Reinsurance. Piercing The Veil Of Reinsurance: Reinsurance Cut Throughs In Insurance Carrier Insolvencies MEALEY S LITIGATION REPORT

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1 MEALEY S LITIGATION REPORT Reinsurance Piercing The Veil Of Reinsurance: Reinsurance Cut Throughs In Insurance Carrier Insolvencies by Joseph C. Monahan, Esq. Saul Ewing LLP Philadelphia, PA A commentary article reprinted from the January 20, 2005 issue of Mealey s Litigation Report: Reinsurance

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3 LexisNexis MEALEY S LITIGATION REPORT: Reinsurance Vol. 15, #18 January 20, 2005 Commentary Piercing The Veil Of Reinsurance: Reinsurance Cut Throughs In Insurance Carrier Insolvencies By Joseph C. Monahan [Editor s note: Mr. Monahan is a reinsurance litigator with Saul Ewing LLP in Philadelphia, and a member of the firm s Insurance Practice Group. Replies to this commentary are welcome. Copyright 2005, Joseph C. Monahan.] As market conditions force primary insurance carriers into increasingly precarious positions, they are finding themselves in reorganization or liquidation proceedings with more frequency. Among the many issues such an insolvency raises, one particular issue that arises with regularity is the question of what happens to the reinsurance that may be payable to the insolvent insurance carrier. Specifically, is that reinsurance an asset of the insolvent carrier, reserved for distribution to its creditors, or is it owed directly to the primary carrier s insureds? This article explores that question. The general, even constant and uniform, principle of law in this country is that the original insured cannot enforce his insurer s contract for reinsurance against the reinsurer because the original insured is not a party to or in privity to that contract of reinsurance. Fontenot v. Marquette Casualty Co., 247 So.2d 572, 576 (Louisiana 1971). Consistent with its status as the general, even constant and uniform principle of law, this rule has been cited routinely by a number of courts. Mellon v. Security Mutual Casualty Co., 5 Phila.Co.Rptr. 400, 1981 WL (1981); Koken v. Reliance Insurance Company, 846 A.2d 167 (Pa. Cmwlth. 2004); Venetsanos v. Zucker, Facher & Zucker, 638 A.2d 1333, 1339 (N.J. Super. 1994) ( original insured does not enjoy a right of direct action against a true reinsurer ); Allendale Mutual Insurance Company v. Crist, 731 F.Supp. 928 (W.D. Mo. 1989). Even when recognizing the general rule, however, courts have cited to a number of exceptions to it. The traditionally-cited exceptions are where the reinsurer by his actions and relations with the original insured directly assumes the insurer s responsibility and liability, where the reinsured and reinsurer merge and where the contract of reinsurance expressly and specifically provides for direct liability to the original insured (and this last is not really a contract of reinsurance but is a type of coinsurance.) Fontenot at 576. At least one court has described this first exception to the general rule as a novation of the reinsurance agreement. Koken v. Reliance Insurance Company, supra. Other courts have articulated the last of those listed exceptions somewhat differently, finding an exception to the general rule where a proper third-party beneficiary contract to that effect may be found Eastern Engineering & Elevator Co., Inc. v. American Re-Insurance Company, 455 A.2d 1235, 1236 (Pa. Super. 1983), citing 19 Couch on Insurance 80:67 at 959 (R.A. Anderson ed., 2d ed. (1959); Allendale Mutual Insurance Company, supra. In determining whether to apply one of the recognized exceptions to the general rule that an insured has no direct right of action, or cut-through, to the reinsurance otherwise payable to its insolvent primary insurance carrier, courts have been careful to examine the particular facts of each case, and have been reluctant to find that a broad exception applies. 1

4 Vol. 15, #18 January 20, 2005 LexisNexis MEALEY S LITIGATION REPORT: Reinsurance In Reid v. Ruffin, 469 A.2d 1030 (Pennsylvania 1983), the plaintiff was injured in an automobile accident when he was struck by a car driven by defendant. Defendant was insured by Granite Mutual Insurance Company, who, in turn, was reinsured by Security Mutual Insurance Company. Leading up to trial, Granite made several offers to settle, all of which were rejected. Security was made aware of Granite s offers to settle. At trial, plaintiff was awarded a significantly greater amount than the largest of the settlement offers. Plaintiff charged both Granite and Security with bad faith refusal to settle. By that time, however, Granite was insolvent. Noting the general rule regarding cut-throughs, and its exceptions, the Reid court nevertheless found that plaintiff had no right of action against Security, as reinsurer of Granite. Because the reinsurer has not assumed a contractual duty to represent the original insured, he has no obligation to the original insured which he must discharge in good faith. The reinsurer s only obligations are toward the reinsured/original insurer and arise out of their contract. Because the Appellant is not privy to that contract and has no interest therein, no enforceable rights inure to his benefit therefrom. Reid at In so holding, the court rejected the plaintiff s alternate argument that since the contract of reinsurance provided Security with the right to consent to all settlements, Granite was acting as Security s agent. Reid at The court emphasized that the right to consent to a settlement was distinct from the right to approve of decisions not to settle. In contrast to Reid, supra, the Superior Court of New Jersey has charged a reinsurer of an insolvent insurance carrier with liability for failure to settle a claim in good faith within the policy limits, thus piercing the technical veil of reinsurance. Venetsanos v. Zucker, Facher & Zucker, 638 A.2d 1333, 1337 (N.J. Super. 1994). In Venetsanos, Homestead Insurance Company, the reinsurer, was a 100% reinsurer of the policy at issue, with the insolvent primary carrier serving as a front. Through discovery, it became clear that Homestead was responsible for underwriting primary risks, and for negotiating the settlement of claims, including that of the plaintiff. In holding Homestead liable, the court recognized the general rule that would insulate a reinsurer from claims from the primary insured, but noted that where the reinsuring agreement itself provides, or the conduct of the reinsurer demonstrates, that it takes charge of and manages the defense of suits against the original insured, the reinsurer may be held to be in a privy to the action. In such cases, judgment creditors of the insured have been allowed to proceed directly against the reinsurer. Venetsanos at The court went on to note a series of factual differences from the situation in Reid, supra. In Reid, unlike in Venetsanos, the reinsurer only reinsured 25% of the risk, and did not control settlement negotiations, but only had the authority to approve settlements. The Venetsanos court explained that the Reid court had not found this reservation of authority to approve settlement was sufficient to justify imposition of liability on the reinsurer for bad faith refusal to settle. Venetsanos at In General Reinsurance Corporation v. Missouri General Insurance Co., 458 F.Supp. 1 (W.D. Mo. 1977), the court considered the interpleader action initiated by the reinsurer in order to resolve who was entitled to receive payment of the reinsurance owed to the insolvent primary carrier (Missouri General Insurance Company), the carrier s receiver or the Mississippi Insurance Guaranty Association (the Association ). In finding that the receiver was entitled to the funds, the court rejected all of the arguments made by the Association. The Association first argued that Missouri General s insured was a third party beneficiary of the reinsurance contract. It followed, according to the Association, that once the Association paid the claim of that insured, it became subrogated to the claim of the insured/third-party beneficiary. In rejecting that proposition, the court cited to both the acknowledged general rule that an original insured may not bring an action against a reinsurer because of the absence of privity of contract and to the express language of the reinsurance contract. General Reinsurance at *3-4. The reinsurance contract provided that proceeds thereof can only be paid to the reinsured company, and, in the event of its insolvency, to its receiver. The contract further provided that in no instance shall any insured of the Company or any claimant against an insured of the company have any rights under this Agreement. General Reinsurance at *3. Nevertheless, relying on a line of Missouri cases that found an exception to the general rule against cut-throughs based on the third-party beneficiary status of the insured, the Association argued that the contractual language 2

5 LexisNexis MEALEY S LITIGATION REPORT: Reinsurance Vol. 15, #18 January 20, 2005 of the reinsurance agreement established Missouri General s insured as a third-party beneficiary. The Missouri cases cited had found such liability based on the contractual language that the liability of the reinsurer shall follow that of [the reinsured] in every case and be subject in all respects to all of the general and special stipulations, clauses, waivers and modifications of [the reinsured s] policy. See First National Bank of Kansas City v. Higgins, 357 S.W.2d 139 (Mo. 1962); Homan v. Employers Reinsurance Corp., 136 S.W.2d 289 (Mo. 1939). The court found that the contract s most closely analogous language was required to be in the agreement pursuant to Missouri statute, did not track the language in Higgins and Homan, and specified that the reinsurance was payable to the insolvent carrier s receiver. General Reinsurance at *4. See also Excess and Casualty Reinsurance Association v. Insurance Commissioner of California, 656 F.2d 491 (9th Cir. 1981) (receiver of insolvent primary carrier, rather than state insurance guarantee association that had paid claims owed by that carrier entitled to reinsurance proceeds). The General Reinsurance court also rejected the Association s claim that it should be entitled to the reinsurance proceeds on grounds of public policy. Id. In another case out of Missouri, Allendale Mutual Insurance Company v. Crist, 731 F. Supp. 928 (W.D. Mo. 1989), the court considered the same issue as in General Insurance, indicating that a reinsurer is only liable directly to the insured where the terms of the reinsurance contract clearly express the intent that the insured is a third party beneficiary of the agreement. In so noting, the Allendale court cited Homan, supra and Higgins, supra, among other cases, but held that the agreements at issue did not expressly establish third-party liability for the reinsurer of the insolvent Transit Casualty Company. Allendale at 931. The court also rejected the insureds argument that they had become third party beneficiaries by virtue of the reinsurers actions. In furtherance of this argument, the insureds claimed that Transit was essentially a fronting company, retaining only 1% of the risk and ceding the balance to the reinsurers. Moreover, all premium payments were made to an agent, which had authority to write policies on behalf of Transit. Transit was only paid premium on its retention, plus commission. Of the more than $1 million paid to the insureds on a particular loss, the reinsurers had paid the entire amount through an intermediary. In fact, Transit was not involved in the transaction at all. At least one reinsurer had made the unusual request to review the adjuster s notes. Allendale at Nevertheless, the court rejected that argument, and rejected the notion that direct liability can be created only by acts of the reinsurers absent language in the reinsurance contract creating direct liability. Allendale at 933. The cut-through issue has been central in two recent insurance company insolvencies in Pennsylvania those of Legion Insurance Company and Reliance Insurance Company. In Koken v. Legion Insurance Company, 831 A.2d 1196 (Pa. Cmwlth. 2003) the court granted the petition of the Pennsylvania Insurance Commissioner to transform the Legion rehabilitation into a liquidation. In the process, however, certain of Legion s insureds were permitted to intervene to explain what impact a liquidation would have on them. Legion was primarily a fronting company that operated in one of two ways. Through its corporate account business, it issued policies that were reinsured by captive reinsurers. Through its program business, Legion wrote policies for a homogenous group of commercial risks presented to it by a managing general agent. Legion ceded nearly all of the underwriting risk to its reinsurers. Legion at Claims against the Legion policies were handled by a third-party administrator. Legion maintained a thinly staffed underwriting and claims department. As the Legion court explained, under both business models, Legion s insureds were policyholders in name only; in effect, they were self-insureds that used Legion... as a means of obtaining stop-loss coverage from a reinsurer. Id. When Legion experienced cash flow problems, it entered rehabilitation. Prior to that time, certain of its reinsurers made direct payments to its insureds. After the rehabilitation orders were entered, the Rehabilitator rejected similar offers. Id. at The Legion court considered the claims of the intervenor/insureds. The circumstances of each insured s Legion policy coverage differed, but in all such cases, it was clear that Legion was little more than a fronting carrier, retaining very little of the risk, if any. At least one of the insureds had negotiated directly with the reinsurer 3

6 Vol. 15, #18 January 20, 2005 LexisNexis MEALEY S LITIGATION REPORT: Reinsurance of its risk, and only when that reinsurance was in place did it request that Legion issue a fronting policy. Legion at With respect to another of the insureds, Legion played no role in the claims process, and never attended any of the annual claims handling meetings between the insured and the reinsurers. Id. at The intervenor/insureds objected to the Rehabilitator s suggestion that the reinsurance proceeds become general assets of Legion. They instead claimed a right of direct access to that reinsurance. Noting that the general rule in liquidations is to deny insureds direct access to reinsurance, the court indicated that in most liquidations, reinsurance proceeds become general assets of the estate. Legion at The court proceeded, however, to find that the general rule has no application to Legion, since it was the policyholder intervenors, not Legion, that had placed the reinsurance, and because Legion neither adjusted nor funded claims. Id. at The court held that all of the intervenors could demonstrate that they were third-party beneficiaries of the reinsurance agreements, in spite of the differences in their circumstances. Id. at In so holding, the court emphasized that the parties intended the reinsurer to assume all underwriting risk, Legion s role was that of a fronting company, and the parties did not intend that Legion use the proceeds of the reinsurance for its general business purposes. Id. To the contrary, the reinsurance proceeds were used exclusively for the payment of the intervenor/insureds claims. In reaching its decision, the Legion court was mindful of its obligation to examine the reinsurance arrangements in their entirety. Id. at See also Mellon v. Security Mutual Casualty Company, 5 Phila.Co.Rptr. 400, , 1981 WL (Pa.Com.Pl. 1981) (finding no third-party beneficiary status, but recognizing that resolution of whether insured of insolvent insurer is third party beneficiary of reinsurance contract must be made on a case-by-case basis, viewing the plain language of the agreement in light of the generally recognized functions and purposes of reinsurance. ) The issue was considered by the Pennsylvania court even more recently in Koken v. Reliance Insurance Company, 846 A.2d 167 (Pa. Cmwlth. 2004). After Reliance Insurance Company was placed into liquidation, two of its insureds sought recovery of the reinsurance proceeds otherwise payable to Reliance. In considering the issue, the court found that Reliance reinsured 100% of the risk to its reinsurer, and paid to the reinsurer 100% of the premium it received, less a 5% commission. The court also found that the reinsurance agreement in question did not contain a cut-through clause, that would allow for the direct payment of the reinsurance proceeds to the insured. Reliance at The court noted that the recognized general rule against cut-throughs can be modified where the reinsurance contract has language that allows for a direct payment to the insured or where a novation has occurred. Id. at 171. The court went on to note that because contractual privity is not limited solely to instances of a writing, and words and conduct can give rise to a contractual relationship, that principle may also be modified by the conduct of the parties. Id. Applying these principles, the Reliance court found that the parties had effected a novation of the reinsurance agreement their conduct, entitling the insureds to a direct recovery of the reinsurance proceeds from the reinsurer. Id. As support for this conclusion, the Reliance court relied on three essential facts. For one, the reinsurer had requested to assume the direct liability of the original insured. Secondly, there was evidence that suggests that a familiar relationship existed between the three principals,i.e. the insured... the primary insurer... and the reinsurers. Finally, it was apparent that the insureds had little or no contact with Reliance and seemingly exclusive contact with the reinsurer. Id. at 171. The Reliance court further noted that one effect of this novation is that the insured stands in the shoes of the primary insurer and elects to accept as its exclusive remedy recovery under the reinsurance agreement, thus effectively releasing the primary carrier from all liability that may have resulted under the insurance contract. Id. at Conclusion The issue of whether or not an insured is entitled to cut-through to the reinsurance proceeds otherwise due to its insolvent insurer must be resolved on a case-by-case basis, taking into account the language of the reinsurance agreement at issue, the conduct of the parties and the degree to which the insurer retained risk as opposed to serving as a mere fronting company. The more an insured can demonstrate that the insolvent carrier functioned as a front, and the more of a role the insured had with respect to placing the reinsurance at issue, the better the chances that the insured will be able to recover directly from the reinsurer. If it cannot do so, it is more likely that the reinsurance proceeds will be considered an asset of the insolvent primary carrier. 4

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8 MEALEY'S LITIGATION REPORT: REINSURANCE edited by Marcy Kowalchuk The Report is produced twice monthly by Mealey Publications P.O. Box King of Prussia, Pa, USA Telephone: (610) Fax: (610) MEALEYS ( ) Web site: ISSN