Some Issues with Reinsurance–Part 1

When negotiating aircraft lease agreements, at some stressful point during the negotiations I will, invariably and usually with some exasperation, make the following statement to the lessee’s commercial people and lawyers: “Look, we’re giving you a [say] US$50M aircraft and in exchange you’re giving us a pile of paper, and so we need to make sure the pile of paper protects our interests.”

If that pile of paper were sorted by the importance of the issues addressed, with the most important issues on top and the least important on the bottom, the lease insurance provisions and insurance documents would be near the top—along with the provisions addressing rent, reserves/return comp and return conditions.

In practice however, the insurance provisions and documents often do not get the attention they deserve from the lessor’s perspective, generally because the review task is spread across a few people—the lessor’s lawyer, the lessor’s internal “insurance person” and usually the lessor’s own broker. In my experience it’s rare that any one of these three people has a good grasp of all the insurance issues—and each tries to shift responsibility to the others. So, if you’re a junior aircraft finance lawyer and looking for a subject-matter to master, I’d put insurance at or near the top of the list. You will soon become an invaluable resource not only to your clients but to other lawyers in your firm/company.

A comprehensive review of aircraft insurance issues from the lessor’s perspective would require a long article or small book, but I’ll tackle one of the more difficult and confusing issues in this post—the use of reinsurance cut-through clauses and/or reinsurance assignments. And I will make an effort to come back to insurance issues on a regular basis over the next few months. (if you have any requests for a specific topic, send me an email.)

A little background: primarily for credit-related reasons, aircraft lessors prefer that the aircraft insurance provided by the lessee is placed by a broker (e.g., Aon) in the London market or with a major U.S. or European insurer experienced in commercial aircraft insurance (e.g., Allianz). It’s very common however for the lessee’s country to have trade protection laws requiring that an airline based in that country place its insurance with an insurance company based in that country. Generally lessors will not be willing to rely on this local insurance because the lessor will not accept the creditworthiness of the local insurer and because relying on a local insurer increases the lessor’s credit exposure to the country; in other words, the lessor will be unwilling to take local insurer credit risk or additional country risk.

The standard workaround is for the airline to place 100% of its insurance with a local insurance company, but then require the insurance company to reinsure 100% (or sometimes less) of the insurance risk with the London market or an acceptable European insurer (I’ve never seen a U.S. insurer act as reinsurer, not sure why). When this happens each of the local insurance company and the reinsurer will issue an insurance certificate to the lessor detaining the scope of aircraft coverage and the lessor’s rights under that coverage; usually the certificates are virtually identical.

Reinsurance is such a standard workaround for the local insurance requirement that the lessor’s lawyer and insurance person may forget for a moment (or more) that (1) the reinsurance policy is a contract between two parties (the local insurance company and the reinsurers) wholly unrelated to the lessor and lessee and not under the control of either, (2) the reinsurance policy is very likely governed by the law of the jurisdiction of the local insurance company, and (3) the loss payee under the reinsurance policy is (forgetting about “cut-throughs” and assignments for a minute) the insured under the reinsurance policy (that is, the local insurance company is the loss payee, not the lessor or the lessee).

I can hear some of you now saying “wait a minute, Brad, what about the cut-through clause in the reinsurance certificate delivered to the lessor by the reinsurer or its broker; doesn’t that clause require the reinsurers to pay the lessor directly (and the not the local insurance company)?”

Well, there are a few problems with cut-through clauses:

1. Cut-through clauses are very often illegal/unenforceable in the countries of the local insurers (e.g., Colombia). I have heard various explanations of why this is the case but the general consensus is that cut-through clauses evade the local insurance requirement and in effect make the reinsurer a de facto (unlicensed) insurer in the local insurer’s jurisdiction. Regardless of the rationale, when a reinsurance certificate is being provided to a lessor one of the first questions the lessor’s lawyer should have for local counsel is “are cut-throughs enforceable in your country?”

And in this context, keep in mind almost all cut-through clauses have a sentence similar to the following: “It is a condition that the provisions of this clause will not operate in contravention of the laws, statutes or decrees of the country of domicile of the Reinsured.”

2. A cut-through clause is just an endorsement to a reinsurance policy between the reinsurers and the local insurer. In ordinary course there is nothing in the reinsurance certificate that prohibits the removal of the endorsement during the policy (the 30-day notice period in AVN67 very arguably does not apply to any cut-through clause) or the failure to include the cut-through at renewal. Yes, such removal or failure would trigger an event of default under the lease agreement between the lessor and lessee, but the lessor would have no recourse against the insurer or reinsurer.

3. Under English law a cut-through clause will not have a the same legal effect as a perfected assignment of reinsurance proceeds (from the local insurer to the lessor), and will likely fail if challenged by a receiver or liquidator (or similar) of the local insurance company.

Ok, then what is the best way to give the lessor a direct, enforceable right to the reinsurance proceeds? I’ll address issue that in Part 2 of this post.

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