Cut-through clause

A cut-through clause (cut-through endorsement, or direct payment clause) carves an exception into the privity of a reinsurance contract, which binds only the cedant and the reinsurer and gives the insured no rights. It provides that if the cedant becomes insolvent, the reinsurer pays the ultimate insured, or a named beneficiary, directly and up to its share. The issue it addresses is security. An insured buying from a weakly rated carrier, often because a fronting arrangement or a captive requires it, wants the reinsurer's strength to actually reach it; without cut-through, the reinsurance recovery falls into the liquidation estate and is shared among all creditors. Its neighbor, the insolvency clause, pulls the other way: it makes the reinsurer pay the liquidator in full, for the benefit of the estate. How the two interact is the first thing to check in any treaty. Whether the clause holds depends on the governing law and on the insolvency forum; some regimes treat it as an unlawful preference among creditors and set it aside, others uphold it. The clause is therefore only as good as the legal opinion obtained for the likely place of liquidation, not the place of the contract. The 2001 failure of Reliance Insurance Company, one of the largest property and casualty insurer collapses in US history with several billion dollars in assets, showed the risk in practice. Many insureds under policies Reliance fronted ended up relying on state guaranty funds rather than the underlying reinsurance, because no explicit cut-through clause tied them to the reinsurers.