Tag Archives: Contingent Insurance

Some Issues with Reinsurance–Part 2

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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.

Contingent Aircraft Insurance: The Exceptions Clause

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As counsel to aircraft lessors I’ve worked with the major brokers in the London insurance markets and have found that the guys (and occasional gal) that work there are on the whole professional, friendly, knowledgeable and very customer oriented, but (you knew the “but” was coming) as a lawyer I frequently am frustrated with the vague drafting of the insurance policies and insurance certificates coming out of London and the equally vague responses to my attempts to understand or clarify the wording.

A prime example of vague drafting are two coverage exceptions that have been in contingent aircraft insurance policies for at least the last 15 years. I’ll discuss those exceptions below, but first some brief background on contingent aircraft insurance.

As you know, each aircraft lessor requires an aircraft lessee to maintain hull/hull war and liability insurance on the lessor’s aircraft during the term of the lease. That insurance is, either directly or ultimately, usually placed through the London insurance market. The London market also sells (or tries to sell) “contingent insurance” directly to the aircraft lessors. Simply stated, contingent insurance covers the risk that the lessee’s insurance doesn’t pay the lessor after a valid claim is made by the lessor. Contingent insurance is generally sold on a fleet basis—that is, the insurance covers the lessor’s entire fleet of aircraft.

I would guess that most aircraft lessors buy contingent insurance. I consider contingent insurance an optional insurance (not a core, required business insurance), but it’s an insurance product that is hard not to buy. If a lessor does buy it and never has to make a claim, the cost is seen as just another cost of doing business—rarely thought about again. If a lessor doesn’t buy it and would have had a claim (or a potential claim), then somebody at the lessor is likely to be fired. I’m not suggesting that the only reason that executives at aircraft lessors buy contingent insurance is for job security, but it is one reason.

With the foregoing as background, let’s get back to the main topic: two coverage exceptions that limit the scope of the contingent insurance. I have seen these exceptions in various policies over the years but the language quoted below is from a policy I found online today through a Google search:

Principal Policy

This Policy does not cover loss or damage which is recoverable as a claim from the Principal Policy.

Insolvency and Financial Default

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 and any amount claimed under a self insured retention within the Principal Policy.

Let’s start with second exception first. Contingent insurance does NOT pay if the primary insurance doesn’t pay because the primary insurer is insolvent. I suspect this fact will surprise some of you. London brokers and underwriters will tell you that this exception is required in contingent insurance policies because Lloyd’s underwriters are prohibited from providing “financial guarantees.” Also note that “insolvent” is not defined and so will likely be broadly construed by a contingent insurer facing a claim.

Now note that contingent insurance also does NOT pay if the primary insurance doesn’t pay “by reason of the . . . financial default of” the primary insurer. What does the “financial default” exception cover that isn’t already covered by the insolvency exception? And isn’t every failure to pay money a “financial default”? I have asked those two questions many times, and have yet to receive a satisfactory response.

Regarding the first exception, note that it does NOT say “this Policy does not cover loss or damage which is recovered as a claim from the Principal Policy”–in other words, you don’t get paid twice. What the above language says is the insured under the contingent policy does not get paid for any claim which is “recoverable” under the primary policy–presumably even if not actually recovered. What does “recoverable” mean? Only that the claim is within the scope of the primary policy? That can’t be right–otherwise no claim would be payable under a contingent policy. That the claim can be recovered if the claimant tries hard enough? Again I have repeatedly raised this issue over the years without a satisfactory resolution.

Some of you may be thinking that I just didn’t do a good job negotiating the language. Maybe, but I don’t think so.

When you look at the look at the two exceptions together a fair question to ask a London broker is: What potential claims under a contingent policy would not fall under one or both of those exceptions? In other words, what risks are actually being covered by contingent insurance? Yet another variation of the question: What are the details of actual claims that have been paid out (or denied) over the last several years?

I don’t mean the above to be a criticism of contingent insurance (I really don’t), but I do think the two exceptions discussed above illustrate the problems lawyers often have when dealing with the London insurance market. Lawyers are looking for clear, precise language that will lead to predictable outcomes over various fact patterns. And the London market operates using insurance forms and precedents that have been in place for years (and years) and that brokers and underwriters are loathe to modify.