There is no doubt that the current global financial crisis is taking its toll on nearly every industry. The insurance industry has not been spared from this crisis, and insurers are taking a hard look at their operations to identify strategies to preserve capital and minimize exposure. As part of this risk assessment, many insurers are reviewing the credit risk presented by their reinsurance and considering the use of commutations and settlements to alleviate exposure to financially troubled counterparties. Depending on the circumstances, however, such commutations run the risk of being voided as a preference if the reinsurer subsequently becomes insolvent and is put into liquidation.
Many state insurance statutes limit the ability of a financially impaired insurer to transfer or place a lien upon its assets for the benefit of a creditor if the effect would be to enable the creditor to receive a greater percentage of the insurer's assets in a liquidation proceeding. In general, these statutes permit a receiver to recover assets transferred by an insurer on account of prior debts, which result in some creditors receiving a preference over other creditors similarly situated. Such transfers are generally referred to as voidable preferences or transfers.
Elements of a Voidable Preference
Voidable preference statutes require the presence of four elements (and in some states five elements) before a transfer may be voided as a preference. Generally speaking, it is the effect of the transaction, rather than the debtor's or creditor's intent, that is controlling. Thus, if all elements of a voidable preference are present, the preference can be unwound regardless of the intent of the parties. These elements are as follows:
In addition to these elements, some state statutes require that a receiver establish that the transfer in question was made with an intent to create a preference. If each of these elements can be established, then a receiver will be permitted to void such a transfer as a voidable preference, unless the transfer falls within one of the common law or statutory exceptions to the general voidable preference rule. For example, transfers made as part of a contemporaneous exchange for new value or in the ordinary course of business are protected under common law (and in some cases, statutory law) from a preference attack. A transfer lacking any of the elements of a voidable preference or falling within one of the “safe harbor” exceptions will be unassailable as a preference.
Recommended Course of Action
Although insurers can defend a preference attack on the grounds that a reinsurance commutation constitutes a contemporaneous exchange for new value to the reinsurer (i.e., the reinsurer is relieved of the uncertainty of future adverse loss development on the covered business in exchange for a fixed sum of assets), the strength of this defense hinges somewhat on whether the consideration provided to the ceding insurer under the commutation is considered fair and reasonable. Regulators likely will assume that any transfer of assets under a commutation will diminish the amount of assets available to pay other creditors of the estate. This is especially true if the commutation deprives assets that otherwise would be available to satisfy claims of creditors in higher claim priority classes such as policyholders.
Apart from the passage of time, there is no bulletproof defense to a preference attack. Nonetheless, certain measures can be taken to reduce the risk that assets received from an insolvent reinsurer will later be recovered as a voidable preference. A few of these measures are as follows:
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Brian S. Kaas