarly is technically not dispositive of the reinsured’s right of action. On that basis such a provision may not effect a “transfer” of the proceeds of the reinsurance – at least in any usual legal meaning of the term, but, instead, simply entail performance of the reinsurance contract upon its terms ie indemnification of the reinsured and payment of the proceeds as directed under the reinsurance contract.

If, on the other hand, these types of provisions are considered to come within the nexus of a transfer of an interest or claim in or under the reinsurance – say because the notion is considered to include provisions which operate so as to vest in the original insured the right to obtain payment of reinsurance proceeds that would, in the absence of such provisions, have been payable to the reinsured - then the question arises whether the exception is nevertheless not available because of the carve back for “a transfer of a right to an insurance payment or other payment as indemnity or compensation for loss of, or damage to, collateral (or proceeds of collateral)" would not appear to be applicable. The “collateral” ie the personal property to which a cut-through is attached, is the reinsured’s chose in action under the reinsurance contract. It is not “lost” or “damaged” within any usual or common sense of these terms - unless these terms are construed to involve the withdrawal, by voluntary agreement of the parties, of the reinsured’s right of indemnity in consideration for the substitution of a right of indemnity in favour of the original insured. There is no “fortuity” in this type of arrangement as regards the extinguishment of the reinsured’s chose in action - which the terms “lost” or “damaged” on a plain reading would suggest should be present for the carve back to be applicable. The carve back is relevant to a transfer of entitlement of insurance proceeds where, say, a security property is damaged or lost by fire or some other extraneous and uncertain peril. The only fortuity present under this type of cut-through provision is whether or not the reinsured in the future may become financially impaired. That, however, is not the immediate cause of the reinsured’s indemnity entitlement being extinguished. That is a direct function of the consensual agreement of the parties that upon such an occurrence the reinsured’s indemnity entitlement shall be extinguished and a substitute entitlement spring up in favour of the original insured.

Depending on the view that is formed as to whether the exemption applies (having regard to the actual terms of the cut-through clause), registration will be essential to perfect the security interest the cut-through creates.