Emmanuèle Lutfalla and Nour Jonot explore the use of cut-through clauses in reinsurance agreements in Insurance Post

Great for business but risky when triggered, a cut-through clause is a powerful provision in a reinsurance agreement. Typically worded in facultatives, it gives the Insured direct access to the Reinsurer to seek compensation, payable by the Insurer, in respect of the Policy.

It challenges regulations in the UK and France by creating a direct legal relationship between the Reinsurer and the Insured, bypassing traditional contract principles such as “l’effet relatif des contrats”[1] in France and its UK equivalent, privity of contracts.

These clauses are often used in risky regions like South America and Asia, where local Insurers may not meet solvency requirements. They can also benefit Insurers with weak financial ratings by attracting large clients or where the Reinsurer lacks a license in a specific jurisdiction.

A clause that attracts policyholders and is good for business

Cut-through clauses are a great competitive tool to capture specific areas of reinsurance business, acting as a safety net for Insureds when Insurers go insolvent, and avoiding the hassle of insolvency proceedings. Large commercial Insureds usually demand reassurance the Reinsurer will step in, making the Reinsurer the true Insurer, while the latter merely fronts the deal.

They can be a Pandora's box if triggered

Reinsurers may find themselves in a lose-lose situation when facing the possibility of payments to both the Insurer and the Insured. A direct payout to the Insured may not shield the Reinsurer from further demands by the Insurer’s liquidator or receiver. To make matters worse, in certain jurisdictions, the Insured can bypass the Insurer and make a claim directly to the Reinsurer, potentially pocketing compensation without bothering to confirm if a claim was already lodged with the Insurer. The potential for deceitful maneuvering by the Insured looms large.

Financially speaking, a Reinsurance agreement with a cut-through clause may prevent a Cedent from receiving annual credit for reinsurance recoverables. Most states’ statute require that, in the event of the Cedent's insolvency, reinsurance proceeds must be paid to the receiver without reduction due to insolvency.

In some instances, a local license is a prerequisite for a Reinsurer to delve into direct insurance liabilities. Failing to obtain said license could plunge Reinsurers into inadvertent breaches of laws and regulations. Any direct payments could be construed as illicit insurance activity for which the Reinsurer lacks authorization, inviting a storm of punitive measures.

Finally, cut-through provisions can lead to unfair discrimination among Policyholders, particularly when large commercial Insureds are the only ones able to negotiate and obtain such endorsements. The creation of preferential rights between Insureds who benefit from a cut-through clause and others that don’t, can be in contravention of the relevant country's bankruptcy laws.

Check-out the drafting of your clauses to spare parties from legal pitfalls

In the UK, disputes over cut-through clauses are typically resolved through settlement agreements or arbitration. Local public policy provisions applicable in respect of the Insured's activity usually impose the choice of law and competent jurisdiction. For this reason, precise and compliant drafting is key to avoiding legal pitfalls.

Large international Reinsurers have an advantage in inserting cut-through clauses, in both financial capacity and legal teams. In any case, the decision to include such clause in any Reinsurance agreement requires a thorough understanding of local laws. Insureds must assess the Reinsurer's financial stability, while Reinsurers must consider direct liability to Policyholders as ambiguous clauses may backfire in court, favouring the insured party. In a nutshell, better safe than sorry.

[1] Article 1199 of the French Civil Code.