Cutting to the chase: suddenly seeking cut-through clauses - Reinsurance Focus

Once given as an accommodation to insurers and rarely charged for in decades past, cut-through clauses are now expensive provisions sometimes wrapped in the reinsurance contract that an insurance company negotiates when laying off their risk.

It's expensive and hard to come by, but that cut-through clause tucked away in a reinsurance contract can mean a world of difference for a corporate insurance buyer if his primary insurer goes belly up.

Once given as an accommodation to insurers and rarely charged for in decades past, cut-through clauses are now expensive provisions sometimes wrapped in the reinsurance contract that an insurance company negotiates when laying off their risk. Securing a clause--which essentially makes a reinsurer liable for certain policyholders' losses if the primary insurer shifts into liquidation--doesn't come easily and carries a hefty fee in the form of surcharges or percentages of the premium.

Yet some industry experts expect the use of cut-through clauses to climb as poor industry financial results mean more property! casualty insurers have their ratings downgraded to shakier territory. In order to secure business from their corporate clients, insurers will pay the price to get the financial backing of the higher-rated reinsurer.

"Risk managers want greater security as insurers are downgraded," says Steven DeLott, an attorney who specializes in insurance regulation at the New York City law firm of Simpson, Thacher & Bartlett. "An insurer will seek a cut-through clause to keep their customers and have someone stand behind them." DeLott is also an adjunct assistant professor at St. John's University School of Risk Management, Insurance and Actuarial Science in New York City.

Adds Sean F. Mooney, chief economist at reinsurance broker Guy Carpenter & Co., "A client might insist on it if he gets the cut-through clause, he's much happier."

The Kemper Example

A recent example of an insurer's decision to seek a reinsurer's backing after a ratings downgrade is the move by Kemper Insurance Cos. to seek the financial backing of National Indemnity Co., an insurance subsidiary of Berkshire Hathaway. On Dec. 23 of last year, the Long Grove, Ill. insurer announced an agreement-in-principal to have National Indemnity Co. provide a cut-through endorsement on certain policies. Those policies would then carry the A.M. Best A++ rating of National Indemnity, which is based in Omaha, Neb.

On Dec. 24, A.M. Best Co. announced that it was lowering its rating on Kemper from A- to B+. That rating was downgraded to B in March of this year. Linda Kingman, a company spokeswoman, declined to comment on Kemper's use of the cut-through clause or the price paid for it.

James Pogorzelski, an executive vice president for the London-based Benfield Group, said that he was seeing an increased desire on the part of insurers to secure the clauses, but that reinsurers also don't necessarily want to supply them.

"The increase in demand is there, yes, if an insurer receives a lower credit rating, they want to lean on their reinsurers," says Pogorzelski, whose Philadelphia office serves as the consulting division for Benfield's U.S. operations. "More than 10 years ago, when reinsurers were making decent margins, they did them as an accommodation. Now they're backing away from them and charging for it."

The clause might be written on a blanket basis, with the reinsurer assuming the risk for an overall line of business, or just for specific policies, which might carry of price tag of $10 to $25 per policy. And the fee might be a surcharge paid up front or a percentage of the premium, say 2 percent to 3 percent. handed over with the premium payments. Pogorzeski says there is no standard fee for a cut-through clause. "There's no rule of thumb (on price), it depends on the perceived risk," he adds.

A Growing Trend?

Officials at the Reinsurance Association of America believe the use of cut-through clauses have increased in recent years, but can't estimate how many of the millions of reinsurance contracts contain them. And while brokers at Guy Carpenter & Co. are seeing an increase in the use of cut-through clauses, brokers at Willis Re are not.

"Contracts with cut-through clauses are a very small percentage of the business," says Kevin McCune, senior vice president and national director of contracts at reinsurance broker Willis Re Inc. "Reinsurers are not going to step into a lot of liabilities if there's a whiff of insolvency on the part of the insurance company."

Industry experts agree that the use of cut throughs is most frequently sought when an insurer receives a downgrade that pushes it into territory below an A- rating. Unfair as it may be, the shift from the two highest categories used by ratings agency A.M. Best to the innocuous-sounding B territory can be the kiss of death for an insurer.

"If a company falls below an A-, it can lead to a downward spiral and people become afraid to place their insurance with the company:' says Robert DeRose, an assistant vice president at A.M. Best Co. in Oldwick, NJ. "An insurer will purchase a cut through in order to keep writing business. It gives the policyholder piece of mind."

And while a ratings downgrade into the dreaded B territory does not mean an insurer is headed for insolvency, at least one risk manager is glad he heeded the signal in the case of Reliance Insurance Co.

Wayne Salen, director of risk management for Niagara County in New York State, moved his company's property and auto program out of Reliance Insurance once the insurer's rating was downgraded to the B category in the 1990s.

"I'm lucky I haven't gotten caught:' says Salen, meaning having to suffer unpaid claims when an insurer he had secured for the county's coverage went belly up. "A risk manager has to be more involved but the reality is that we're not privy to that relationship (contract between the carrier and the reinsurer).

Reliance: A Test Case

The Reliance case is one of the biggest insolvency cases in the insurance industry with billions of dollars of unpaid claims as the case sits in the Commonwealth Court of Pennsylvania.

In June of 2000. Reliance Insurance Co. stopped writing virtually all new and renewal property and casualty business. Eleven months later, the Pennsylvania Insurance Department placed the troubled insurer into rehabilitation and ordered it into liquidation in October2001. Reliance had $8 billion in assets and $9 billion in claims as of Oct. 3,2001, said Roseanne Placey, a spokeswoman for the Pennsylvania insurance department. Placey says department officials don't know how many of Reliance's reinsurance contracts included cut-through provisions.

But a document filed with the court in March of 2002 set out guidelines for the payment of Reliance's reinsurance proceeds to specific insureds based on cut-through provisions. The court approved the guidelines but no claim has yet been paid in the case, which Placey estimates will take years to wind down.

State insurance departments, which are charged with the duty of liquidating and distributing the remaining assets of a failed insurer, are sometimes at odds with the reinsurers and policyholders that are to be reimbursed under cut-through provisions. Under the insolvency clause reinsurers are required to pay reinsurance claims to the insolvent primary insurer or a liquidator appointed by the court. State liquidators want to be sure they receive the correct compensation from the reinsurers while reinsurance companies do not want to pay twice: once to the liquidator and once to the original insured covered by a cut through clause.

For their part, policyholders with the backup of a cut-through provision want to be paid directly by the reinsurer, not wait years or decades for liquidation cases to wind down.

Reason for Insolvency 1993--2002

Deficient loss reserves were the biggest reason insurers sank into
insolvency

   I  Deficient Loss Reserves  51%
  II  Rapid Growth             10%
 III  Alleged Fraud             3%
  IV  Overstated Assets         2%
   V  Discontinued Operations   8%
  VI  Change in Business        3%
 VII  Reinsurer Failure         0%
VIII  Catastrophic Loss         3%
  IX  Unidentified             17%
   X  Impairment of Affiliate   3%

Source: A.M. Best Co. data

Note: Table made from pie chart

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