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.

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