Some Issues with Reinsurance–Part 2

In Part 1 of this post I talked about the use of reinsurance in aircraft lease transactions and the issues raised by an aircraft lessor relying on reinsurance cut-through clauses. In this Part 2, I’ll look at one way to address those issues. Unfortunately the best solution has some traps for the unwary.

Rather than rely on a reinsurance cut-through clause, the best approach for a lessor to get direct recourse to the reinsurance proceeds is by an assignment of the rights to those reinsurance proceeds by the local insurer (viz. the insured under the reinsurance policy). I suspect that most or all or you are familiar with reinsurance assignments and so I’ll note only that a reinsurance assignment (1) is an assignment by the local insurer to the relevant lessor party (lessor, owner or possibly security trustee) of any hull and hull war (usually not liability) proceeds under the reinsurance policy and (2) provides for notice of such assignment to the reinsurers (or their representative), which notice serves to “perfect” the assignment under relevant law. Such a perfected assignment should trump any claims by the local insurer (or its representative) in the reinsurers’ jurisdiction to such proceeds.

OK, now let’s talk about the traps for the unwary:

1. The rationale behind the illegality/unenforceability of cut-through clauses also applies to reinsurance assignments. Like a cut-through clause, a reinsurance assignment effectively (we hope) cuts the local insurer out of the picture; for this reason, it is imperative that the reinsurance assignment be governed by the law of the jurisdiction of the reinsurer and the parties agree to submit to the courts in the jurisdiction of the reinsurer. I have had local insurers insist on their local law/courts, and I strongly suspected they were trying to subvert the assignment–knowing that the local courts would find the assignment invalid.

And as discussed in Part 1 of this post, one of the reasons for a lessor requiring reinsurance is to reduce the lessor’s country exposure to the lessee’s jurisdiction. By a lessor agreeing to use the local insurer’s law/courts, it is exposing itself to additional lessee country risk–and, separately, as noted in the preceding paragraph, possibly undermining the validity of the assignment.

2. Things change. Reinsurance policies generally run for a 12 month period. We all talk of “policy renewals” but as a matter of practice (at least in the London market) policies are replaced, not renewed; that is, when one policy expires, a new one will be put in its place. In addition, in the London market the underwriters/insurers for the policy (the “syndicate”) are very likely to change at each renewal–a few will be added, a few will drop out. And most importantly, the local insurer can change at each renewal (and even between renewals).

So, what does a lessor need to do?

(1) A reinsurance assignment needs to be carefully drafted to give the lessor a valid interest under not only the current reinsurance policy, but also under each replacement policy.

(2) In addition, to satisfy the notice of assignment requirement each year, at a bare minimum, the reinsurance certificate issued at renewal should list the reinsurance assignment in the “Contracts” section; a lessor may also want to actually issue a notice of assignment each year, especially if the reinsurance broker changes.

(3) If the primary insurer changes, then there needs to be a new reinsurance assignment–no way around that requirement. Why? Because the replaced primary insurer is the “Assignor” under the existing reinsurance assignment, but no longer has any interest under the reinsurance policy.

All of these “things change” issues should be discussed with the lessor’s counsel from the reinsurers’ jurisdiction during lease documentation, and the lease agreement and reinsurance assignment drafted accordingly. The above requirements are not something you want to try to impose retroactively after delivery–and without adequate support under the provisions of the lease documentation (and I’m not counting the lease agreement’s “further assurances” clause as adequate support).

A reinsurance assignment is not a document can be forgotten after delivery. At a minimum it should be reviewed at each insurance renewal to make sure it is still relevant and accurate. And the lease documentation should be clear that the lessee has an obligation to arrange the amendment or replacement of the reinsurance assignment during the lease term upon the request of the lessor “in order to effectively carry out the intent and purpose of the Reinsurance Assignment and to establish, perfect and protect the rights and remedies created or intended to be created in favor of Lessor thereunder” (or something like that).

A couple other random thoughts on reinsurance:

1. Let’s say (1) an aircraft suffers a total loss, (2) the local insurer fails to pay the lessor any hull insurance proceeds because the local insurer is insolvent (or is made insolvent by the claim from the lessor) and (3) the reinsurers pay the reinsurance proceeds to the local insurer because the cut-though and/or reinsurance assignment is found to be invalid (and almost needless to say the reinsurance proceeds are not passed on by the local insurer to the lessor). Does the lessor have a claim under its contingent insurance policy? Good question. See my discussion of the “exceptions clause” in contingent insurance policies. Such clause usually contains an exception similar to the following:

“This Policy does not pay any claim for liability, loss or damage which is not recoverable (in whole or in part) as a claim from the Principal Policy by reason of the insolvency and/or financial default of an Insurer or Insurers.”

2. I discussed cut-through clauses and reinsurance assignments. Are there any other options? Occasionally counsel in a lessee’s jurisdiction will suggest using an “irrevocable instruction” where the local insurer “irrevocably” instructs the reinsurers to pay the lessor directly. Workarounds put forth by local counsel should always be considered, but I’ve never seen how an irrevocable instruction differs substantively from a cut-through or how it offers more protection than a properly documented reinsurance assignment.