Policyholders Demonstrating Third-Party Beneficiary Rights Granted Direct Access to Reinsurance Proceeds Under Facultative Contracts

On July 19, 2005, in a per curiam opinion, the Pennsylvania Supreme Court affirmed the Commonwealth Court's opinion in Koken v. Legion Insurance Company, which had been decided by Judge Mary Hannah Leavitt on June 26, 2003, Koken v. Legion Insurance Company, 831 A.2d 1196 (Pa. Commw. 2003), aff'd, 878 A.2d 51 (Pa. 2005).

In a precedent-setting decision, the Pennsylvania Supreme Court has allowed policyholders who can demonstrate third-party beneficiary rights in reinsurance contracts to access directly reinsurance proceeds under facultative reinsurance contracts covering their specific insurance programs. The Pennsylvania Supreme Court affirmed on the basis of the opinion of Commonwealth Court Judge Leavitt, which placed Legion Insurance Company and Villanova Insurance Company into liquidation, while allowing certain policyholders to recover directly from reinsurance companies.

Legion sold many 'fronting' insurance policies, in which the policyholder's risk of loss was passed through entirely to reinsurance companies. Often, policyholders had directly purchased the reinsurance from solvent reinsurance companies, and Legion issued an insurance policy solely to meet regulatory requirements. When Legion became insolvent, however, Legion claimed that all of the reinsurance proceeds should flow into the estate instead of flowing to the policyholders who had arranged and paid for the reinsurance.

Four policyholders had intervened in the Commonwealth Court proceedings, seeking direct access to reinsurance. In considering the claims of those policyholders, Judge Leavitt had concluded that 'Legion has no right to the proceeds of the reinsurance agreements that cover the liability claims of Pulte Homes, Inc.; Psychiatrists' Purchasing Group, Inc.; Rural/Metro Corporation; and American Airlines, Inc.'

For example, Pulte Homes directly purchased reinsurance for Pulte's sole benefit and used Legion Insurance Company as a licensed 'fronting' or 'pass-through' insurance company to issue certificates of insurance to enable Pulte to satisfy state and regulatory financial responsibility requirements. For its services, Legion received a fronting fee every year. The reinsurance companies bore the entire risk of any losses in excess of Pulte's deductible. A third-party administrator handled all claims that were covered by the general liability insurance policies.

Judge Leavitt had found that Pulte and the other intervening policyholders would be harmed if they were denied access to the reinsurance they had purchased for their benefit. The court found that while in most insurance company liquidations reinsurance proceeds become general assets of the estate, the general rule has no application to Legion when Legion did not place the reinsurance, adjust claims, fund claims, or expand its underwriting capacity through reinsurance. In short, according to the reasoning affirmed by the Pennsylvania Supreme Court, the general rule made 'little sense, however, where following it will turn upside down the contractual arrangements established by the Policyholder Intervenors for providing for their liability risk.'

Under Judge Leavitt's reasoning, which was adopted by the Pennsylvania Supreme Court, 'Direct access to reinsurance in the case of the above-named Policyholder Intervenors will give effect to the reasonable expectations of policyholders; will not adversely affect the Legion estate; and will not constitute preferences. Each of the above-named Policyholder Intervenors has a contractual right, as a third-party beneficiary, to payment by the reinsurer on its losses.'

In addition to approving direct access by those four policyholders, the Pennsylvania Supreme Court's decision affirms Judge Leavitt's mandate that the Liquidator must create a procedure for allowing direct access for policyholders in situations similar to those of the Policyholder Intervenors. This allows a number of other policyholders the ability to pursue their direct access rights to reinsurance in the Commonwealth Court insolvency proceedings.

The Pennsylvania Supreme Court's decision affirms Judge Leavitt's rejection of the argument 'that 'sophisticated' policyholders are less deserving than others and, thus, prime candidates for having their contractual expectations compromised.' Judge Leavitt had recognized that the equitable purpose of a rehabilitation or liquidation is to protect all consumers of insurance, big or small, rich or poor. The Pennsylvania Supreme Court agrees.

A dissenting opinion was filed by Justice Sandra Schultz Newman, which was joined by Justice Ronald D. Castille. The dissenters recognized the established common-law rule that a policyholder may bring a direct action against a reinsurance company when the policyholder is deemed to be a third-party beneficiary of the reinsurance contract. Nevertheless, the dissenters believed that Section 534 of the Insurance Department Act required those third-party rights to be expressly set forth in the reinsurance contract. Because the dissenters did not believe that the reinsurance contracts contained such express provisions, they would have reversed.

The dissenters, however, did not refute Judge Leavitt's factual findings reached after days of evidentiary hearings that, when construed as a whole, the reinsurance contracts did provide third-party beneficiary rights to Pulte and the other policyholder intervenors. Indeed, Judge Leavitt had answered the concerns of the dissent before they were made:

A facultative reinsurance agreement provides for 'direct coverage of an individual named insured.' Section 534 of Article V, 40 P.S. '221.34. No other inference is possible where the reinsurer, not Legion, bears 100% of the underwriting risk, and the reinsurer was chosen by the policyholder. This was the case with all the Policyholder Intervenors. The Policyholder Intervenors, through their consultants and agents, chose their reinsurers as the intended source of their coverage. The fronting party was the last party to the transaction; its identity was not even known until after the reinsurance was placed and all material terms decided by the Policyholder Intervenors and their reinsurers. Notably, Section 534 refers to diminishment of the estate. Here, Legion's estate will be saved diminishment by allowing Policyholder Intervenors direct access. This step will relieve Legion of the expenses of claims adjustment, reinsurance billing and collections. At the same time, Legion will not have the liability for substantial claims. Koken v. Legion Insurance Company, 831 A.2d 1196, 1241 (Pa. Commw. 2003).

John N. Ellison and Timothy P. Law are shareholders at Anderson Kill & Olick, P.C. The authors represented Pulte Homes, Inc.

On July 19, 2005, in a per curiam opinion, the Pennsylvania Supreme Court affirmed the Commonwealth Court's opinion in Koken v. Legion Insurance Company , which had been decided by Judge Mary Hannah Leavitt on June 26, 2003, Koken v. Legion Insurance Company , 831 A.2d 1196 (Pa. Commw. 2003), aff'd , 878 A.2d 51 (Pa. 2005).

In a precedent-setting decision, the Pennsylvania Supreme Court has allowed policyholders who can demonstrate third-party beneficiary rights in reinsurance contracts to access directly reinsurance proceeds under facultative reinsurance contracts covering their specific insurance programs. The Pennsylvania Supreme Court affirmed on the basis of the opinion of Commonwealth Court Judge Leavitt, which placed Legion Insurance Company and Villanova Insurance Company into liquidation, while allowing certain policyholders to recover directly from reinsurance companies.

Legion sold many 'fronting' insurance policies, in which the policyholder's risk of loss was passed through entirely to reinsurance companies. Often, policyholders had directly purchased the reinsurance from solvent reinsurance companies, and Legion issued an insurance policy solely to meet regulatory requirements. When Legion became insolvent, however, Legion claimed that all of the reinsurance proceeds should flow into the estate instead of flowing to the policyholders who had arranged and paid for the reinsurance.

Four policyholders had intervened in the Commonwealth Court proceedings, seeking direct access to reinsurance. In considering the claims of those policyholders, Judge Leavitt had concluded that 'Legion has no right to the proceeds of the reinsurance agreements that cover the liability claims of Pulte Homes, Inc.; Psychiatrists' Purchasing Group, Inc.; Rural/Metro Corporation; and American Airlines, Inc.'

For example, Pulte Homes directly purchased reinsurance for Pulte's sole benefit and used Legion Insurance Company as a licensed 'fronting' or 'pass-through' insurance company to issue certificates of insurance to enable Pulte to satisfy state and regulatory financial responsibility requirements. For its services, Legion received a fronting fee every year. The reinsurance companies bore the entire risk of any losses in excess of Pulte's deductible. A third-party administrator handled all claims that were covered by the general liability insurance policies.

Judge Leavitt had found that Pulte and the other intervening policyholders would be harmed if they were denied access to the reinsurance they had purchased for their benefit. The court found that while in most insurance company liquidations reinsurance proceeds become general assets of the estate, the general rule has no application to Legion when Legion did not place the reinsurance, adjust claims, fund claims, or expand its underwriting capacity through reinsurance. In short, according to the reasoning affirmed by the Pennsylvania Supreme Court, the general rule made 'little sense, however, where following it will turn upside down the contractual arrangements established by the Policyholder Intervenors for providing for their liability risk.'

Under Judge Leavitt's reasoning, which was adopted by the Pennsylvania Supreme Court, 'Direct access to reinsurance in the case of the above-named Policyholder Intervenors will give effect to the reasonable expectations of policyholders; will not adversely affect the Legion estate; and will not constitute preferences. Each of the above-named Policyholder Intervenors has a contractual right, as a third-party beneficiary, to payment by the reinsurer on its losses.'

In addition to approving direct access by those four policyholders, the Pennsylvania Supreme Court's decision affirms Judge Leavitt's mandate that the Liquidator must create a procedure for allowing direct access for policyholders in situations similar to those of the Policyholder Intervenors. This allows a number of other policyholders the ability to pursue their direct access rights to reinsurance in the Commonwealth Court insolvency proceedings.

The Pennsylvania Supreme Court's decision affirms Judge Leavitt's rejection of the argument 'that 'sophisticated' policyholders are less deserving than others and, thus, prime candidates for having their contractual expectations compromised.' Judge Leavitt had recognized that the equitable purpose of a rehabilitation or liquidation is to protect all consumers of insurance, big or small, rich or poor. The Pennsylvania Supreme Court agrees.

A dissenting opinion was filed by Justice Sandra Schultz Newman, which was joined by Justice Ronald D. Castille. The dissenters recognized the established common-law rule that a policyholder may bring a direct action against a reinsurance company when the policyholder is deemed to be a third-party beneficiary of the reinsurance contract. Nevertheless, the dissenters believed that Section 534 of the Insurance Department Act required those third-party rights to be expressly set forth in the reinsurance contract. Because the dissenters did not believe that the reinsurance contracts contained such express provisions, they would have reversed.

The dissenters, however, did not refute Judge Leavitt's factual findings reached after days of evidentiary hearings that, when construed as a whole, the reinsurance contracts did provide third-party beneficiary rights to Pulte and the other policyholder intervenors. Indeed, Judge Leavitt had answered the concerns of the dissent before they were made:

A facultative reinsurance agreement provides for 'direct coverage of an individual named insured.' Section 534 of Article V, 40 P.S. '221.34. No other inference is possible where the reinsurer, not Legion, bears 100% of the underwriting risk, and the reinsurer was chosen by the policyholder. This was the case with all the Policyholder Intervenors. The Policyholder Intervenors, through their consultants and agents, chose their reinsurers as the intended source of their coverage. The fronting party was the last party to the transaction; its identity was not even known until after the reinsurance was placed and all material terms decided by the Policyholder Intervenors and their reinsurers. Notably, Section 534 refers to diminishment of the estate. Here, Legion's estate will be saved diminishment by allowing Policyholder Intervenors direct access. This step will relieve Legion of the expenses of claims adjustment, reinsurance billing and collections. At the same time, Legion will not have the liability for substantial claims. Koken v. Legion Insurance Company , 831 A.2d 1196, 1241 (Pa. Commw. 2003).

John N. Ellison and Timothy P. Law are shareholders at Anderson Kill & Olick, P.C. The authors represented Pulte Homes, Inc.