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Outwards reinsurance and insurance portfolio transfers

Recap

In an article entitled “Some legacy issues for transfers of insurance business” in a previous edition of this publication we discussed some legacy issues flowing from transfers of insurance portfolios effected prior to the commencement (on 1 July 2002) of Division 3A of Part III of the Insurance Act 1973 (Cth) that continue to have potential relevance for Schemes implemented under the Div 3A regime. 

Prior to 1 July 2002, transfers of insurance portfolios were usually effected by an agreement between two locally authorised insurers.  A Court approved solvent scheme of arrangement was very much the exception.  An insurance portfolio transfer may have required the approval of Treasury or the local prudential supervisor - the Australian Prudential Regulation Authority and, prior to its establishment, the Insurance and Superannuation Commission - under the Insurance Acquisitions and Takeovers Act 1991 (Cth).  Additionally, it may have been necessary to obtain Foreign Investment Review Board approval pursuant to the screening procedure under the Foreign Acquisitions and Takeovers Act 1975 (Cth).

An insurer, typically, would assign its interests, rights and benefits (as insurer) under either:

(a) all of the insurance policies comprising its insurance business - as a step towards the surrender of its authorisation under the Insurance Act and to procure the release of regulatory capital to the insurer’s shareholder/s; or

(b) a specific line/s of its insurance business,

to another locally authorised insurer.

Because of the impracticality of novating individually each policy comprised in the portfolio to be assigned (portfolio policies), the transfer was ‘synthetic’: the insurer (legally or equitably) assigned its interests in its policies and received an indemnity from the assignee in respect of the burden of those policies.  The assignor would continue to have privity of contract with the counterparties (insureds) to the portfolio policies post assignment and to have an ongoing relationship of indemnity (upon the terms of cover) with them and to any third party beneficiaries outside the contractual nexus to whom the portfolio policies extended protection.  This was the case even where the assignor proceeded to surrender its authorisation under the Insurance Act.  The assignee would hold, as applicable, the equitable or legal title to the issuing insurer’s interests, rights and benefits, as insurer, under the portfolio policies and assume the risk in the burden of the policies via the contractual indemnity given to the assignor.

Where the assignee (first assignee) subsequently on-assigned some or all of the portfolio policies to another insurer (subsequent assignee), the first assignee would cease to hold, as applicable, the equitable or legal title to the insurer of record’s interests, rights and benefits, as insurer, under the policies on-assigned.  In the case of an equitable assignment, the benefit of such equitable interest would then be held by the subsequent assignee.  The on-assignment of the insurer of record’s interests, rights and benefits under the policies meant that the insurer of record then became a trustee of those interests, rights and benefits for the subsequent assignee.

Reinsurance

This regime posed, and continues to pose, some complex issues for recoverables under the outwards reinsurance contracts under which the portfolio policies are reinsured.  It is these reinsurance assets, and their preservation in connection with a Scheme under the Div 3A regime, that is the focus of this article.  Given the length of time that has elapsed since the commencement of Div 3A, the issues are, in the main, confined to reinsurance of ‘long tail’ policies of insurance that were the subject of a pre-July 2002 portfolio transfer.

In conjunction with the legal or equitable assignment of an issuing insurer of record’s interests, rights and benefits under its insurance policies, the issuing insurer would also usually assign its interests, rights and benefits, as reinsured, in the outwards reinsurance contracts reinsuring the portfolio policies (relevant reinsurance contracts).  Alternatively, or possibly both, the issuing insurer might agree to account to the assignee for the amount of any recoverables under those reinsurances following their collection or receipt.  One circumstance where an issuing insurer might opt to agree to account for those reinsurance assets following their collection/receipt rather than agree to assign its chose in action, as reinsured, under the relevant reinsurance contracts, was where a reinsurance contract was not limited in its scope to the portfolio policies the subject of assignment but also included, as reinsured contracts, other insurance policies that were not the subject of assignment1.

Both approaches were informed by the fact the issuing insurer continued to retain, post assignment, an ‘interest’ in the reinsured policies - for the reason the relationship of indemnity with the insured under a reinsured policy was not severed by the assignment of the issuing insurer’s interests, rights and benefits in the policy. This was the case notwithstanding the ‘right’, based on the authority of CSR Ltd & Anor -v- The New Zealand Insurance Co Ltd & Ors (CSR-v-NZI),2 that accrued to those insureds to claim directly against the assignee - at least where the assignment was effected for the purposes of former s36 of the Insurance Act to procure revocation of the assignor’s authorisation under that Act.

An assignment of the issuing insurer’s interests, as reinsured, under its outwards reinsurances, whether legal or equitable, did not have the effect that the assignee was substituted for the issuing insurer, as named reinsured.  Neither did the assignee thereby become an additional reinsured so as to entitle the assignee to claim upon the reinsurances in respect of claims made upon it by the original insured - anymore than the assignment of the issuing insurer’s interests in the reinsured policies substituted the assignee for the issuing insurer, as insurer of record, under those policies.  Neither did the assignment of the issuing insurer’s interests, as reinsured, under its outwards reinsurances, entitle the assignee to claim upon the reinsurances in respect of claims made upon it by the issuing insurer (or assignor) under the indemnity provided to the issuing insurer (or assignor) by the assignee in connection with the assignment of the reinsured policies in relation to a claim made upon the issuing insurer (or assignor) by the original insureds.3  

Instead, an assignment of the issuing insurer’s interests under its outwards reinsurances constituted an assignment to the assignee of the issuing insurer’s chose in action under the outwards reinsurances i.e. an assignment of the right of indemnity of the issuing insurer for its loss/liability under the reinsured policies.  It did not create a separate and independent right to indemnity in the assignee.

The assignee may have independently approached the relevant reinsurers for the reinsurance contracts to be endorsed to enable it to also claim upon the reinsurance i.e. as an additional named reinsured, without extinguishing the assignor’s protection.  This would have been advisable in the case of assignments effected to procure surrender of the assignor’s authorisation under the Insurance Act on the basis of the judgment in CSR-v-NZI and the authority that case establishes for the original insured/s to additionally claim directly upon the assignee in respect of policy liabilities ie. where the pre-July 2002 portfolio transfer was effected pursuant to former s36 of the Insurance Act as a precursor to surrender of the assignor’s authorisation.  However, for the reasons stated, the assignment of the issuing insurer’s (reinsured’s) interests in the outwards reinsurances did not, of itself, create in favour of the assignee a right to indemnity in its own right in respect of its own liabilities under those reinsurance contracts.  If the assignment of the issuing insurer’s chose in action, as reinsured, under the reinsurance contracts was a legal assignment then the assignee could, in its own name, enforce the issuing insurer’s right of indemnity as reinsured.  If it wasn’t a legal assignment but a valid equitable assignment, then the issuing insurer became a trustee of its chose in action (as reinsured) for the assignee.  It would have needed to be joined in any action enforcing the reinsurance.  It possibly may have authorised the assignee to prosecute claims upon the reinsurance in its (the issuing insurer’s) name.  However, if the insured claimed upon the assignee (in the circumstances contemplated in CSR-v-NZI) the issuing insurer did not incur a loss to which the reinsurance would respond.  Commercially, reinsurers may have treated the assignee as if it was the reinsured and the claim was made on it.

Relevance for Schemes under Div 3A of Part III of Insurance Act

A Scheme under the Div 3A regime, and the transfer agreement implementing such Scheme, will need to carefully address outwards reinsurances reinsuring policies synthetically transferred prior to 1 July 2002 ie that remain on foot and have not been discharged by performance or otherwise if the Scheme includes such in its scope.

It may not be appropriate for the Scheme to provide for the wholesale substitution of the Scheme transferee for the named reinsured (and issuing insurer of record of the reinsured policies) under the relevant reinsurance contracts unless the transferee will also be substituted for the original issuing insurer as insurer of record under the reinsured policies themselves.

For the purposes of analysis, two scenarios are posited: firstly, where the Scheme transferor holds legal or equitable title to the issuing insurer of record’s rights, title and interests as insurer of the reinsured policies and the insurer of record is not a related company of the Scheme transferor, and secondly the reverse where the Scheme transferor is the insurer of record of the reinsured policies but legal or equitable title to its rights, title and interests are held outside the corporate group.

In the first scenario, wholesale substitution of the Scheme transferee for the issuing insurer potentially gives reinsurers of the Scheme policies a windfall gain if the Scheme transferee is not made a reinsured under the reinsurance contracts reinsuring the Scheme policies.  Substitution of the Scheme transferee for the issuing insurer would also require the latter’s involvement in the Scheme.  This is because notwithstanding the prior assignment of the benefit of the Scheme policies to the Scheme transferor, the burden of those policies remains with the issuing insurer.  Involving the issuing insurer may be problematic if it is not a Group company of the parties to the Scheme or has been wound up.

In the second scenario, the person entitled to the beneficial interest in the insurer of record’s (i.e. Scheme transferor’s) rights, title and interests, as insurer, of the reinsured policies, will be likely to have provided an indemnity to the Scheme transferor in respect of the burden of those policies.  Even if the Scheme transferee is substituted for the Scheme transferor as insurer of record of the reinsured policies and as named reinsured under the associated outwards reinsurances, unless the person entitled to the beneficial interest in the reinsured policies agrees to the substitution (or addition) of the Scheme transferee as indemnitee in substitution for (or in addition to) the Scheme transferor, the question arises whether the Court can order such under the Division 3A regime.  Whilst the indemnity may be functionally analogous to reinsurance, it is arguably a contractual indemnity only and not one that involves any undertaking of liability by way of insurance.  No doubt this would be a disputable matter and affected by the actual terms of the indemnity.  The point in any event is this: the power of the Court under Division 3A of Part III of the Insurance Act to make such orders as it thinks fit in relation to reinsurance (refer discussion below) may not assist.  To the extent, either consensually or by Court order, the Scheme transferee is not substituted (or added) as indemnitee of the indemnity provided by the person entitled to the beneficial interest of the reinsured policies the Scheme transferee, as the substituted insurer of record of the reinsured policies, will be exposed to loss.

On any scenario, even where the Scheme transferee is substituted for the issuing insurer of record, as insurer, under the Scheme policies, it will be necessary to carefully consider the terms of the relevant reinsurance contracts.  If the reinsurances include in their ambit insurance policies which have not been assigned, or perhaps other insurance policies which have been assigned to another insurer, then it may not be appropriate for there to be a wholesale global substitution of the Scheme transferee, as reinsured, in place of the original issuing insurer of record (and reinsured).  The only exception, possibly, may be if those other policies have all been discharged by performance and the reinsurer has exercised all its rights associated to its indemnity obligations in respect of them such that, moving forward, the relevant reinsurances only have work to do in relation to the policies within the scope of the Scheme.  The question when some ‘long tail’ liability insurance contracts are actually discharged is hard, if not impossible, to determine.

Whilst, at one level it may be viewed as being inferentially evident that a wholesale substitution of the Scheme transferee for the issuing insurer, as reinsured, on the relevant reinsurance contracts is intended to only operate to the extent necessary to ensure the reinsurances continue to respond in respect of the reinsured policies within the Scheme’s ambit, the actual terms of the reinsurance contracts, as amended, cannot be simply ignored to arrive at a more commercially expedient construction.  The High Court decision (refusing special leave to appeal) of Western Export Services Inc v Jireh International Pty Ltd [2011] HCA 45 (please see here) establishes that a Court interpreting a contractual term whose meaning is plain and unambiguous cannot ignore that meaning in order to give that term a more commercial and business-like operation.  If the Scheme transferee was to be wholesale substituted for the named reinsured such that, moving forward, it (the Scheme transferee) was the reinsured in respect of all the policies ceded to and reinsured under the relevant reinsurance contracts then, notwithstanding this may give rise to a windfall gain for the reinsurers as regards any reinsured policies outside the Scheme’s scope i.e. in respect of which the Scheme transferee is not substituted as the named insurer of record (for example because the insurer of record continues to hold the beneficial interest or has assigned that beneficial interest to another insurer), that is the plain and unambiguous effect of the wholesale substitution of the transferee for the named reinsured. 

Even as regards those policies within the Scheme’s scope in relation to which the Scheme transferor holds the beneficial interest but is not the insurer of record, reinsurers could obtain a windfall gain if the Scheme transferee is substituted for the insurer of record as reinsured.  This is for the reason the burden of the reinsured policy remains with the insurer of record.  The indemnity provided by the Scheme transferor (and, in turn, any back to back indemnity given to the Scheme transferor by the Scheme transferee) will drop down to the extent the reinsurance is not responsive because the Scheme transferee has no ‘interest’ (as insurer) in the burden of the relevant insurance.

What is properly the subject of the Scheme is the transferor’s title on which it holds as applicable, the chose in action, or the equitable interest in the chose in action, of the insurer of record (as insurer) in the Scheme policies and the chose in action, or the equitable interest in the chose in action, of the insurer of record (as reinsured) under the associated outwards reinsurances.  The indemnity provided to the issuing insurer of record in connection with a prior synthetic portfolio transfer is not discharged, and does not evaporate, simply because the benefit of the chose in action in the Scheme policies and associated outwards reinsurance is on-transferred.  Where the Scheme transferor is entitled to the beneficial interest in certain of the Scheme policies for which the insurer of record is another entity, the question arises whether the Scheme transferor requires a back to back indemnity from the Scheme transferee in respect of the burden of those Scheme policies for which it holds the beneficial interest but is not the insurer of record if the insurer of record does not join in the Scheme - namely to provide balance sheet protection for a prior indemnity provided by the Scheme transferor to the insurer of record (or previous assignor) in respect of the burden of the Scheme policies.  Further, it raises the question whether and if so, how, the Scheme transferee can enforce the issuing insurer’s rights, as reinsured, under the relevant outwards reinsurance contracts.  This is not unimportant economically because if the Scheme transferee provides an indemnity to the Scheme transferor in respect of its indemnity to the issuing insurer, ultimately the risk in the enforceability and collectability of the reinsurance assets is ceded to the Scheme transferee - for the reason its indemnity will dropdown automatically to the extent the Scheme transferor does not obtain the economic benefit of those reinsurance assets in respect of its own indemnity.

Flexibility in framing Court orders

Under s17F(2) of the Div 3A regime, the Court may make such orders as it thinks fit in relation to reinsurance.  Upon its terms at least, this provides considerable flexibility and scope for the drafting of provisions in a Scheme document, and the transfer agreement giving effect to the Scheme, to address reinsurance and so avoid any potential for reinsurance assets to be lost and reinsurers to obtain a windfall gain.

Under s17G, when a Scheme is confirmed by the Federal Court it becomes binding on all persons.  Notwithstanding ss17F and 17G, having regard to the international nature of the reinsurance market and potential conflicts of laws issues which might arise in making orders in relation to reinsurance, before confirming a Scheme the Court would be likely to require evidence of the agreement of reinsurers to the Scheme as it relates to the reinsurance.

1. The issuing insurer may have appointed the assignee as its agent to collect recoverables under the outwards reinsurances - at least recoverables pertaining to the portfolio policies assigned it.  In practice, these recoverables would be retained by the assignee on the basis it was directly or indirectly liable (within the reinsured policy limit and upon its term) to indemnify the insured/s for 100 cents in the dollar of insured losses pursuant to the indemnity provided in connection with the assignment of the reinsured policies, and was therefore required to make up the difference between the insured loss and the reinsurance recoverable.  Effectively, the assignee had assumed the collection and credit risk in the insurance recoverables in the sense that its indemnity of the assignor “dropped down” to the extent a recoverable was not actually collected. 
2. (1993) 7 ANZ Ins Cas 61-193.
3. In relation to its indemnity obligation to the assignor, the assignee possibly may have asserted such indemnity obligation was secondary and not primary to, or co-ordinate with, that of reinsurers but query whether such an assertion would in all cases have succeeded.  In the writer’s experience indemnities provided to an assignor were not usually expressed to be excess of other recoverables (including reinsurance) or to be for the assignor’s ultimate net loss only – at least where the assignment in question was given pursuant to former s36 of the Insurance Act in connection with a proposed surrender of the assignor’s authorisation under the Insurance Act.  Whilst functionally analogous to reinsurance, the indemnity was usually drafted as a contractual indemnity furnished as consideration in connection with an assignment of the insurer of record’s interests in its policies.  As case law has developed, usually (but not invariably) a contractual indemnity is determined to be primary to a contract of insurance, including inferentially, a contract of reinsurance.

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