From time to time the question is asked whether an insured (original insured) can contractually reserve to itself legal entitlement to the proceeds of reinsurance payable to an insurer (primary insurer) of the original insured. The question is usually raised in the context of strategies for mitigating the risk of a primary insurer becoming insolvent or otherwise financially impaired and, as a consequence, unable to discharge its indemnity obligations to the original insured.
One approach periodically floated to mitigating this risk is inclusion of a cut-through provision in the primary insurer’s outwards reinsurance.
What is a cut-through?
A cut-through provision is a term of a reinsurance contract (reinsurance contract) between a reinsurer and a primary insurer of an original insured reinsuring a contract of insurance (reinsured policy) between the primary insurer (as insurer) and the original insured (as insured) which term confers upon the original insured a right of action directly against the reinsurer to recover the reinsurance proceeds payable to the primary insurer in respect of the reinsured policy in the event of occurrence of prescribed events - usually, as noted, the primary insurer’s insolvency or other financial impairment. As a related term, it would be usual for the reinsurer to stipulate that any payment it makes under the cut-through provision to the original insured provides a discharge to it (the reinsurer) in respect of its liability to the primary insurer, and to any liquidator, receiver or other controller of the primary insurer, in respect of the claim triggering the reinsurance contract.
In this article we discuss some of the legal issues that are relevant to the enforceability of a cut-through provision. In overview these are:
- (potentially) an absence of privity of contract; and
- (potentially) want of a licence condition authorising the reinsurer to undertake liability by way of “direct” insurance; and
- (potentially) inconsistency with priority regimes under applicable insolvency laws. The operation of a cut-through provision, upon its terms, may also be affected by various statutory provisions enacted in relation to reinsurance proceeds or which include such proceeds in their ambit. Due to the density of the issues these provisions raise, including their interaction, they will be discussed in a future article.
Privity of contract
One objection to the enforceability of a cut-through provision is that it is not enforceable by the promisee ie original insured, under the doctrine of privity of contract.
However, if the clause is drafted to include, and it clearly stipulates:
- who is the original insured;
- what events trigger a direct right of action against the reinsurer by the original insured; and
- what the original insured is entitled to,
the absence of privity of contract between the original insured and the reinsurer and the fact consideration does not move from the original insured (if this is the case), should not be an impediment to the original insured being entitled to enforce the cut-through provision directly against the reinsurer where local law applies to the reinsurance contract. 1
As a result of the majority judgments in Trident General Insurance Co Ltd v McNiece (Trident)2, and subsequent cases, a promisee under a contract of insurance who is not a party to that contract can sue on the contract and the indemnity contained within it where, upon its terms, the insurance contract extends protection to that promisee. There is no reason in principle for limiting the authority of Trident to direct insurance. Accordingly, if a cut-through provision in a reinsurance contract governed by local law is drafted so as to conform with (a) to (c) above, an original insured with whom the reinsurer has a relationship of indemnity under the cut-through provision should be able to sue on the cut-through directly notwithstanding the fact the original insured is not a party to the reinsurance contract..
Whilst the Insurance Contracts Act 1984 (Cth) contains a provision - s 483 - which, for all practical purposes, has a similar operation to the conclusion reached in the majority judgments in Trident, that Act has no application to contracts of reinsurance4. However, to the extent a cut-through provision may involve the “reinsurer” under a contract of reinsurance undertaking liability by way of direct insurance to an original insured under a reinsured policy, arguments are available that the original insured can enforce the cut-through directly in reliance upon s48 of the Insurance Contracts Act. This is for the reason the cut-through is a provision of insurance and the Insurance Contracts Act applies to provisions of insurance contained in other agreements in some cases5. Regardless of the source of the entitlement - statute or common law - where local law applies to a cut-through provision in a reinsurance contract an absence of privity of contract between the reinsurer and the original insured should not be an impediment to its enforceability.
An absence of privity of contract may be an impediment to enforceability under applicable foreign law. This will of course depend on the jurisdiction of the governing law.
However, depending on the licensing or authorisation regime applicable, it may not be legally permissible for a reinsurer to enter into a reinsurance contract that confers upon an original insured direct rights against the reinsurer in respect of loss covered by a reinsured policy (ie where the primary insurer does not discharge its indemnity obligations under the reinsured policy). The concern is this: to the extent a direct relationship of indemnity does arise between the reinsurer and the original insured, albeit limited in its ambit to circumstances where the primary insurer is insolvent or financially impaired, functionally this may constitute direct insurance and not reinsurance in the relevant jurisdiction. This could be of special concern where the nexus criteria to the licensing requirement is not centred on undertaking liability under types of contracts (eg a contract of insurance) but undertaking liability, or carrying on business, by way of type of insurance. If the reinsurer is only authorised to carry on insurance business by way of reinsurance under its insurance licence or is only exempted from the requirement to hold a licence in respect of insurance business it underwrites in a jurisdiction in relation to the business of reinsurance, notwithstanding the indemnity obligation to the original insured is an incidental term of what is otherwise a reinsurance contract, the reinsurance contract, or at least a cut-through provision contained in it, may be illegal. That is in the sense the reinsurer is not appropriately licensed to undertake that type of insurance liability. In this case, a question may arise as to whether the cut-through provision (or the entire reinsurance contract) is void or unenforceable upon public policy grounds. Separately, an issue may arise as to whether an offence is commited for carrying on a type of insurance business for which a licence is required (and is not held) and what sanction the commision of that offence carries.
Licensing issues may arise under both foreign law and local law. Foreign law issues are outside the scope of this article. Below are some local law considerations.
Australian Financial Services (AFS) licensing issues
Whilst reinsurance is specifically exempted from being a financial product for the purposes of the AFS regime, as for the Insurance Contracts Act a contract that includes provisions of insurance is treated as being a contract of insurance for the purposes of the AFS regime to the extent of those provisions of insurance. This is the case even if the contract would not ordinarily be regarded as a contract of insurance8.
A cut through provision under which a reinsurer undertakes a direct relationship of indemnity with the original insured under a reinsured policy, even as an incidental rider to the reinsurance cover provided for the primary insurer, may be a financial product in its own right for the purposes of the AFS licensing, conduct and disclosure regime. This is the position notwithstanding the primary purpose of the contract is the provision of reinsurance cover (which is not a financial product). If the “reinsurer” does not hold an AFS licence with appropriate authorisations and would be required to do so because it is carrying on a financial services business in this jurisdiction (for which an exemption is not available) or taken to be 9 then a right to rescind the reinsurance contract may be available to the primary insurer10.
If the reinsurer is authorised by APRA then, depending on the conditions on its APRA authorisation and how the insuring obligations constituted by the cut-through would be classified (retail or wholesale based on the class of insurance liability undertaken under the cut-through and the profile of the original insured), the APRA wholesale exemption may be available from the AFS licensing regime for the cut-through cover.
APRA authorisation regime
If the reinsurer is not authorised by APRA then the question will arise whether the inclusion of a cut-through provision in a reinsurance contract involves the undertaking of a direct insuring obligation so as to give rise to a requirement for the reinsurer to be locally authorised. Reinsurance is expressly included within the definition of “insurance business" under the Insurance Act 1973 (Cth) - including for the purposes of that Act’s authorisation regime. However, a foreign insurer carrying on insurance business offshore who would only come within the local authorisation regime as a result of the nexus criteria for onshore conduct of someone acting on behalf of the insurer or by a broker11, is exempted from that regime to the extent the relevant insurance business so deemed to be carried on locally is solely reinsurance. That exemption, however, would not be available to the extent the undertaking of liability under a cut-through clause/s is not a business of reinsurance.
A broker arranging reinsurance with a cut-through provision could also be carrying on a financial services business for which it requires an AFS licence - even though it is a reinsurance broker and as regards its business of arranging and advising on reinsurance it is not required to hold an AFS licence (for the reason, in this regard, it is not carrying on a financial services business for the purposes of the AFS regime). A broker who holds an AFS licence may also technically be contravening the requirement in Chapter 7 of the Corporations Act 2001 (Cth) to only deal in general insurance underwritten by an insurer who is locally authorised or exempted from that requirement12 where it places a contract of reinsurance containing a cut-through provision with a foreign reinsurer who is not locally authorised - if the inclusion of a cut-through provision brings the foreign insurer outside the exemption (discussed above) from the local authorisation regime under the Insurance Act for a foreign insurer who solely carries on a business of reinsurance locally.
Direction to pay
A cut-through clause that, upon its terms, is merely a ‘direction to pay’ the proceeds of the reinsurance to the original insured in the event of the primary insurer becoming insolvent or financially impaired but which is not a separate and independent indemnification by the reinsurer of the original insured, or other undertaking of liability by way of insurance to the original insured, is less likely to involve a reinsurer undertaking a liability for which it is not licensed. It is also less likely to come within the ambit of the Insurance Contracts Act.
In this case, however, another enforcement issue may arise. It is a contestable issue whether a provision that in substance merely directs payment to the original insured of proceeds payable to the primary insurer entitles the original insured to sue on the contract under the principles laid down in Trident or in reliance upon s48 of the Insurance Contracts Act ie in the event that the original insured is not a party to the reinsurance contract. In this case the original insured is not a promisee of the insurance cover under the reinsured policy in the sense of being a third party beneficiary outside the contractual nexus to whom the reinsured policy extends protection upon its terms. It is the beneficiary of a direction to pay contained in the reinsured policy. Possibly, neither s48 of the Insurance Contracts Act nor Trident relaxes the rule of privity of contract to this extent.
Inconsistent with priority provisions in insolvency laws
Another objection to the enforceability of cut-through clauses is that they, and/or payments under them, breach the priority regime under applicable insolvency laws - for the reason such a clause and/or payments under it purports to give priority to one unsecured creditor in a manner inconsistent with the statutory priority regime.
A related issue is whether a cut-through clause constitutes a charge over or agreement to assign proceeds payable under the reinsurance contract and, if so:
- whether it needs to be registered or otherwise perfected in order to be enforceable; and
- when is the security interest created.
Among other things, these are relevant considerations because:
- a registrable security interest which is not registered in accordance with an applicable regime for registration of charges; and
- a security interest given over a company’s assets when it is insolvent or financially impaired,
will be likely to be void as against a liquidator or administrator of the company. The security interest could be void for the reason it is registrable and has not been registered as required. It may also be void if it only springs up at the time the primary insurer becomes insolvent or financially impaired - for the reason it entails the primary insurer’s property (the reinsurance proceeds) being applied to satisfy an unsecured creditor’s claim in a manner inconsistent with the priority regime under applicable insolvency laws.
The harder factual scenario is a cut-through provision which is more than a re-direction of proceeds payable to the primary insurer; that is one under which the primary insurer’s chose in action and the reinsurer’s corresponding indemnity obligation, expire or terminate and a substitute (economically equivalent) monetary obligation on the reinsurer in favour of the original insured springs up (possibly subject to a condition precedent that the original insured withdraw its claim upon the primary insurer). The question in this case is whether, by disapplying liability to the primary insurer and substituting a monetary obligation in favour of the original insured, this constitutes a re-direction or, alternatively, an annihilation of, a debt or other property of the primary insurer. That is: does the primary insurer’s chose in action and right of indemnification expire and an independent chose in action entailing discrete monetary obligations spring up.
It is at least open and arguable that the legal effect would still be a distribution (or attempted distribution) of property of the primary insurer (namely, reinsurance proceeds) in a manner which is at risk of being inconsistent with the priority regime under applicable insolvency laws. The clause arguably effects a change in a chose in action or indemnification right of the primary insurer which is enlivened upon insolvency or financial impairment of the primary insurer. Further it may be a security interest and void because it springs up on insolvency or financial impairment. Alternatively it may be void because it is not registered.