Freiberg and Peck, Distribution of Assets of an Insolvent Reinsurer


In AssetInsure Pty Ltd v Newcap Reinsurance Corporation Ltd (in liquidation)1 the High Court of Australia has ruled in a split three-to-two decision that the Australian assets of an insolvent reinsurer should be used to discharge all Australian liabilities, not just liabilities under contracts of insurance, when an insurance company is wound up in Australia. It rejected an argument that it considered would have seen creditors who held insurance policies paid in priority to other general unsecured creditors of the insolvent insurer.

The court also held that the priority afforded by Section 562A of the Corporations Act 2001 in relation to the application of proceeds of contracts of reinsurance, which provides that the proceeds are to be distributed to those insured under the original contract of insurance, also applies where the contract is one of re-reinsurance (sometimes referred to as retrocession).

Background
In Australia, by virtue of Section 555 of the Corporations Act, all debts and other claims proved in a winding-up rank equally and, if the property of the company is insufficient to meet them in full, they must be paid proportionately.

This section embodies the principle of equality among creditors in a liquidation. In the context of the insolvency of an insurance company, there are two important qualifications to this principle in Australia:

(i) Section 116 of the Insurance Act 1973, which requires the assets of an insolvent insurer to be applied first towards the discharge of liabilities in Australia and then, only if and when those liabilities are paid in full, to be made available to meet other liabilities; and

(ii) Sections 562 and 562A of the Corporations Act regarding the proceeds of contracts of insurance and reinsurance where the proceeds are to be paid to the party for whose benefit the reinsurance existed.

Facts
Newcap Reinsurance Corporation Ltd was a company incorporated in Australia, and resident and carrying on business only in Australia, that operated a reinsurance business. Newcap went into voluntary administration in April 1999 and its creditors subsequently resolved that it be wound up.

AssetInsure Pty Ltd, an Australian insurer, and Faraday Underwriting Limited, part of a syndicate of British insurers providing cover in various parts of the world to AK Steel Corporation, were both reinsured under facultative reinsurance contracts with Newcap. Newcap had in turn taken out re-reinsurance (or retrocession) with other reinsurers. Both AssetInsure and Faraday were among Newcap's creditors having claims under the original facultative reinsurance.

The proposals for the reinsurance were accepted by Newcap in Australia and the reinsurance policy was issued by Newcap in Australia. All the relevant risks involved events that could have occurred only at certain defined locations outside Australia.

Proceedings were brought by Newcap's liquidator to resolve issues relating to the manner in which the proceeds of the contracts of retrocession should be distributed among creditors.

Issues
Two issues were considered by the High Court.

The first concerned the operation of Section 116(3) of the Insurance Act, which at that time provided that in the winding-up of an insurance company, the insurer's assets in Australia should be used to discharge only 'liabilities in Australia', unless there are no Australian liabilities. The key question was whether the expression 'liabilities in Australia' for the purpose of Section 116(3) referred only to liabilities under contracts of insurance.

The question was complicated by a need to consider the operation of Section 31 of the Insurance Act which was referred to in Section 116. Section 31 appeared in Part III of the Insurance Act, dealing with the authority to carry on an insurance business. Section 31 makes reference to the liabilities of a company carrying on an insurance business. In particular, it defines what is a liability in Australia in respect of a liability under a contract of insurance or reinsurance.

The second issue concerned whether Section 562A of the Corporations Act applied to the proceeds of a contract of re-reinsurance (or retrocession). This section deals only with contracts of reinsurance and provides for the application of reinsurance proceeds in satisfaction of the insolvent insurer's liabilities under the contracts of insurance that were reinsured. No mention is made of retrocession.

Insurance Act issue
AssetInsure argued that the phrase 'liabilities in Australia' in Section 116 of the Insurance Act was limited to insurance liabilities (including reinsurance) under contracts of insurance.

According to the High Court the consequence of this argument succeeding was as a matter of construction that creditors under insurance contracts would be paid in priority to other creditors of the insurance business (eg, landlords, employees, suppliers of goods and services and financiers) whose claims would be postponed. The High Court said this was not a conclusion in aid of equality of distribution of assets among creditors; rather, it produced inexplicable inequality. The High Court could see no reason why the legislature intended to give policyholders priority over other general creditors.

The High Court found the contract at issue in this case was not a liability in Australia under Section 31(4) of the Insurance Act because it related to liabilities contingent on events that could only happen outside Australia, and which Newcap had not expressly undertaken to satisfy in Australia. However, at common law based on conflict of laws principles relating to the location of a chose in action, it was a liability located in Australia.

Accordingly, the question was whether the purpose of Sections 31(4) and 116(4) was to supplement or exclude the general law in relation to the location of a chose in action determined by conflict of laws principles.

At first instance in the New South Wales Supreme Court, Justice Windeyer had held that 'liabilities in Australia' under Section 116 were not confined to liabilities arising only under insurance contracts. Section 31(4) was not the exclusive basis for determining the location of a liability for the purpose of Section 116. Accordingly, common law conflict of laws principles applied to determine the location of the relevant liability. The New South Wales Court of Appeal reversed this ruling by a two-to-one majority.

The New South Wales Court of Appeal's decision was reversed by the High Court and the decision of the judge at first instance was restored. The majority in the High Court dealt with Section 31(4) of the Insurance Act on the basis that its purpose was to provide affirmatively that certain insurance liabilities will be liabilities in Australia in certain cases where at general law there may be a different conclusion or at least uncertainty.

By contrast, the minority on this issue of Justices Hayne and Kirby came to quite the opposite conclusion, holding that Section 31(4) should be read as an exhaustive definition of 'liabilities in Australia'. They rejected a construction that would allow the common law principles of conflict of laws to determine that a liability was located in Australia where, but for the application of those principles, the liability would have been expressly excluded by Section 31(4).

The minority considered that Section 116(3) had been introduced to resolve the competition that could exist between a local liquidator of a foreign incorporated business and the foreign liquidator appointed under the law of the place of incorporation. Under Australian conflict of laws rules the foreign liquidator would be entitled to speak for the company and could seek control and transfer of its local assets. Without Section 116(3) there was no statutory provision to resolve competition between local and foreign liquidators.

With that background in mind, the minority in the High Court had little hesitation in reading Section 116(3) as confined to liabilities under the contracts specified in Section 31(4), rather than the wider, less definite class of creditors determined by the application of common law rules as to the situs of liabilities.

Corporations Act issue
The second issue was whether Section 562A applied only to the proceeds of the contracts of reinsurance or whether it applied also to the proceeds of contracts of re-reinsurance (or retrocession), such as that taken out by Newcap against liabilities it might incur under reinsurance contracts issued to AssetInsure and Faraday.

At first instance Windeyer had held that Section 562A applied to the proceeds of both reinsurance and re-reinsurance contracts.

Windeyer's decision on the Corporations Act issue was unanimously upheld by the High Court, which found that there was no basis for confining the operation of Section 562A in the winding-up of an insolvent company to only some of the contracts of insurance which the company undertook. The court saw no reason to treat the expressions 'contracts of insurance' and 'contracts of reinsurance' in Section 562A as any more than a drafting device, and not as intended to exclude from Section 562A a retrocession contract by which a reinsurance company had reinsured its risks under reinsurance contracts.

As a result, on the insolvency of a reinsurer, any recoveries under retrocession arrangements will be available after deducting expenses of getting in the recoveries to be paid to the relevant underlying reinsured in priority to other creditors.

Implications
At first glance the decision seems to broaden the classes of creditor entitled to be paid out of Australian assets in the winding-up of an insurer operating in Australia before any surplus is made available for the payment of non-Australian liabilities.

The Insurance Act has now been amended by the insertion of a new Section 116A which applies to general insurers. Part III of the act, which contained Section 31(4), has been repealed, and the provisions in Section 31(4) have effectively been inserted into Section 116A. The legislature has not taken up the minority's invitation to enlarge the class by clear enactment. Thus, the law seems to be back with the majority position, where for liabilities other than under contracts of insurance the question requires consideration and application of the general law, while for liabilities under contracts of insurance it would seem that Section 116A will provide the answer to the question of what is a liability in Australia.

The wider interpretation of Section 562A now provides more certain protection for creditors of insurers who take out reinsurance with a reinsurer in Australia which subsequently reinsures that risk and undertakes to satisfy it in Australia. Subject to the limitations in the section, the proceeds of the retrocession will be available for the creditors whose reinsurance policies were in turn reinsured by the insolvent reinsurer

Freiberg and Peck