We would like to ensure that you are still receiving content that you find useful – please confirm that you would like to continue to receive ILO newsletters.
29 July 2009
In early 2007 the monopoly that the Brazilian Reinsurance Institute had held over Brazil's reinsurance market for nearly 70 years began to come to an end. Legislation that had been expected for 10 years was finally ratified. Part of that legislation addressed cut-through clauses in reinsurance contracts, which are particularly relevant to aviation contracts given the extent to which risk is reinsured through international reinsurance markets.
The basic law addressing this issue is the Complementary Law (126/2007), which is regulated by National Council of Private Insurance Resolution 168/2007. However, despite the Complementary Law having been in effect for more than two years and Resolution 168/2007 having been in effect for more than one year, considerable uncertainty remains in relation to the Brazilian position on cut-through clauses.
Article 14 of the Complementary Law and Article 34 of Resolution 168/2007 contain the following identical language:
"The reinsurers and their retrocessionaires shall not be directly liable to the insured, participant, beneficiary or assisted for the amount assumed in reinsurance and retrocession, being the cedents that issued the contract fully liable for indemnifying them.
Sole Paragraph. In the event of the cedent's insolvency, liquidation or bankruptcy, the direct payment to the insured, participant, beneficiary or assisted of the part of the indemnification or benefit relative to the reinsurance is allowed, provided the payment of this part has not been effected by the cedent to the insured nor by the reinsurer to the cedent, if:
I. the contract is a facultative one as defined by the insurance regulator;
II. in all other cases, if there is a cut-through clause."
The 'cedent' in this case would be the Brazilian primary insurance company. The reference to 'retrocessionaires' is a reference to insurers that reinsure the reinsurers. Given the magnitude of aviation risk, the ultimate risk tends to be spread among many reinsurers and retrocessionaires through reinsurance and retrocession agreements.
Cut-through clauses are not universally accepted in other jurisdictions. In the United Kingdom, cut-through clauses were generally assumed to be unenforceable until 1999. In the United States, the enforceability of cut-through clauses is questionable in certain states. One reason for the failure of cut-through clauses is that in case of an insurer's bankruptcy they appear to provide preferences to selected insureds. Further, those insureds tend to be the largest insureds, since they have the economic power to demand cut-through clauses. Enforcement issues have also arisen due to the lack of contractual privity between the insured and the reinsurer.
The Complementary Law and Resolution 168/2007 address these potential problems by expressly allowing preferences in favour of beneficiaries of cut-through clauses and allowing enforceable cut-through clauses in the absence of privity. Hence, the general rule in Brazil is that cut-through clauses are enforceable, provided that the primary insurer is insolvent. However, notwithstanding this seemingly clear position, three distinct trends have emerged in the issuance of aircraft reinsurance certificates.
One trend, which has been established by the Brazilian office of at least one international reinsurance broker, is that cut-through clauses are simply invalid in Brazil. This conclusion seems to be based on an erroneous interpretation of the Complementary Law and Resolution 168/2007. This broker has been known to refuse to certify cut-through clauses by alleging that they are illegal in Brazil. This broker has yet to justify its refusal to include cut-through clauses in its certificates. However, it is the broker and not the applicable law that is preventing qualified cut-through clauses from being underwritten. Therefore, airlines using this broker's services deliver reinsurance certificates stating that there is no cut-through clause, and that the insured bears the risk of the primary insurer's insolvency. While the law and related regulations allow cut-through clauses in case of insolvency, they do not impose cut-through terms by operation of law. Thus, in the absence of an express clause, no cut-through terms would exist.
A second trend, which is also erroneous, but not as serious as the first, is to include cut-through clauses in reinsurance certificates with no indication of any limitations. This approach, although preferable to the insured, is potentially problematic since the cut-through clause might be deemed to violate the general rule that cut-through is allowed only in case of primary insurer insolvency. There have been no test cases of cut-through clauses being issued under these types of certificate.
The third trend, which is the most accurate, is to certify that a cut-through clause exists, but is enforceable subject to the limitations of the Complementary Law and Resolution 168/2007. Although this would seem to be the most logical approach, relatively few reinsurance certificates are issued with these terms. Reinsurance certificates issued by the Brazilian Reinsurance Institute tend to follow this practice. Such certificates usually state that the cut-through clause is valid, subject to the limitations of Brazilian law, without reference to the insolvency requirement. Thus, while these certificates are correct, a simple reading of them could be misleading, since they do not mention the nature of the limitations.
Does the rule established by the Complementary Law and Resolution 168/2007 allowing a qualified cut-through clause adequately protect insureds in aircraft agreements? The reasons why insureds seek cut-through clauses vary; however, a primary reason is to guard against primary insurer insolvency. In a simple analysis the new legislation adequately addresses this concern; however, there are potential issues relating to the insolvency requirement. It is conceivable that an insurer could become financially distressed without being insolvent. In this circumstance a cut-through clause might not yet be valid. If the primary insurer were to receive reinsurance proceeds from an insurable event, but use a portion of the proceeds to discharge its other obligations, then the insured might be left unindemnified (or underindemnified). This has not occurred in Brazil and to some extent the risk appears remote. If such a case were to arise, the insured would be wise to try to make prior arrangements for the flow of reinsurance proceeds to ensure that they are reconveyed to its account.
Another potential problem relates to the Brazilian judiciary's general reluctance to declare financially distressed entities insolvent. This has occurred with a number of airlines that have sought restructuring protection, but probably had no real prospects of recovery. The judiciary's initial reaction in such cases has been to allow the company to continue operating while under court protection, in the hope that a financial miracle will occur. However, the risk of this occurring with a primary Brazilian insurance company should be more remote given the regulations imposed by the insurance regulator, the Superintendence of Private Insurance.
Another reason why an insured might want a cut-through clause is foreign exchange risk. Although Brazil's foreign exchange reserves have improved considerably over the past few years, the country is still subject to strict foreign exchange regulation and restrictions. The Central Bank of Brazil continues to control the flow of foreign currencies to and particularly from Brazil. Therefore, there is a risk that reinsurance proceeds reaching Brazil might be held up where the primary insurer arranges to reconvey them to an insured outside Brazil. Again, this problem is only a potential one as it has not arisen in the past.
Since the Complementary Law and Resolution 168/2007 took effect, Brazil has suffered from one major air disaster. The insured of the hull proceeds for the aircraft received the insurance payment within a few weeks of the loss. Although the rules on cut-through clauses are not ideal for insureds, they do seem to address the main area of concern - primary insurer insolvency - and the insurance proceeds payment history from the Brazilian insurance market has been good. One area that still requires improvement is the level of accuracy in reinsurance certificates. While some certificates are accurate, others might be misleading, and in some cases brokers have prevented cut-through clauses from being included to protect insureds.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
ILO is a premium online legal update service for major companies and law firms worldwide. In-house corporate counsel and other users of legal services, as well as law firm partners, qualify for a free subscription.