Insolvency Clause

DEFINITION of 'Insolvency Clause'

A reinsurance contract clause that requires the reinsurer to uphold its obligations even if the ceding party becomes insolvent. An insolvency clause mandates that in the event that the reinsured becomes insolvent, the reinsurer must still make its payments due, but to the liquidator overseeing the insolvent reinsured's assets.

BREAKING DOWN 'Insolvency Clause'

In a reinsurance contract, the cedent shifts a portion of its liabilities to a reinsurance company. For example, in an excess-of-loss reinsurance treaty, the reinsurer is obligated to pay for losses that exceed what the ceding insurance company has retained. In exchange, the reinsurer receives a portion of the premiums that the insurer collects on the policies that are covered by the reinsurance contract.

The premiums that the reinsurer collects are set aside, with a portion being invested in low-risk, liquid assets that can be readily accessed to pay for its obligations if claims are made. By understanding the liabilities and risks associated with the reinsurance treaty, by pricing accordingly, and by enacting loss control mechanisms the reinsurer increases the likelihood that the contract will be profitable.

While the reinsurer may take steps to ensure that it can cover its obligations, the insurance company that ceded some of its risk may not. In some cases, the insurance company may be unable to meet its obligations to its policyholders, and may become insolvent. State insurance regulators establish guidelines for how to deal with insolvent insurance companies, since it is in their interest to ensure that policyholders are paid for losses.

Just as it is in the interest of insurance regulators to ensure that insurance companies pay for their obligations, so too is it in their interest to ensure that reinsurance companies pay for the obligations that they take on. To do this, regulators may require insolvency clauses to be included in reinsurance contracts. Insolvency clauses are used to ensure that a reinsurance contract remains in force, even in situations in which the ceding insurance company becomes insolvent.

For example, an insurance company enters into an excess-of-loss reinsurance contract with a reinsurer. The insurer has underwritten a property insurance policy with a maximum coverage of $500,000, but only wants to retain $100,000 of liabilities. The reinsurer agrees to cover losses in excess of $100,000 up to $500,000. The policyholder submits a claim for $400,000, but due to poor investments, the insurer is unable to meet its obligations. Even though the insurer can’t pay its $100,000 obligation, the existence of an insolvency clause means that the reinsurer is still responsible for $300,000 in losses ($400,000 claim less the $100,000 the insurer retained).