What Is a Cut-Through Clause?

A cut-through clause is a reinsurance contract provision that allows a party, other than the ceding company and reinsurance company, to have rights under the agreement. Cut-through clauses are often triggered by specific events, such as when a ceding company becomes insolvent.

Key Takeaways

  • A cut-through clause is a reinsurance contract provision that allows a party, other than the cedent and reinsurer, to have rights under the contract.
  • Cut-through clauses are often triggered by specific events, such as when a ceding company becomes insolvent.
  • A cut-through clause might allow a third party, such as another reinsurer, insurance company, or policyholder, to gain access to funds.

How a Cut-Through Clause Works

The relationship between the ceding company and reinsurer changes when a cut-through clause is present. A reinsurance contract is made between a ceding company, such as an insurance company, and a reinsurance company. An insurance company is always at risk of an event occurring that would result in a payout of insurance claims made by their policyholders. An insurance company can reduce the risk of their policies being paid out by ceding or transferring some of their policies to another insurer–called a reinsurer. The reinsurance company receives a portion of the ceding company's policies and in exchange, gets paid a portion of the premiums earned by the ceding company–called the cedent–from its policyholder customers.

As a result, the reinsurance company agrees to indemnify the ceding company from claims made. The reinsurance contract is typically between the ceding company and the reinsurer and not any other parties, such as policyholders. In other words, even the insured can't force the reinsurance company to act since the insured is not part of the contractual relationship between the cedent and reinsurer. However, a cut-through clause changes this contractual relationship allowing a third party to have rights against the reinsurance company.

However, those rights only kick in if the cut-through provision has been triggered. The cut-through provision is a clause within the reinsurance agreement that allows a third party to have rights in certain circumstances. A cut-through clause essentially cuts through the contract. However, a cut-through endorsement could be neeeded as well, which is a separate add-on allowing a third party to file a claim for damages from the reinsurer if the cedent is unable to pay.

How a Cut-Through Clause is Used

Cut-through clauses are most commonly attached to reinsurance agreements when the ceding company is struggling or becomes financially insolvent, meaning it can't pay its debts. A cut-through endorsement might also be included, which allows for financial payouts by the reinsurer for claims. Typically, the insured parties obtaining rights under the clause are most in need of protection when the insurance company is insolvent and cannot make payments on claims, or is liquidated by insurance regulators.

Insurance policies and the relationships between the reinsurance companies, cedents, and the insureds can become quite complex. Even reinsurers, for example, cede some of their policies to other reinsurers in a process called retrocession. The receiving reinsurance company of policies from another reinsurer is called the retrocessionaire.

All of these actions of ceding policies from one insurance company to another helps the insurance industry spread out the risk of claims being paid by one insurer. In other words, ceding policies help prevent one insurer from enduring the brunt of payouts following a major event, such as a natural disaster.

A cut-through clause allows third parties, such as reinsurers, insurance companies, and policyholders, to modify the original reinsurance agreement and gain access to funds or rights within that agreement.

However, circumstances can become challenging when a reinsurer has an obligation to the cedent, while the policyholders are also filing a claim for money from the cedent. As a result, a reinsurer may be caught between conflicting demands between the insured, the cedent, and other reinsurers. A clearly defined cut-through clause can help in these challenging situations, particularly if the cedent is insolvent.

Benefits of a Cut-Through Clause

There are numerous benefits to cut-through clauses for all of the parties involved, including the insured, the reinsurer, and the ceding insurance company.

Policyholders

Policyholders benefit from the added protection provided by cut-through provisions. Rather than having to work with insurance regulators to make claims against an insolvent insurer, policyholders can work directly with the reinsurer.

Ceding Insurance Company

Ceding insurers find the clause helpful since it makes the reinsurance company guarantee claims payments, which allows a company that may not typically be able to attract larger commercial clients to seem more stable and thus more attractive.

Reinsurance Company

Reinsurers find the clause useful because it can allow them to provide services in areas where it may not be licensed. A cut-through clause functions as a competitive tool, which enables the reinsurer to capture a certain type of reinsurance business. However, a cut-through endorsement might also be attached, which can help reinsurers that are not licensed in a particular area to provide reinsurance.