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Insurance Company Insolvencies--Protecting Your Captive or Self-Funded Plan

By Timothy P. Law

An insurance company insolvency can have devastating and unexpected consequences. Businesses that include captive insurance in their employee benefits arrangements may not be exempt from those hardships. The same is true for self-funded plans that rely heavily upon stop-loss insurance. This article briefly discusses both proactive and reactive solutions to avoid or overcome those difficulties.

Most captive insurance companies, or self-funded plans, have relationships with standard insurance companies. In one common structure, a standard insurance company (often called a "fronting" company) issues a traditional insurance policy to the captive's parent. The traditional insurance is then reinsured by the captive insurance company through facultative reinsurance. A third party administrator ("TPA") pays claims from a loss payment account that may be funded by the fronting company or directly by the captive. Variations of this structure can involve self-funding mechanisms other than captive insurance companies, including stop-loss insurance retrospective premium and high-deductible plans in which the policyholder itself is responsible for funding the loss payment account or reimbursing the fronting company. The policyholder or captive may provide substantial collateral to the standard insurance company to ensure payment.

Insurance company insolvency is governed by state statutes that typically do not address captives or other self-funding arrangements. Insolvency statutes are designed to ensure full payment by reinsurance companies to the insolvent insurance company and partial payment by the insolvent insurance company to policyholders. The estate thereby maximizes the amount available to all policyholders for an eventual pro rata distribution. Applying this general framework to the captive scenario, a liquidator may attempt to collect the full amount of loss from the captive and make partial, pro rata payments to the policyholder parent years later. If permitted, the insolvency of the "fronting" company could wholly undermine the captive or self-funding program.

Claim Payments

The captive reinsurance should be used solely to pay the liabilities of the parent policyholder, rather than to pay the claims of all policyholders of an insolvent fronting company. The most direct manner to achieve that objective is through a "cut-through" provision in the reinsurance contract between the fronting company and the captive insurance company.

Although they vary in form, cut-through clauses explicitly allow a reinsurance company to pay the policyholder directly in the event of the insolvency of the fronting company. Many state insolvency statues state that payments by a reinsurance company must be made directly to the ceding insurance company or its receiver except where the original reinsurance contract specifically provides for another payee or where there is a novation with the consent of the direct insured, the insurance company, and the reinsurance company. Because a cut-through clause specifies an alternate payee in the event of an insolvency, insolvency statutes in most states should permit the direct payment of loss by the captive when the reinsurance contract includes a cut-through clause. While a novation may also be possible, it is more complicated than a simple cut-through clause.

Even if there is no novation or cut-through provision, courts may act to protect the parent's reasonable expectation that the reinsurance provided by the captive would flow to the captive's parent. On July 19, 2005, the Pennsylvania Supreme Court affirmed and adopted the Commonwealth Court's opinion in Koken v. Legion Insurance Company, 831 A.2d 1196 (Pa. Commw. 2003). The Pennsylvania Supreme Court allowed policyholders who can demonstrate third-party beneficiary rights in reinsurance contracts to access directly reinsurance proceeds under facultative reinsurance contracts covering their specific insurance programs. Certainly, the policyholder parent of a captive insurance company is the intended beneficiary of captive reinsurance. Accordingly, the parent policyholder should be permitted to collect directly from the captive if the fronting company becomes insolvent, even where there is no cut-through clause or novation.

Collateral and Loss Payment Accounts

Although some recent statutory amendments in some states have attempted to regulate the treatment of policyholder collateral in insurance insolvencies, the treatment of loss payment accounts and policyholder collateral remains a source of controversy.

When drafting agreements relating to TPA services, collateral, and loss payment accounts, the question of ownership of the accounts and how they will be treated in the event of an insolvency should be addressed explicitly. To the extent possible, the agreements should make clear that the loss payment accounts are to be used to pay the claims of the policyholder only, that those accounts are not the property of the fronting company, and that the insolvency of the fronting company shall not change the obligations of the TPA. The agreements should work in tandem to enable the captive to fund the claims administered by the TPA through the loss payment account, even if funds had previously flowed through the fronting company.

Conclusion

In any captive or self-funding structure, the potential for the eventual insolvency of the direct insurance company should be considered and addressed in the agreements governing the program. The goal should be to ensure the smooth functioning of the insurance program even if the fronting company becomes insolvent. It is important to recognize, however, that even if the agreements do not specifically contemplate what will occur in the event of an insolvency, courts may act to protect the intent of the parties.

ABOUT THE AUTHOR

Timothy P. Law is a shareholder in the Philadelphia office of Anderson Kill & Olick, P.C. Mr. Law regularly represents policyholders in coverage disputes with their insurance companies.

Reprinted with permission from the Spring 2007 issue of Self-Funding Advisor, published by Anderson Kill & Olick, P.C.

riskVue | The webzine for risk management professionals
August 2007