Author: VU Faculty
Sometimes when an insurer encounters financial problems (real or perceived), cut-through endorsements may be issued. A cut-through endorsement is usually attached to insurance policies of the primary carrier by both it and a reinsurer. The endorsement should specifically reference the policy by number and policy term. What, however, does the endorsement actually represent?
Just recently, our "Ask an Expert" service received the following 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. Reportedly Best has them under review with 'negative implications.' ABC 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 in the event we had 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."
This is a great question–and a timely one–considering the current financial condition of a number of insurers. Below are some observations of our faculty, along with links to a related article on the VU dealing with insolvency and a great article from IRMI that specifically examines the issues surrounding cut-through endorsements.
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.
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 will need to move because they will 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 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 over at least the last 35 plus years in similar situations. I have not heard, nor can I recollect, any of the concerns occurring that you outlined. Again, caution is good, check with your E&O carrier and with your state IIABA association which may have access to information and advice from your state regulators.
And, by the way, most banks and mortgage companies are satisfied with this arrangement. You will need to make sure to evaluate options for those that are not. Unfortunately, I don't think this is the last time we will see this happen.
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 by the insured.
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 as long as the cut-through is made a part of the policy and includes language which clearly expresses this.
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 is 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 does not cross over all coverage parts, this may 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 may 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-through's. 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. You should check with your state insurance department–either directly or via your state IIABA association–to discern these issues.
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-through's. But if it is a precursor to a transfer of a book of business, it may be applicable.
Finally is the issue of financial impact. Although it may be early in the financial problems of ABC, you should be cautious of how guaranty 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 do not consider this as a statement that ABC is heading towards insolvency. It is 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.
For more information, be sure to check out the following articles on the VU or internet:
In addition, IRMI published an excellent, more detailed article on cut-through endorsements in the April 2002 (Vol. 19, No. 2) issue of their Risk
Financing Perspectives. For more information about this and other IRMI products, visit their web site at www.irmi.com.