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Cancelling insurance: insolvency and downgrade clauses

March 2009 - Insurance. Legal Developments by Reynolds Porter Chamberlain LLP.

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One of the most common concerns for both parties to an insurance contract (including reinsurance) is that the other party might become insolvent and unable to perform its obligations under the contract. Both insurer and insured will therefore wish to have the right to cancel the insurance mid-term in the event of the other party’s insolvency, or a change in its financial circumstances that makes its insolvency a more likely prospect in the near future.

A typical cancellation clause will include a number of grounds to cancel the policy, one of which will be insolvency. In relation to potential or actual insolvency as a cancellation trigger, the range of events that can constitute ‚Äėinsolvency‚Äô should be clearly defined to avoid disputes. The definition of ‚Äėinsolvency‚Äô should take into account the various procedures by which companies can be wound up or put into administration, both in the UK and under equivalent insolvency regimes in other jurisdictions (if applicable).‚Ä©


Other events that do not amount to an insolvency event but represent a significant worsening of a company’s financial position falling short of insolvency (eg financial impairment, loss of paid-up capital) should be clearly defined if they are intended to permit unilateral cancellation by a policyholder. There is no consistent internationally accepted interpretation of these terms and yet most standard market clauses fail to give any clarification as to their intended meaning.


Where mid-term cancellation occurs there will usually be a formula for return of premium, which may take into account reinstatement premiums, as well as any loss reserves. ‚Ä©


The parties to the (re)insurance contract may also wish to ensure that the opportunity to terminate the contract arises well in advance of an insolvency event occurring. A cancellation clause may therefore also provide for either party to cancel in the event of a change in the other party’s financial circumstances that falls short of an insolvency event, but indicates a significant worsening of its financial status and ability to pay its debts and the real prospect of it being declared insolvent in the near future. Typical examples include a given percentage impairment of the insurer’s capital or a reduction in paid-up capital (effectively the same thing), or a percentage loss of policyholders’ surplus funds. For similar reasons, there may be a right to terminate in the event that the insurer is no longer authorised to transact insurance business because of solvency issues.


Also for similar reasons, the policyholder may be given the right to cancel in the event of the insurer’s financial strength being downgraded, as rated by one of the principal ratings agencies, such as A.M. Best or Standard & Poor’s. This reflects the commercial reality that the policyholder may have internal requirements as regards security, and the fact that a downgrading may suggest financial difficulties being experienced by the insurer.


The industry has long been concerned at the power of the ratings agencies and one of the reasons why insurers and reinsurers are very sensitive to rating downgrades is the existence of these cancellation triggers.‚Ä©


For downgrade clauses it is common for an A or A- rating to be specified as the benchmark below which insureds are entitled to invoke cancellation. There are hundreds of insurance companies that presently have such ratings and, given the pressures of the global credit crunch, there is an obvious risk that, over time, a number of these companies may come to be downgraded to BBB status or lower.‚Ä©


The consequences of downgrades are, of course, at their most extreme in the bond insurance market, where the securities they ‚Äėwrap‚Äô or back may be downgraded as well, creating counterparty and credit risk for related transactional parties.‚Ä©


A concern amongst some insurers at the moment is the introduction into downgrade provisions of language that entitles the policyholder to invoke cancellation if the policyholder subjectively considers that the security of the insurer has materially deteriorated since inception of the policy. The obvious difficulty insurers have with brokers seeking to use such language is the subjective, discretionary element given to the policyholder and the scope for related disputes arising.‚Ä©


The global credit crisis brings an increased risk of insurer insolvency and ratings agency downgrades. Such events may give policyholders the right to cancel policies mid-term, but the cancellation triggers are not standard and should be checked. If in doubt, speak to your broker.‚Ä©

‚Ä©By Simon Kilgour, partner, Reynolds Porter Chamberlain LLP. ‚Ä©E-mail: