Liquidators of insurance companies face a major quandary when assessing reinsurance recoveries.
A new Court decision may undercut the legislative policy that reinsurance proceeds should be quarantined from the normal rules for paying out creditors of insolvent companies.
The policy is in section 562A of the Corporations Act. That section applies where an insolvent insurance company has reinsurance for an insurance policy it has issued. Moneys received "under the contract of reinsurance" in respect of a claim under the policy are to be paid directly to the insured, rather than being shared out among all of the company's creditors.
The NSW Supreme Court has just ruled that section 562A does not apply where, instead of recovering directly from the reinsurer, a liquidator realises a sum of money by assigning the proceeds of the reinsurance claim to a third party: In the matter of HIH Casualty & General Insurance Limited  NSWSC 923.
Background to the HIH dispute
HIH was an insurance company in liquidation. It had reinsurance. In anticipation of difficulties in recovering some of the reinsurance debts, the liquidators assigned those debts to a third party (at a discount which reflected the anticipated difficulties).
There was a dispute about the appropriate distribution of the funds received by the liquidator under the assignment. When that dispute went to court, the central issue was whether the funds had been received "under the contract of reinsurance" within the meaning of section 562A.
Section 562A did not apply
Basically, there were three arguments advanced to support the proposition that section 562A applied to the money received by the liquidators.
The first was that, although the immediate source of the payment was the assignment agreement, it ultimately arose under the reinsurance contract.
This was rejected by the Court:
"[T]he relevant payment under the Assignment Agreement was made, not under the contract of reinsurance, but in substitution for any payments that the liquidator would have received had it received a payment under the contract of reinsurance. The requirements of s 562A(1) are therefore not satisfied and that section does not apply to the relevant payment."
The second argument was that excluding the payment from section 562A would frustrate the policy of the section. The Court said that the policy had to take second place to the plain words of the section. Section 562A is a statutory exception to the pari passu rule and can only apply where the statutory requirements have been satisfied. One of those requirements is that the relevant payment must be made "under the contract of reinsurance".
The third argument was a floodgates argument ‒ that liquidators could avoid section 562A by assigning reinsurance debts to third parties. There is no obvious reason why liquidators would want to do that but, as the Court pointed out, any liquidator adopting that course could find himself the subject of a section 536 inquiry into his conduct.
Implications for liquidators of the HIH decision
Unless overturned by a higher court, this decision has significant implications for liquidators ‒ and not just liquidators of insolvent insurance companies.
To begin with, it places liquidators in an invidious position ‒ especially in the current political climate, where liquidators are sometimes accused of prolonging liquidations in order to boost their fees.
Assignment of debts is a commercially-justifiable way of expediting the realisation of assets, particularly where (as in this case), there is no certainty that the debts might ultimately be recoverable. A liquidator who expended a lot of time and money attempting to recover a reinsurance debt would run the risk of being accused of delay and wasting company funds, particularly if the ultimate beneficiary ‒ such as a policyholder ‒ were just one of the company's creditors. On the other hand, that policyholder might take the view that expediting the liquidation by selling the reinsurance debt encroached on the policyholder's statutory entitlements under section 562A.
The other potential problem that the decision may also be applicable to section 562. That section says that, if an insolvent company is insured against a liability to a third party, the proceeds of a claim under that liability policy are to be paid directly to the third party (as with section 562A, bypassing the pari passu rule). The relevant wording in section 562 is "an amount in respect of that liability… received … from the insurer". The Court's reasoning in the HIH case would seem to be equally applicable ‒ if not more so ‒ to that wording.