Insurance: limiting indemnity rights when an insured is insolvent

In a recent case, the court held that a party to a settlement agreement (in this case a broker) cannot restrict the indemnity it is providing so that the indemnity is not payable if the insured goes into administration, or liquidation, or undergoes some other insolvency event. The decision is important on its own facts, but it does also raise questions about the legitimacy of other clauses in insurance contracts which depend on whether or not the insured or reinsured has entered into any kind of insolvency event.

A company was insured by the respondent insurer and brought a claim against that insurer for personal injury following an accident involving the company and a third party. The claim was denied on the grounds of an exception in the policy. The company claimed in negligence against its broker, and the parties entered into a settlement agreement under which the broker agreed to indemnify the company for sums payable in respect of the underlying claim. Payment to the company would follow 21 days from payment by the company to the injured party.

A key term of the settlement agreement stipulated that the company’s right to the indemnity ceased if it was subject to an insolvency arrangement. The company subsequently went into administration and the insurer was joined as a defendant. The administrators assigned the benefit of the settlement agreement to insurers. Insurers sought to enforce the indemnity but the broker refused on the basis that the fact that the insured had gone into administration meant the right to the indemnity no longer applied.

The question for the courts to consider was whether the clause in the agreement validly achieved what it set out to do: that the company’s insolvency released the broker from its indemnity obligation?

The Court of Appeal confirmed the first instance decision that the clause in the agreement went against a long-established principle of insolvency law: a court will refuse to enforce provisions in a contract which achieve a distribution of the insolvent’s property that defeats the principles of insolvency legislation and, in particular, the ranking of creditors in the event of an insolvency event such as administration or liquidation (the “anti-deprivation principle”). No-one may, at any time, contract for its property subsisting at the date of the insolvency event to be dealt with in any way that is not in accordance with the Insolvency Act 1986. This includes the right to an indemnity under a settlement agreement. Consequently, in this case, the broker was unable to rely on the clause in the agreement because to do so would deprive the creditors of the company what was rightfully owed to them. Contracting out of the Insolvency Act is against public policy.

This clearly limits the ability of an indemnifying party under a settlement agreement to make the indemnity obligation conditional upon the other party being solvent. It also, however, raises other questions for insureds, insurers, reinsurers and brokers.

First, are cut through clauses in facultative reinsurance arrangements which are triggered when the insurer/reinsured goes into administration, or liquidation, or upon the happening of some other insolvency event, a breach of the anti-deprivation principle?

Secondly, can an insurer or reinsurer restrict the insured or reinsured’s right to an indemnity in circumstances where the insured or reinsured (as the case may be) has gone into administration, gone into liquidation, or undergone some other insolvency event?

The answers to these questions are not straightforward. What this decision does serve to highlight very clearly, though, is that parties to an agreement which contains an obligation which is limited upon the happening of an insolvency event such as administration cannot rely on that term just because it has been clearly drafted and agreed by both parties.

This article first appeared in Law-Now, CMS Cameron McKenna's free online information service, and has been reproduced with their permission. For more information about Law-Now, please go to www.law-now.com.