CUT-THROUGH ENDORSEMENTS
by the IIABA Virtual University Faculty
Sometimes when an insurer encounters financial problems, cut-through endorsements will be issued. Both the primary carrier and reinsurer usually attach a cut-through endorsement to the policy. The endorsement should specifically reference the policy by number and policy term. This document by the IIABA Faculty investigates what the endorsement actually represents.
Our “Ask an Expert” service recently received this question:
“We have just received official notification of Best downgrading one of our companies (let's call them ABC Ins. Co.) from an A- to a B+ rating. Best reportedly has them under review with ‘negative implications.' ABC's press release indicated that XYZ Ins. Co. will be providing a cut-through endorsement which, and I am quoting, ‘ ... means that ABC policies issued under the agreement are backed by the A++ rating of XYZ.'
“Since the cut-through endorsement is between ABC and XYZ, the insured has no direct contract with XYZ should ABC go under. What problems will we — or our clients — experience if we have to look to XYZ for coverage under the ‘indirect' contractual relationship our clients would have with XYZ? What legal or regulatory support would we have to help us deal with XYZ?
“There is debate among our staff as to the real value and protection to the agency and our clients that the cut-through endorsement provides. Any light you can shed on this would be greatly appreciated.”
FACULTY RESPONSE
A cut-through endorsement is an agreement between the insured and the reinsurance company. I don't think an insured has any standing with regard to an agreement between the insurer and the reinsurer. If the reinsurance company is serious about providing a cut-through endorsement, they need to provide evidence to the policyholder.
FACULTY RESPONSE
ABC is not the only company in 2002 to experience this situation. Earlier in the fall, another major carrier was put in the same position. Most of their agents are working with them. However, there are or will be clients that you'll need to move because they'll be uncomfortable. Most of these will be commercial accounts.
Although I am not aware of all of the legal ramifications, the first thing to do is to make sure you know why ABC was downgraded. Can it be isolated to a specific issue? Can it be corrected? If yes, then chances of the company “going under” are slim.
The cut-through endorsement process has been used for more than 35 years in similar situations. I have not heard, nor can I recollect, any of the concerns occurring that you outlined. However, caution is good. Check with your state IIABA association and E&O carrier for their input.
And by the way, most banks and mortgage companies are satisfied with this arrangement. You'll need to make sure to evaluate options for those that aren't. Unfortunately, I don't think this is the last time we'll see this happen.
FACULTY RESPONSE
Unless the cut-through endorsement is filed and formally issued to each client as an amendment to the policy, it has no guarantee. It is, in the absence of the aforementioned formality, an indication of goodwill that, knowing the reputation behind it, will in all likelihood be honored, but out of integrity rather than legal/contractual power of enforcement.
FACULTY RESPONSE
The “intended” purpose of the cut-through is to grant privity to the insured. In a normal reinsurance agreement, the contract is between the cedant and the reinsurer and the insured has no privity. The cut-through attempts to grant this missing privity to provide direct access to the reinsurer in the event of loss.
Now, there are quite a few legal, financial, and operational concerns with the cut-through. First the operational matters:
- Does the cut-through apply to the entire insurance contract, or just for property causes of loss? This is important because most requirements for “A” ratings or better come from lenders. Many construction contracts also require the “A” ratings. If the cut-through doesn't cross over all coverage parts, this could cause a problem.
- Does the cut-through carry a sub-limit, or does it follow full policy limits?
- Are there joint loss adjustment conditions that might require dual loss notifications to “ABC” and “XYZ”?
In the area of legal concerns, you need to determine how the states of all of your insureds have enforced (or not enforced) cut-throughs. There are multiple positions taken by the courts and the departments of insurance. Some states have attempted to regulate them and others have just ignored them.
Another legal concern is whether the cut-through includes a novation . In a novation, XYZ actually takes the full place of ABC and ABC retains no legal obligations. This is not common practice in “normal” cut-throughs. But if it is a precursor to a transfer of a book of business, it might be applicable.
Finally there's the issue of financial impact. Although it's early in the financial problems of ABC, you should be cautious of how insolvency funds treat cut-throughs. Many insolvency laws don't recognize their ability to step in. They look at them as a preferential disbursement of assets. Please don't consider this as a statement that ABC is heading toward insolvency. It's just a warning as to a potential problem with cut-throughs on long-tail lines.
Beyond the direct issues of cut-throughs are the indirect issues, the most important being whether or not the insureds or their lenders will accept them. Most sophisticated buyers (e.g., risk managers) will not accept cut-throughs without direct negotiations and discussions with the cedant and reinsurer. Even then, acceptance is not guaranteed.
Reproduced, with permission, from the VuPoint Newsletter of the IIABA Virtual University. For more information on the Virtual University, click here. The members of the University Faculty offer expertise in every aspect of agency management and marketing. Many of these faculty members are available for in-house training or consulting. For contact information on faculty members, click here.