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Emmanuèle Lutfalla and Nour Jonot examine cut-through clauses in Insurance Edge

By Emmanuèle Lutfalla & Nour Jonot

Partner Emmanuèle Lutfalla and Associate Nour Jonot carry out a deep-dive into cut-through clauses, the legal issues to try and circumvent, as well as current market practice for dispute resolution.

Emmanuèle and Nour’s article was published in Insurance Edge, 9 April 2024, and can be found here.

A cut-through clause is a provision of a Reinsurance agreement (usually facultative) between a Reinsurer and a primary Insurer, reinsuring an insurance policy between the Insurer and the Insured.  A cut-through clause provides the Insured with a direct right of action against the Reinsurer to recover the reinsurance proceeds payable to the Insurer in respect of the Policy.

Cut-through clauses are not often used on the French market because of a public policy provision which provides that the Insurer remains solely liable to the Insured[1]. Thus in France, the Insured’s legal relationship only exists with its Insurer, and the first has in principle no recourse against the Reinsurer.

This stems from the principle that the Reinsurance agreement drawn up between the Insurer and the Reinsurer does not create any legal relationship between the latter and the Insured, as per a legal principle in France called “l’effet relatif des contrats”[2].

The recourse to cut-through clauses are nonetheless used to cover risks which are mainly located in South America and Asia. Each and every French Reinsurer needs to check if it fits its requirements, whether formally or in content.

What about formalism?

Cut-through clauses are usually drafted, alternatively or cumulatively:

  • in the cover note during the underwriting process;
  • as a special clause in the Reinsurance agreement;
  • as an endorsement to the Reinsurance agreement.

Why are cut-through clauses useful?

Cut-through clauses are used:

  • in countries where insurance with a local Insurer is mandatory and when the latter does not meet solvency expectations;
  • when the Insurer has insufficient financial rating to attract large commercial Policyholders;
  • when the insured risk is very important;
  • in fronting arrangements, where the Reinsurer is not licensed in a particular jurisdiction and intends to retain all of the risk from the Policy.

They benefit the Insured as a cut-through provision is a safety net when the Insurer is insolvent. It spares the Insured the risks and paperwork associated with insolvency proceedings (assuming the Reinsurer remains solvent) and allows the Insured to have more control in cases where the administration and claims handling is borne by the Reinsurer – as large commercial Insureds may not engage with an Insurer unless they have some assurance that the Reinsurer standing behind the Insurer will be liable to the Insured in the event the Insurer is unable to fulfil its policy obligations. Some Insurance programs are structured in such a way that the Reinsurer is, for all intents and purposes, the true Insurer-in-interest and the Insurer is merely fronting the deal.

They benefit the Reinsurer as a cut-through clause functions as a competitive tool, which enables the Reinsurer to capture a certain type of reinsurance business and help the Insurers that are not licensed in a particular area to provide reinsurance. Reinsurers, however, tend to avoid cut-through clauses to avoid direct exposure in lieu of the Insurer.

Some likely legal issues encountered with cut-through clauses?

The insolvency of the Insurer:

Reinsurers could be subjected to double payment as the Insured is a beneficiary under the Reinsurance contract and be held liable towards both the Insurer and the Insured. A direct payment to the Insured might not free the Reinsurer when the insolvent Insurer as a liquidator or official receiver can request the payment again. Reinsurers thus sometimes include in cut-through clauses that any payment they make under the cut-through provision to the Insured provides a discharge to the Reinsurer in respect of its liability to the Insurer, and towards any liquidator, receiver or other controller of the Insurer, in respect of the claim triggering the Reinsurance agreement.

Breaching of local regulation in force:

There is sometimes a need of a licence condition authorising the Reinsurer to undertake liability by way of direct insurance – licensing issues may arise under both foreign and local law.

Failing that licence, Reinsurers could unintentionally breach applicable laws or regulations, as the direct payment made by the Reinsurer may be considered as insurance activity for which the Reinsurer might not be licensed to act as in the relevant country. This could cause fines and penalties depending on the applicable law of the country.

There is also a risk of breaching of local insolvency laws with the creation of preferential rights between Insureds in contravention of the relevant country’s bankruptcy laws by providing compensation to some Insureds which benefit from a cut-through clause rather than others, even though they all bear the consequences of the bankruptcy of their Insurer.

Some Insureds, which are creditors of the bankrupt Insurer, would therefore be reimbursed for their claim if they benefit from a cut-through clause, unlike Insureds without cut-through clause which would have to register their claim as liabilities of the Insurer, with all the procedural implications that this entails.

The Insured’s bad faith:

In some countries, the Insured can make a claim directly to the Reinsurer. The latter would compensate the claim without double-checking with the Insurer if the Insured has also submitted a claim to the Insurer. There is therefore a possibility of bad faith on the part of the Insured seeking to receive two compensations for the same claim. Damages could be paid by the Insured depending on what is provided in the cut-through clause and/or the applicable law in the country.

What is market practice for dispute resolution?

Usually, disputes are handled over settlement agreements or by arbitration. As for the applicable law, local public policy provisions applicable in respect of the Insured’s activity (i.e., where the risk is located) may sometimes impose the choice of law and competent jurisdiction.

 

[1] Article L. 111-3 of the French Insurance Code.

[2] Article 1199 of the French Civil Code.

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