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Insurance Law

Consequences of Insurer Insolvency – New Appleman on Insurance Law Library Edition, Chapter 102

By Bruce Baty and Jodi Adolf


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Chapter 102 discusses the consequences of an insurer insolvency for the policyholders, agents, excess insurers and reinsurers of the insolvent insurer.

The chapter begins in Section 102.01 with a general discussion of the liquidation process, and then considers the impact of an insurer insolvency on the policyholders of the insurer.  In most instances, after an insurer has been placed in receivership by a state insurance Superintendent or Commissioner, the policies that were issued by the insurer are canceled upon a set number of days after entry of the court approved order of liquidation, often 30 days.  A bar date is set before which proof of claim forms must be submitted, and policyholders are advised as to the procedures they must follow in order to perfect a claim against the insolvent estate.  A policyholder claim may be an “absolute” claim (a claim of certain liability) or a “contingent” claim (a liability imposing event has occurred but it is uncertain that the claim will be made or coverage and liability established).

A policyholder remains liable to the insolvent insurer for any earned premiums due and owing at the time of the liquidation, and failure to make these premium payments may bar policyholders from participating in any recovery of assets from the estate.  Policyholders, however, are not liable for, and may recover, any unearned premiums after the insurer is placed in liquidation.

State insolvency statutes generally establish priorities for recoveries from the assets of insolvent insurers, and policyholder claims, although subordinate to the expenses of administering the estate, enjoy priority over all other classes of creditor claims.  All claims within a priority class are paid in full before payment is made to the next lower class, and within a class, all claims are paid pro rata if there are insufficient funds to pay the class in full.

Within the policyholder priority class are the claims of the state insurance guaranty funds.  These state guaranty funds, established by state law to protect insureds in the event of the financial failure of an insurer, take on the claims-paying responsibilities of the failed insurer upon liquidation.  These guaranty funds are financed by surcharges on all solvent insurers doing business in the state, and will pay claims subject to coverage limitations and limits of liability that vary by jurisdiction.  Upon payment of the policyholder’s claim, the state guaranty fund is then subrogated to the rights of the policyholder and participates in the policyholder priority class of creditors in the distribution of estate assets.

The chapter next considers in Section 102.02 the impact of an insurer insolvency on the agents and producers of the insurer.  Generally, when an insurance company is placed in liquidation, agency contracts are terminated unless the liquidator extends or renews the agency contract, and any property belonging to the insurer in the hands of an agent at the time of liquidation now belongs to the liquidator, and must be turned over to the liquidator upon demand.  This property includes premiums that the agent may have collected from policyholders prior to liquidation, and the obligation to turn over any premiums the agent has collected includes not only earned, but also unearned premium.  In most states, an agent may not retain premiums as an offset against any commissions due; instead, the agent must turn over the premiums in its possession, and seek the recovery of any unpaid commissions through the liquidation’s claims procedures.  An agent’s right to commissions ends when the agency contract is terminated by liquidation.  In the event the liquidator is able to sell the insolvent insurer’s policies to another solvent insurer, an agent generally has no right to continuing commissions on that business because an agent’s commissions are generally considered earned when the policy is originally issued and they are due and owing from the original insurer.

When an agent has placed business with an insurer that subsequently becomes insolvent, the agent usually is not held liable for any losses sustained by the policyholder because the agent is not considered a guarantor of an insurance company’s solvency.  Liability may be imposed upon the agent, however, if the agent placed the policy with an insurer that the agent knew or should have known was insolvent at the time the policy was placed.  A few courts have held agents liable for damages to policyholders arising out of a subsequent liquidation of an insurer if the agent knew or should have known of an insurer’s financial difficulties and likely insolvency at the time the policy was placed.  Under this exception, the agent may have a duty to notify the policyholder of the insurer’s financial difficulties.

The chapter then considers in Section 102.03 the implications of an insurer insolvency for any excess insurers of the insurer.  Excess insurers whose coverage sits on top of a primary insurer are exposed to demands by policyholders to “drop down” and provide the coverage that the primary insurer can no longer pay due to the primary insurer’s insolvency.  Excess insurance is affordably priced based on the assumption that the risk of loss will rarely pierce the primary layer, and therefore excess insurers do not have the premiums to fund losses at the primary layer.  Nevertheless, a number of courts have held that language in an excess policy that provides that coverage is excess to “collectible” or “valid and collectible” insurance is sufficient to hold an excess insurer liable for the primary layer of coverage when the primary insurer has gone into liquidation.  Reacting to these court decisions, the insurance industry responded with excess insurance policy language that makes it clear that excess coverage is not triggered unless the primary coverage has been reduced or exhausted by actual payment.  Even with this language, however, a few courts will still find, based on the specific circumstances of the case, and perhaps guided by public policy concerns, that excess insurers are required to “drop down” in the event of the primary insurer’s insolvency.

The chapter concludes with Section 102.04 discussing the impact of an insurer’s insolvency on the reinsurers of the insurer.  Under normal circumstances, the insurer (the reinsurer’s reinsured) must first pay a loss and then seek reimbursement from its reinsurer, because the reinsurance agreement is considered to be a contract of indemnity.  When an insurer is placed in liquidation, however, a reinsurer’s obligations are now triggered by the insolvent insurer’s liability for loss.  The reinsurer must continue to make payments to its reinsured as the liquidator goes about the process of determining and allowing claims as part of the estate’s claims procedures, even though the insolvent insurer is no longer making payments to policyholders.  Originally, this was not the case. In order to prevent what was seen as a windfall to reinsurers, state legislatures enacted “credit for reinsurance” laws. These laws require that reinsurance agreements contain an “insolvency clause” (providing that reinsurance obligations are payable to the insolvent insurer’s receiver on the basis of claims allowed and without diminution because of the insolvency), before an insurer may take financial statement credit for the reinsurance.  An exception to this requirement to pay reinsurance proceeds to an insolvent insurer’s liquidator is when the reinsurance agreement itself contains an express cut-through clause, which permits a reinsurer to make its reinsurance payment to the direct insured (the policyholder); the direct insured could not otherwise access these funds because of its lack of privity of contract with the reinsurer.  Many state insurance insolvency statutes provide for this exception to the “insolvency clause” rule.  In addition, a few courts have held that, under certain or limited circumstances, a direct insured could access the insolvent insurer’s reinsurance under a third-party beneficiary theory.

Other than this transformation of the reinsurance agreement from a contract of indemnity to a contract of liability, the contractual rights and obligations of a reinsurer remain intact in an insurance liquidation.  The reinsurer is entitled to reinsurance premiums owed under the agreement, to notice of claims as provided for in the agreement, and under most circumstances, to setoff rights, except as may be specifically limited or restricted by state statute.  In the event of a dispute with the liquidator of the insolvent insurer, courts remain split on whether a reinsurer may enforce an arbitration clause and require a liquidator to resolve any disputes before a private arbitration panel or the liquidation court.

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Bruce Baty is a partner with Dentons US LLP in Kansas City, MO, where he concentrates in the areas of insurance regulation and reinsurance.  Mr. Baty currently serves as the Special Deputy Receiver of National States Insurance Company in Liquidation.  He is an active member of AIDA Reinsurance & Insurance Arbitration Society (ARIAS) and organizes and hosts the annual Heartland Insurance Symposium for insurance professionals and regulators.  His presentations at this event have included a wide range of topics, including insurance insolvency issues.  He received both his B.A. and J.D. from the University of Notre Dame. 

Jodi Adolf is a partner in Dentons US LLP insurance practice in Kansas City, MO.  Her practice focuses on regulatory and compliance matters related to life, accident and health, and property and casualty insurance.  Ms. Adolf provides full service to clients by addressing their regulatory issues and handling any litigation and/or arbitrations that may arise.  As general counsel to the Liquidator of National States Insurance Company, a Missouri-domiciled

life and health company, Ms. Adolf represents the Liquidator in all of his dealing with other state departments of insurance and the affected and the affected state insurance guaranty association and oversees the day-to-day operations of the receivership estate.  Ms. Adolf is an active member of AIDA Reinsurance & Insurance Arbitration Society (ARIAS) and organizes and hosts the annual Heartland Insurance Symposium for insurance professionals and regulators.  She received her B.A. from Southern Connecticut State University and her J.D. from Washburn University School of Law.

The authors wish to thank colleagues Gayle Levy, Partner with Dentons US LLP in New York, NY, Bella Shirin, Managing Associate with Dentons US LLP in San Francisco, CA, and Adam Pankratz, Senior Managing Associate with Dentons US LLP in Kansas City, MO for their invaluable assistance.

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§ 102.01 Consequences of Insurer Insolvency for Policyholders

[1] Insurance Insolvency Rehabilitation and Liquidation

[2] Premium Obligations

[3] Priority of Claims

[4] State Guaranty Funds

§ 102.02 Consequences of Insurer Insolvency for Agents

[1] Agency Contracts

[2] Premiums

[3] Commissions

[4] Agent Liability for Placing Insurance With an Insolvent Insurer

§ 102.03 Consequences of Insurer Insolvency for Excess Insurers

[1] Distinction Between Primary and Excess Insurance

[2] Types of Excess Insurance

[a]  “Follow Form” Policies

[b] Umbrella Policies

[3] When Excess Insurer Drops Down to Take the Place of Insolvent Insurer

[a]  Review of the Policy to Determine Parties’ Intent

[i] Generally, Drop Down Requirement Must Be Explicitly Stated, but There Are Exceptions

[ii] Interpreting Collectability Provision

[iii] Interpreting Loss Payable Provision

[iv] Interpreting Other Policy Provisions

[b] Public Policy and Drop Down

[c] Attempting to Limit Drop Down by Express Policy Provisions

§ 102.04 Consequences of Insurer Insolvency for Reinsurers

[1] Effect of Insolvency on Reinsurer’s Obligations to Insolvent Insurer

[a]  Reinsurance Contracts

[b] Insolvency Clause

[c] Reinsurer Setoffs

[2] Original Policyholders’ Right to Seek Reinsurance Benefits

[a]  Lack of Privity

[b] Third-Party Beneficiary Theory

[3] Right to Arbitration or Obligation to Appear in Supervising Court

[4] Reinsurer Defenses to Coverage

[a]  Loss Notification

[b]  Contract

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