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Cut-Throughs to the Rescue

Whenever A.M. Best, Standard & Poor’s, Moody’s or Fitch drop an insurance company’s rating below an A, businesses become worried that an insurance company might not have enough capital to pay their claims. To reassure the risk managers of these businesses, insurers often seek cut-throughs from their reinsurers.

A cut-through is an endorsement to a reinsurance agreement that requires the reinsurer, in the event of the ceding company’s insolvency, to pay a loss covered under the reinsurance agreement directly to the insured or its beneficiary. The endorsement gets its name because reinsurance claim payments “cut through” the usual route of payment from reinsured company-to-policyholder, substituting instead payment of reinsurer-to-policyholder. A cut-through affects the payment only, and does not increase the risk to the reinsurer. Most cut-throughs are provided only for property, almost never for casualty, unless the cut-through can be limited to claims on a yearly basis.

Those insurance companies that get a cut-through from reinsurers are borrowing the size and rating of their reinsurers. A cut-through permits the insured or its beneficiary to collect insurance proceeds directly from the reinsurer if the insurer becomes insolvent. The insured does not have to wait for the liquidator of the insolvent insurer to pay claims, usually paid at a discount, which could take years.

A cut-through can be written on a blanket basis, where the reinsurer assumes liability for a complete line, or for specific policies. The fee or surcharge paid to the reinsurer can vary considerably, depending on how urgent the primary insurance company needs the cut-through and how willing the reinsurer is to consent to the plea.

Because of the continuing hard insurance market, obtaining a cut-through is difficult for a downgraded insurer. One reason for the difficulty is in the event of an insurer insolvency, the reinsurer has to become involved with adjusting claims. Because reinsurers don’t handle claims directly, they would have to hire a third party.

Further complicating the cut-through provision is determining which policies have the cut-through and which do not in the event of insolvency. Sometimes, records of the insolvent insurer can be incomplete or missing, and the reinsurer has to spend considerable expense to determine which claims are to be paid to the receiver and which to the beneficiary of a cut-through. If the accounting is not carefully fulfilled, the reinsurer may pay the same claim twice.

State insurance regulators are opposed to cut-throughs, arguing they give an unfair preference to sophisticated insurers and third parties at the expense of consumers and should not be enforced. The officials contend that reinsurers have a statutory obligation to pay reinsurance proceeds to the receiver of an insolvent insurance company.

Almost every state requires that reinsurance contracts contain an “insolvency clause” if the cedent is to receive financial statement credit for the reinsurance. An insolvency clause obligates the reinsurer to pay claims to the receiver of the cedent without diminution due to the insolvency of the cedent. A guiding principle of receiverships of insolvent insurers is that all creditors of the same class are treated equally. Ordinarily, this means all policyholders and loss payees would be paid the same proportion of their allowed losses.

But in some states, the “insolvency clause” contains language allowing payment of reinsurance proceeds directly to the insured if there are cut-through provisions. This difference can cause conflicts between contractual cut-throughs and receivership policy and case law on the other.

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