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.

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.