Insurers collect premiums, invest them, incur overhead, and pay claims. Sometimes this life cycle gets out of whack, leading to the voluntary or forced insolvency of an insurance company. Whenever an insolvency occurs, one job of the rehabilitator or liquidator is to equitably distribute whatever money is available to the policyholders with unpaid claims in the queue. And a policyholder that already received payment from the insurer may be required to disgorge those monies back to the estate if it is found that the claim payment constitutes a preference.
This was the issue in a recent decision of the Utah Supreme Court, Wilcox v. Anchor Wate Co., (Utah Nov. 3, 2006). Anchor Wate was a policyholder of an insurer that soon after making part payment was placed into involuntary liquidation by Utah insurance regulators. The policy at issue provided $5 million of coverage, and the insurer had paid $3 million toward the claim and entered into an agreement to pay the remaining $2 million owed in four equal installments. After the insurer made its initial $3.5 million payment, the order of liquidation was entered (and Anchor Wate submitted a proof of claim for $1.5 million).
Before the liquidation order, the insurer had received the cash to make the payment to Anchor Wate from its reinsurers, which were required under the preexisting reinsurance certificates to make advance payments whenever there was a large loss (as with Anchor Wate). Advancing a number of theories, Anchor Wate sought to fend off the liquidator’s effort to recover the $3.5 million payment as a preference.
The Utah court found that Anchor Wate had no direct rights under the reinsurance agreements: it was not an express third-party beneficiary; there was no “cut through” clause; nor did the reinsurers assume the obligations of the later-insolvent insurer by essentially substituting themselves in discharging the insurer’s obligations. The court did not find any fraud on the part of the insurer that would warrant imposing a constructive trust. And the Utah court found that the “earmarking” doctrine did not apply. Compare In Re Moses, 256 B.R. 641, 6445 (10th Cir. 2000). Accordingly, the Utah court ordered repayment of the $3.5 million in insurance proceeds, plus interest (subject to Anchor Wate’s receiving whatever ratable distribution of the assets to which creditors of its class were entitled).
Of course, this is not a satisfactory result for Anchor Wate, which had received $3.5 million in cash and would have been entitled to a ratable distribution for its claim of $1.5 million against the estate. Instead, Anchor Wate had to disgorge the cash already received and was left with a claim for $5 million against an insolvent estate.
Is there anything a policyholder in Anchor Wate’s position could have done to ensure it received maximal payment? Put more directly, is there a way to structure a preference in favor of one policyholder that will be insulated from claw back by the liquidator?
Where reinsurance policies contain a cut-through clause, the policyholder has direct rights against the reinsurers that it may enforce outside of the insolvent-insurer’s estate, and there has been recent litigation in the Reliance and Legion insolvencies, for example, over whether there a cut through was implied in fact in the circumstances of a particular arrangement covering a policyholder or group of policyholders. Such arrangements are unusual, and typically involve facultative reinsurance (that is, a reinsurance policy or policies issued in connection with the sale of an insurance policy to a particular insured).
In the absence of a cut through, however, probably the best the policyholder can do is to try to shoehorn its way into the earmarking doctrine, whereby money is deemed to pass outside the estate from a debtor of the estate to one of the estate’s creditors. In Anchor Wate’s situation, it might have sought to get its insurer to agree to the following:
a. In consideration of the policyholder’s release of claim, the insurer agrees to obtain all advance payments from its reinsurers to which it is entitled.
b. The insurer will segregate the proceeds so obtained from the reinsurers into a separate account for the purpose of paying the insured.
c. The insurer will notify the reinsurers from which it is obtaining the advance that it will devote the payment to the policyholder’s claim for coverage.
d. The policyholder agrees upon receipt of payment to release the reinsurers from any claims it may have against them (some element of consideration needs to be offered from the policyholder to the reinsurers).
e. Ideally, the reinsurers would agree that any such agreement to make payment on the condition that the policyholder is paid modifies the terms of the reinsurance certificate.
Essentially, what I am trying to create is a point-of-claim cut-through agreement whereby the perhaps insolvent insurer is a mere conduit facilitating the transaction between the policyholder and the reinsurers. Usually, cut-throughs are negotiated at the time the policy is originally sold, since the reinsurance backing is integral to the transaction (hence, the logic for the reinsurers allowing a cut through in the first place). The foregoing would obviously (especially after this posting) be intended to insulate the policyholder’s recovery from later recoupment by the liquidator/rehabilitator, i.e., it is an effort to create an enforceable preference. There are good reasons why preferential asset transfers are unwound, as in the Anchor Wate case. But when one’s ox is gored on this basis – when the policyholder has paid a liability claim with the expectation of retaining already agreed insurance recovery – fairness to other creditors of the estate – fairness to other policyholders – is not foremost in mind.