What is an 'Insolvency Clause'

An insolvency clause is a reinsurance contract clause that requires the reinsurer to uphold its obligations even if the ceding party becomes insolvent. An insolvency clause mandates the reinsurer must make all payments due. Payment is to the liquidator overseeing the bankrupt ceding party assets.

BREAKING DOWN 'Insolvency Clause'

Insolvency clauses, as part of a reinsurance contract, assure that a reinsurance contract remains in force, even in situations in which the ceding insurance company becomes insolvent.

In a reinsurance contract, the cedent shifts a portion of its liabilities to a reinsurance company to spread its risk. For example, an excess-of-loss reinsurance treaty obligates the reinsurer to pay for losses that exceed what the ceding insurance company retained. As payment for this possible risk, the reinsurer will receive a portion of policy premiums collected by the ceding insurer for those policies they covered. The premiums the reinsurer collects are set aside, with a portion invested in low-risk, liquid assets readily assessable to pay its obligations for any possible claims. 

The reinsurer will increase the likelihood of a profitable relationship through understanding liabilities and risks associated with the reinsurance treaty. A price will match the risk, and the reinsurer may enact various loss control mechanisms.

A reinsurer may take steps to guarantee it can cover its obligations but cannot control the actions of the ceding company. In some situations, the ceding company may be unable to meet its obligations to policyholders and may become insolvent. State insurance regulators establish guidelines for dealing with bankrupt insurance companies. It is in the best interest of the state and its citizens to warrant policyholders receive payment for losses. Regulators will also assure that reinsurance companies pay for the obligations they assume. To this end, regulators may require the inclusion of insolvency clauses in reinsurance contracts. 

Insolvency Clause Example

For example, an insurer has underwritten a property insurance policy for a civil engineer with maximum coverage of $500,000 but wishes to retain only $100,000 of the liability. The company then enters into an excess-of-loss reinsurance contract with a reinsurer. The excess loss contract includes an insolvency clause due to regulatory oversight. The reinsurer agrees to cover losses exceeding the $100,000 commitment. They will agree to cover up to the total $500,000 liability of the written policy. 

If the policyholder submits a claim for $400,000, and the ceding company is unable to meet its obligations, the reinsurer is still responsible for their portion of the claim, or $300,000.

RELATED TERMS
  1. Ceding Company

    A ceding company is an insurance company that passes a part or ...
  2. Reinsurance Ceded

    Reinsurance ceded is the portion of risk that a primary insurer ...
  3. Ceded Reinsurance Leverage

    Ceded Reinsurance Leverage is the ratio of ceded insurance balances ...
  4. Obligatory Reinsurance

    Obligatory reinsurance is when the ceding insurer agrees to send ...
  5. Underlying Retention

    Underlying retention is the net amount of risk or liability arising ...
  6. Reinsurance

    Reinsurance is the practice of one or more insurers assuming ...
Related Articles
  1. Insurance

    When Things Go Awry, Insurers Get Reinsured

    Guru Warren Buffett is making this sector popular. Learn more here.
  2. Tech

    The Reinsurance Industry: An Inside Look (BRK.A)

    Warren Buffett has a major influence on the global reinsurance market, which has seen momentum in 2016 for higher revenue.
  3. Investing

    5 Reinsurance Stocks To Watch

    Due to the decline in the reinsurance sector, many stocks within the sector are now trading at historic lows relative to book value. For investors, the time may be right to pounce on the values. ...
  4. Insurance

    Insurance, Excess Insurance and Reinsurance: What's the Difference? (ALL)

    Understanding the differences might help you avoid being overinsured or underinsured.
  5. Insurance

    Third Point Reinsurance Notes Largest Profit in Years

    Third Point Reinsurance saw a tripling of net income in the second quarter of 2016 over last year.
  6. Taxes

    2 Ways Hedge Funds Avoid Paying Taxes

    Learn about two strategies hedge funds use to minimize their tax liabilities. Read why some hedge funds are in the reinsurance business in Bermuda.
  7. Insurance

    Life Insurance Clauses Determine Your Coverage

    Understanding these key parts of your policy will help you to ensure that your family will be covered.
  8. Insurance

    World's Top 10 Insurance Companies

    These are the 10 largest insurance companies in the world.
  9. Small Business

    Berkshire Hathaway Stock: Analyzing 5 Key Customers (BRK)

    Discover how Berkshire Hathaway began as a failing textile company and grew into the fifth-largest company worldwide with help from its key customers.
RELATED FAQS
  1. What Is an Alienation Clause?

    An alienation clause when in reference to insurance policies, mortgages or commercial loans stipulates certain things to ... Read Answer >>
  2. How is the consumer price index (CPI) used in market escalation contracts?

    Understand the purpose of market escalation contracts and learn how the consumer price index (CPI) is often used to make ... Read Answer >>
  3. Are my investments insured?

    Find out what types of insurance investors have against investment losses. Learn about the protections against broker bankruptcy ... Read Answer >>
  4. Can my insurance company refuse me coverage?

    Insurance isn't always as straightforward as other products, and insurers can deny coverage in many different instances. Read Answer >>
  5. How much do changes in interest rates affect the profitability of the insurance sector?

    Learn about the relationship between interest rates and insurance company profitability, and how interest rates can affect ... Read Answer >>
Trading Center