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Policyholders who can demonstrate third-party beneficiary rights to reinsurance contracts can have direct access to reinsurance proceeds when the main insurer becomes liquidated, Commonwealth Court Judge Mary Hannah Leavitt has ruled in two companion cases of first impression in a Pennsylvania appellate court. Leavitt said the decision to allow direct access is made on a fact-specific basis, and the facts in Koken v. Legion Insurance Co. and Koken v. Villanova Insurance Co. were unique enough to warrant a deviation from the standard rule that reinsurance proceeds become part of the general assets of the estate of a liquidated insurer. The facts of the cases were so distinctive because the insurers to be liquidated, Legion Insurance Co. and Villanova Insurance Co., which fell under the general title of Legion Group, mainly sold “fronting” policies that were reinsured by other insurers. Therefore, the risk of loss was passed almost entirely onto the reinsurers. “The policyholder intervenors, not Legion, placed the reinsurance; Legion neither adjusted nor funded claims; and Legion did not seek to expand its underwriting capacity through reinsurance,” Leavitt said. “Indeed, it sought to avoid any underwriting because its business plan called for generation of fees not underwriting profits.” Attorney John Ellison of Anderson Kill & Olick, the lead attorney representing one of the intervening policyholders, Pulte Homes Inc., said Leavitt’s ruling simply makes sense. “While the court’s ruling is precedent-setting, it is founded on common sense — a party that arranges for, negotiates and pays for a contract has the right to enforce and obtain the benefits of the contract,” Ellison said. “Whether it is called reinsurance or something else, that is and always has been a fundamental tenet of contract law.” The firm’s Timothy Law and Kevin Dreher were also counsel for Pulte. Morgan Lewis & Bockius attorneys Jay H. Calvert Jr. and Richard F. McMenamin were counsel for another policyholder, American Airlines Inc. McMenamin said the case was significant for a reason beyond the policyholders’ issue, because Leavitt allowed liquidation of Legion and Villanova. “This is the third major insurance company placed in liquidation in the last five years in Pennsylvania, in addition to Reliance and PHICO,” McMenamin said. Calvert said it should also be noted that the decision allows other policyholders who can prove the same third-party beneficiary status to seek direct access to reinsurance funds. The state Insurance Department was unable to comment by press time Friday. David R. Moffit of Saul Ewing represented policyholder Rural/Metro Corp. and New York-based attorney Terry Cummings represented policyholder Psychiatrists’ Purchasing Group Inc. According to Leavitt’s 89-page opinion in the lead case, Legion, Insurance Commissioner M. Diane Koken filed petitions asserting grounds to liquidate Legion and Villanova, claiming both insurers consented to liquidation, were insolvent, and that any further rehabilitation was futile and would increase the risk to creditors, policyholders and the public. Leavitt said the ultimate controlling shareholder of both insurers, Mutual Risk Management, was granted intervention to contest the liquidation and that further rehabilitation was futile. The rehabilitation and liquidation of insolvent insurers is governed by Article V of the Insurance Department Act of 1921. Section 518(a) of the act stipulates that the rehabilitator may petition the Commonwealth Court for liquidation if he or she believes further rehabilitation will be fruitless. It also gives the Commonwealth Court the power to allow directors of the targeted insurers to defend against the rehabilitator’s petition. After Koken and MRM underwent evidentiary hearings and submitted briefs, certain policyholders petitioned to intervene, Leavitt said. The court granted intervention to four of them: American Airlines, Rural/Metro, Pulte and PPG. Leavitt said the record was opened to allow the four to introduce evidence as to why the liquidation would harm their interests. A collection of underwriters from Lloyds of London, known as Syndicate 271, filed an emergency petition to intervene, Leavitt said, for the purpose of opposing the relief sought by American Airlines. The petition was granted. Leavitt explained that Legion and Villanova are “fronting companies” offering property and casualty insurance in several commercial insurance programs. In that capacity, they mainly issue insurance policies that were reinsured by other insurers. “The commercial insurance policies they ‘fronted’ generally fell into two basic categories: corporate account business and program business,” Leavitt said. “The goal in writing this business was to generate earnings from fees, not underwriting profits.” Legion and Villanova began accepting some underwriting risks in early 2000, Leavitt said, in an attempt to generate more cash flow through increased premium retention. Its aggregate total responsibility for claims, however, never exceeded 10 percent. Generally, Legion Group funded the loss payout and was reimbursed by the reinsureds. But Legion Group began experiencing cash flow problems, beginning in 1999, Leavitt said. The unpaid claims had been either funded directly by reinsurers or reimbursed by reinsurers upon Legion’s or Villanova’s payment, Leavitt said. “In short, the putative claims backlog of $162.5 million can be substantially reduced by reinsurance payments that the rehabilitator has refused to allow since placing Legion and Villanova into rehabilitation and by collateralized reinsurance,” Leavitt said. The rehabilitations of Legion and Villanova were prompted by their cash flow problems, which were caused by reinsurers who did not make payments on time, Leavitt said. As of June 30, 2002, the reinsurance payments that were past due and owed to Legion and Villanova totaled $310 million, Leavitt said. The situations of Legion and Villanova were unique, Leavitt said, because their woes were not related to statutory surplus. “As of June 30, 2002, Legion had a statutory surplus as regards to policyholders of $289 million, and Villanova had a surplus of $37 million,” Leavitt said. “As the rehabilitator has acknowledged to the court, the Insurance Department, at least since 1989, has never sought to liquidate an insurance company with a positive net worth, as is the case here.” In her legal analysis of the court’s decision regarding the liquidation. Leavitt first found that Koken could not consent to her own petition for liquidation. Leavitt explained that Koken had amended the bylaws of Legion and Villanova to state that “the rehabilitator shall have all the powers of the directors, officers, and managers” of the companies. It was by that power that Koken consented to the liquidation, Leavitt said. However, Article V of the Insurance Department Act does not confer on the rehabilitator the power to amend an insurers’ bylaws to assert “all” rights of its board of directors onto the rehabilitator, Leavitt said, and it does not give a rehabilitator the power to consent to an insurer’s liquidation. The court also rejected Koken’s argument that she should be allowed to decide when to liquidate an insurer unless the court finds she has abused her discretion. The policyholders argued a standard liquidation would harm their interests. Instead, they wanted direct access to their reinsurance, in either continued rehabilitation or liquidation. Koken had suggested that all reinsurance proceeds would become general assets of Legion and Villanova. “At some point, which all parties agree is many years away, those assets will be used to pay policyholder claims,” Leavitt said. “In the meantime, policyholder claims will be transferred to various state guaranty funds for payment.” Leavitt said there is some case law establishing that insureds may have a right to directly access reinsurance, citing a 1981 Philadelphia Common Pleas Court case, Mellon v. Security Mutual Casualty Co. The Mellon court acknowledged that courts in several jurisdictions had granted insureds direct access to reinsurance on several alternative grounds and that there are exceptions to the general rule. Looking at the specific facts of the policyholders’ reinsurance agreements in the instant case, Leavitt said Pulte, Rural/Metro and PPG all claimed third-party beneficiary rights stemming from facultative reinsurance agreements specific to their individual risks. American Airlines claimed rights under a reinsurance agreement that is not strictly facultative. Leavitt noted that the contract between Legion and Syndicate 271 contains language that sets forth American’s right to “cut-through Legion to collect reinsurance directly from Syndicate 271.” Leavitt said that despite their different circumstances, each policyholder successfully proved third-party beneficiary status under the two-part test established in the 1983 state Supreme Court case Guy v. Liederbach. The test considers whether recognition of the beneficiary’s right is “appropriate to effectuate the intention of the parties” and that the contract performance satisfies “an obligation of the promisee to pay money to the beneficiary” or “circumstances indicate that the promisee intends to give the beneficiary the benefit of the promised performance.” “Legion acted as a fronting company, and it bore no true underwriting risk. Legion did not underwrite the risk, but, rather, was content to allow the true risk bearer, the reinsurer, to conduct the necessary due diligence,” Leavitt said. “Legion also did not participate in the claims handling process, or the funding of claims. In all cases, these were the responsibility of the reinsurers.” Direct access is expressly authorized by Article V, Leavitt said, where it states: “Payment made directly to an insured or other creditor shall not diminish the reinsurer’s obligation to the insurer’s estate except when the reinsurance contract provided for direct coverage of an individual named insured and the payment was made in discharge of that obligation.” Turning back to the liquidation issue, Leavitt said continued rehabilitation could substantially increase the policyholders’ risk of loss. Liquidation was preferable, she said. “Liquidation will result in the transfer of all claims files to guaranty funds that will become responsible not only for workers’ compensation and health insurance claims but also for the claims that have been in stasis since the inception of the rehabilitation,” Leavitt said. Leavitt noted that guaranty fund coverage will satisfy most of Legion’s and Villanova’s claims, although “guaranty funds are not a panacea” for all claims. “The court is persuaded that access to guaranty fund coverage is needed and that access will not occur in the absence of a liquidation,” Leavitt said.

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