Lead Opinion
Opinion
Insurance Code section 620 (all further statutory references are to this code unless otherwise stated) defines a reinsurance contract as “one by which an insurer procures a third person to insure him against loss or liability by reason of such original insurance.” Typically, under a reinsurance contract, the primary insurer “cedes” a portion of the premiums for its policies, and the losses on those policies, to the reinsurer.
In a reinsurance transaction, policyholders pay premiums to their original insurer, who, in turn, pays a reinsurer a percentage of the initial premiums as consideration for reinsuring a specified part of the original risk. If, after a loss, the original insurer must compensate its policyholders, the reinsurer in turn indemnifies the insurer. The advantage of reinsurance is to secure to the original insurer adequate risk distribution by transferring a portion of the risk assumed to another insurer. (Semple & Hall, The Reinsurer’s Liability in the Event of the Insolvency of a Ceding Property and Casualty Insurer (hereafter Semple & Hall) (1986) 21 Tort & Ins.L.J. 407 [“A reinsurance agreement is one by which the reinsurer indemnifies the ceding company for losses paid”].)
We granted review to determine as a matter of first impression whether reinsurance debts and credits generated between a reinsurer and the original insurer, under the terms of their reciprocal reinsurance contracts, may be set off pursuant to section 1031, when the original insurer becomes insolvent. Section 1031 provides in pertinent part that: “In all cases of mutual debts or mutual credits between the person in liquidation under Section 1016 and any other person, such credits and debts shall be set off and the balance only shall be allowed or paid. . . .”
Section 1031 allows the setoff of all mutual debts and credits in the course of liquidation proceedings and is patterned after the federal Bankruptcy Act of 1898 (11 U.S.C. § 108, repealed and reenacted as 11 U.S.C. § 553), and an identical New York statute that has been adopted by several states (N.Y.
Assuming setoff is permitted, there remain questions pertaining to the relative priorities of setoff and other claims in liquidation against the insurer. An exception to the general rule of section 1031 is provided in section 1031, subdivision (a) (hereafter section 1031(a)), which does not allow setoff when the “obligation of the person in liquidation to such other person does not entitle such other person claiming such setoff to share as a claimant in the assets of such person in liquidation.” Accordingly, we must also consider whether section 1031(a) allows setoff claims if the estate has insufficient assets to satisfy fully all primary policyholders and claims of the California Insurance Guarantee Association (CIGA) whose claims, absent setoff, have priority (under section 1033) over those of reinsurers and other general creditors.
We conclude that section 1031 may not reasonably be construed as conditioning a reinsurer’s right to set off on the insolvent insurer’s ability to
We also conclude that section 1031(a) does not preclude setoff in this case. Plaintiff reinsurer has shown a contractual and legal entitlement to the status of creditor of the insolvent insurer, and the contract between the two entities does not make setoff contingent on the ultimate financial ability of the original insurer or its estate to first pay all claimants in higher priority classes.
Finally, we determine that any policy considerations favoring payment of insureds under original policies may not override the unequivocal language of section 1031 or policies favoring setoff. To disallow setoff in this case would not only subvert clear legislative intent, but would also lead to an increased cost of insurance for the consumer, because offsetting an insurer’s debts spreads the risk incurred by the insurer and often allows smaller insurers to remain in business. (See Stamp v. Insurance Co. of North America (7th Cir. 1990)
I. Background
On February 2, 1982, the Commissioner of Insurance (Commissioner) placed Mission Insurance Company (Mission) and its affiliated insurance companies into conservatorship due to insolvency. (§ 1011, subd. (d) [vesting title to assets in Commissioner when insurer’s transaction of business is hazardous to policyholders].) Several weeks later, the Commissioner obtained an order pursuant to section 1016, authorizing liquidation of the Mission companies. The Commissioner was appointed liquidator, and thereafter demanded all reinsurers of Mission pay in full the amounts owed under their reinsurance contracts. The reinsurers refused to make any such payments, claiming that under section 1031, they were entitled to set off the amounts owed by Mission for reinsurance proceeds and “unearned premiums” (or amounts insureds prepaid for coverage in the days and months ahead), owed to them by the insolvent insurers, against the debts they owed the insolvent insurers under reinsurance contracts executed prior to insolvency. The Commissioner commenced the underlying action against 144 reinsurers, and brought the present summary judgment motion against petitioner Prudential Reinsurance Company (Prudential Reinsurance) to compel payment, without setoff, of moneys owed the Mission companies.
The trial court granted the Commissioner’s summary judgment motion on the ground that section 1031 allows a setoff only when the assets of the
The Court of Appeal followed the rule of every state and federal court that has considered the reinsurer’s right to statutory setoff and issued a peremptory writ of mandate ordering the trial court to vacate its order granting summary judgment and to enter a new order allowing Prudential Reinsurance the right of setoff. The Commissioner seeks our review of this judgment.
As we explain, we adopt the thoughtful analysis of the Court of Appeal and conclude that a plain reading of sections 1031 and 1033 allows an insolvent insurer and a reinsurer to set off debts and credits after the appointment of a liquidator. Because we agree with the Court of Appeal that Prudential Reinsurance is entitled to set off Mission’s debts, we affirm the Court of Appeal’s judgment.
II. Discussion
A. The Reinsurance Contracts
Reinsurance contracts, as contracts of indemnity, operate to shift a part of the risk of loss under the insurance policy from the original insurer to the reinsurer. (1 Cal. Insurance Law & Practice, Reinsurance (1991) § 11.01, pp. 11-6, 11-7.) The insured, however, remains in privity with the original insurer, and the reinsurer owes no duties to the insured. (Ibid.) Thus, the original insured has no right to pursue contract or bad faith actions against the reinsurer. (§ 623; Ascherman v. General Reinsurance Corp. (1986)
Reinsurance contracts are classified as either “facultative” or “treaty.” Reinsurance is facultative if it covers the reinsured’s risk on an individual policy. The majority of reinsurance contracts are placed under a treaty, which covers the reinsured’s risk for an entire class of policies. (1 Cal. Insurance Law & Practice, supra, § 11.02, at p. 11-22.)
In the present case, Prudential Reinsurance is the reinsurer under 14 reinsurance treaties. The parties refer to these treaties as “Relation A” contracts; these contracts reinsure the Mission companies. The other reinsurance contracts at issue here are called “Relation B” contracts and reinsure
The setoff clauses of the “Relation A” contracts provide in substance that Mission, other named Mission subsidiaries (as reinsureds), and Prudential Reinsurance (as reinsurer) agree that the parties thereto may offset any and all reinsurance debts owed by or to them “under the same or any other reinsurance agreement between them.” Some of the clauses acknowledge that in the event of insolvency of a party thereto, setoff rights are controlled by section 1031. Similarly, the “Relation B” contracts also grant Prudential Reinsurance the express right to set off moneys due from Mission against amounts due Mission under the same or any other reinsurance contract between them. Keeping this background in mind, we now turn to the issues before us.
B. Mutuality
As noted above, in 1935 the Legislature granted a statutory right of set-off under section 1031 “in all cases of mutual debts or mutual credits.” The key to setoff is the requirement of mutuality. Justice Benjamin Cardozo defined mutuality as follows: “To be mutual, [the debts] must be due to and from the same persons in the same capacity.” (Beecher v. Peter A. Vogt Mfg. Co. (1920)
Next, such debts must exist between the same persons or entities in order to establish mutuality of identities. (Matter of Midland Ins. Co. (N.Y. 1992)
1. Contemporaneous Mutuality
The Commissioner first contends the reinsurance obligations between Prudential Reinsurance, its subsidiary, Gibraltar, and Mission did not meet the contemporaneous requirement for mutuality, because the debts owed by the reinsurers to Mission (namely, payments on insured losses) are postliquidation debts, while those owed to the reinsurers by Mission (namely, past-due premiums) are preliquidation debts. The Commissioner reasons that the reinsurance proceeds and the return of policy premiums may not be set off because those debts are postliquidation debts that will not be due until the policyholders’ loss claims are allowed or liquidated. As the Court of Appeal herein observed, however, the Commissioner’s assertion is not supported by section 1031 or case law.
Prior to the enactment of sections 1031 and 1033 in 1935, California and federal decisions addressing the common law doctrine of equitable setoff held that debts and credits of an insolvent insurer amounted to mutual obligations for purposes of equitable setoff even if the obligations were technically not payable until closing of the insolvency estate.
For example, in Carr v. Hamilton (1889)
In Downey v. Humphreys, supra,
After the trial court allowed the setoff, the Court of Appeal affirmed on the ground that the agreement between the agent and the insurer that their cross-claims should mutually compensate each other, established the necessary relationship between the parties—that of debtor and creditor—to permit the setoff. (Downey v. Humphreys, supra, 102 Cal.App.2d at pp. 335-336.) In so holding, the Downey court reasoned that, “At the time [the insurer] was adjudicated insolvent, April 19, 1933, and at the time the liquidator was appointed, June 28, 1933, the statute providing for prоceedings against delinquent insurance companies was silent as to the right of setoff. (Stats. 1919, p. 265, as amended Stats. 1933, p. 1420.) In 1935 the statute was amended to provide for setoff of mutual debts and mutual credits. (Stats. 1935, p. 544.) The statute was based on the New York law and was but the enactment of the prevailing rule. [Citations]. The Bankruptcy Act provides for a setoff of mutual debts and mutual credits. (11 U.S.C.A. § 108.)” (Downey, supra,
“A receiver occupies no better position than that which was occupied by the party for whom he acts. . . . The right [of setoff] is to be determined by the condition of things as they existed at the moment the party was adjudged insolvent. If the right of setoff was available to defendant at that time, the insolvency of [the insurer] did not defeat it. [Citations.] The fact that the policyholders received their unearned premiums did not create an unlawful preference.” (Downey v. Humphreys, supra,
Although California courts have not addressed the statutory right of setoff since Downey in 1951, other jurisdictions have more recently discussed the issue, and we look to them for guidance. For example, in O’Connor v. Insurance Co. of North America (O’Connor), supra,
The O’Connor court addressed the requirement of contemporaneous mutuality under the Illinois Insurance Code which provides, inter alia, that debts “between the company and another company” would be subject to setoff as long as the debts were mutual. (Ill.Rev.Stat. ch. 73, § 818 (1983).) In O’Connor, the liquidator of an insolvent insurer asserted that debts owed to it involving reinsurance proceeds, as well as unearned premiums that followed the cancellation of the policies on insolvency of the insurer, amounted to post-liquidation debts that could not be set off by the debts owed by the insolvent insurer to the reinsurers, because those debts amounted to preliquidation debts. The O’Connor liquidator concluded that mutuality did not exist when the reinsurers’ debts were postliquidation debts, whereas the insolvent insurers’ debts were preliquidation dеbts. (O’Connor, supra,
Like the courts in Carr v. Hamilton, supra,
Finally, the O’Connor court concluded that the reinsurers and the insolvent insurer “entered into a reinsurance contract which defined all of the
The Commissioner in the present case attempts to distinguish the O’Con-nor holding. In O’Connor, all claims giving rise to the insurer’s liability were filed prior to the insolvency order. By contrast, the Commissioner observes, in the present case, the “vast majority” of the reinsurance obligations arose after the liquidation order, and therefore the debts could not be mutual.
As the Court of Appeal explained, however, the O’Connor court determined that mutuality depends on whether the debts were in existence before insolvency, not whether individual claims arose before the date of insolvency. Thus, if the reinsurance debts arose from contracts executed prior to the date of liquidation, debts arising from those contracts are considered preliquidation debts subject to setoff. (See also Ainsworth v. Bank of California, supra,
The O’Connor view of contemporaneous debt is shared by Stamp v. Insurance Co. of North America, supra,
In an attempt to diminish the authority of O’Connor, Justice Kline’s dissent herein asserts "O'Connor proceeds on the unstated assumption, legally incorrect and illogical, that setoff must be allowed because it is
First, rather than reject O’Connor’s reasoning, the Northern District Court in Illinois denied the liquidator’s motion to reconsider O’Connor in O’Con-nor v. Insurance Co. of North America (N.D.Ill. 1987)
In addition, as noted above and contrary to the dissent herein, the Stamp court followed the O’Connor holding in allowing reinsurers to exercise their statutory setoff rights. (Stamp v. Insurance Co. of North America, supra,
This dissent criticizes the O’Connor court’s reliance on Professor Collier’s 1978 treatise for the proposition that federal bankruptcy law recognizes that “one creditor may be getting paid more than other creditors” (O’Connor, supra,
Based on the foregoing, we reject the Commissioner’s contention that the reinsurance obligations between Prudential Reinsurance and Mission were not contemporaneous preliquidation debts subject to setoff.
Section 922.2 requires all reinsurance contracts to contain an “insolvency clause” allowing the liquidator to collect from the reinsurer the amount that would have been due if the ceding company had not become insolvent. The insolvency clause in this case states in pertinent part that “reinsurance provided by each and every reinsurance agreement heretofore or hereafter entered into by and between the parties hereto shall be payable by the Reinsurer directly to the Company or to its liquidator, receiver, conservator or statutory successor on the basis of the liability of the Company without diminution because of the insolvency of the Company or because the liquidator, receiver, conservator or statutory successor of the Company has failed to pay all or a portion of any claim. . . .”
In a very recent case addressing statutory setoff and the requirement of mutuality, the New York Court of Appeals upheld a reinsurer’s statutory right of offset against an insolvent insurer. (Midland, supra,
The Midland court was faced with the issue whether a reinsurer could offset amounts it was owed by Midland under separate reinsurance contracts at the time Midland was placed into liquidation. The liquidator objected to the setoff on the grounds that the debts were not mutual, the insolvency clause contained in one of the contracts prevented setoff, and the debts were not owed to and from the same person.
The New York Court of Appeals allowed the setoff under New York Insurance Law section 7427, subdivision (a). In addressing the liquidator’s argument that the insolvency clause contained in one reinsurance contract prevented the offset, the court observed that “[although reinsurance contracts are indemnity contracts, they commonly contain insolvency clauses which, even in the absence of a primary insurer’s payment to policyholders, permit a liquidator to cоllect from the reinsurer the amount of reinsurance proceeds that would have become due if the ceding company had not become insolvent. The [offset] statutes encourage such clauses by providing that unless the reinsurance contract contains an insolvency clause the primary insurer may not consider the reinsurance as an asset or claim a
The Commissioner relies on Melco System v. Receivers of Trans-America Ins. Co. (1958)
The Melco court held that a reinsurer was not entitled to set off unpaid premiums due from the insolvent, because the insolvency clause in reinsurance contracts requires payment of proceeds after insolvency, when the clause becomes operative. (Melco, supra,
As Midland, supra, observed, statutory provisions comparable to section 922.2 that require an insolvency clause in reinsurance contracts were “enacted in response to the Supreme Court’s decision in Fidelity & Deposit Co. v. Pink (1937)
Thus, as noted above, the purpose of section 922.2 and the insolvency clause is to provide the liquidator with the same rights and obligations of the insolvent insurer pursuant to the terms of the reinsurance contract. Certainly, the setoff in this case does not shield the reinsurers from paying reinsurance obligations directly to the liquidator or allow the reinsurer to walk away fully compensated, leaving policyholders and other more favored creditors holding the bag. Indeed, no “dimunition because of insolvency” will occur in light of this setoff.
Therefore, section 922.2 does not conflict with section 1031; rather, it simply prevents the reinsurer from refusing to pay valid claims “on the grounds that its obligation was to indemnify the reinsured against loss, and that the reinsured only incurred loss in the amount of the diminished payments” made by the liquidator. (1 Cal. Insurance Law & Practice, supra, § 11.05(6)(c) at p. 11-52; Semple & Hall, supra, 21 Tort & Ins. L.J. 407; American Re-Insurance Co. v. Insurance Com’n, Etc. (C.D.Cal. 1981)
Melco, supra,
In a related context, Justice Kline’s dissent herein suggests the statutory setoff scheme was not intended to be used to create a preference for reinsurers over other creditors of the insolvent insurer. (See dis. opn., post, at
In refuting the liquidator’s argument that statutory setoff ignores bаnkruptcy priorities, Midland observed that although “permitting offsets may conflict with the statutory purpose of providing for the pro rata distribution of the insolvent’s estate to creditors, the Legislature has resolved the competing concerns and recognized offsets as a species of lawful preference. Indeed, if an offset is otherwise valid, there would seem to be no reason why its allowance should be considered a preference: it is ‘only the balance, if any, after the set-off is deducted which can justly be held to form part of the assets of the insolvent.’ ” (Midland, supra,
Finally, Justice Kline’s reliance on Corcoran v. Ardra Ins. Co., Ltd. (2d Cir. 1988)
3. Mutuality of Identity and Capacity
The Commissioner next asserts that the order of liquidation destroyed the debtor-creditor relationship between the Mission companies and Prudential Reinsurance. According to the Commissioner, as a result of the liquidation order, the reinsurance debts are owed to the Commissioner as a trustee for the benefit of the Mission companies, and are no longer owed to Mission; there is no mutuality because the trustee has no contractual obligation to Prudential Reinsurance. We agree with the Court of Appeal, and find the Commissioner’s contention without merit.
As the Court of Appeal observed, section 1031 broadly frames its mutuality criterion in terms of “all cases of mutual debts or mutual credits between the person in liquidation under section 1016 and any other person . . . .” (Italics added.) It is well settled that once insolvency has occurred and a liquidator has been appointed to assume all the rights of the insolvent
In concluding that mutual credits and debts arising from mutual reinsurance contracts may permit section 1031 setoffs in insurance liquidation proceedings, the Court of Appeal limited application of the setoff doctrine to true contractual debtor-creditor relationships between principal insurers. In doing so, it rejected Prudential Reinsurance’s assertion that its subsidiary, Gibraltar, should be permitted to set off debts owed by Prudential Reinsurance under the “Relation A” contracts even though Gibraltar is not a party to those contracts. The Court of Appeal concluded that because Gibraltar does not owe reinsurance proceeds or premiums to the Mission companies as a principal reinsurer under the “Relation A” contracts, it has no mutual credits or debts with those companies upon which Prudential Reinsurance may claim a section 1031 setoff against what it owes to Mission as their reinsurer.
The Court of Appeal also observed that because Prudential Reinsurance was reinsured by Mission and by Mission National Insurance Company, but not other Mission companies, the remaining Mission companies are not principal reinsurers having mutual reinsurance debts and credits with Prudential Reinsurance.
We agree with the Court of Appeal. Accordingly, we refuse to expand the section 1031 setoff of debts in the absence of an express mutual agreement that the subsidiary would be deemed a mutual debtor-creditor of the parent. (See, e.g., In re Berger Steel Company (7th Cir. 1964)
C. Section 1031(a)
As discussed above, under section 1031(a), no setoff is allowed when the “obligation of the person in liquidation to such other person does
The Court of Appeal rejected this argument, concluding that under the Commissioner’s construction, a claimant’s right to assert a setoff cannot be determined until all the insolvent’s assets have been marshalled and the claims of all superior classes have been submitted. As the Court of Appeal observed, “entitlement” under section 1031(a) should be considered independently of Mission’s obligations to other claimants. If Prudential Reinsurance is owed a debt that satisfies the requirements of mutuality, it is “entitled” to share in Mission’s assets. (§ 1031(a).)
The Commissioner now contends that the Court of Appeal erred in so interpreting section 1031(a) because a claimant asserting the right of setoff must already be a creditor of the insurer in liquidation. According to the Commissioner, if the claimant is a creditor, it is ipso facto entitled to share in the assets of the insolvent, and section 1031(a) is simply redundant.
As the Court of Appeal observed, however, if we were to adopt the Commissioner’s proffered construction of section 1031(a), the statutory provision would be nullified because “setoffs would essentially be permitted only in cases where the estate is sufficient to pay higher priority classes in full and most likely be sufficient to also pay the setoff claimant in full without resort to setoff. [j[] If the Legislature had meant to gear setoff entitlement to the estate’s financial capacity, we presume it would have worded [sjection 1031 to make that intention sufficiently clear.”
Finally, the Commissioner’s assertion that the Legislature, when it amended section 1033 priorities in 1979 to create the separate priority ranks, intended to protect original policyholders from diminution of their loss recоveries due to setoffs by lower priority claimants, is contravened by
D. Public Policy and Equitable Considerations
The Commissioner’s final contention is that considerations of public policy and equity should preclude reinsurers’ right to set off debts they claim to be owed by the Mission companies. The Commissioner claims the allowance of a setoff permits reinsurers to obtain complete satisfaction of the debt they are owed, while Mission policyholders are relegated to partial satisfaction only. This result, he claims, subverts the recovery scheme expressly adopted by the Legislature and codified in section 1033, which, as discussed above, generally ranks the claims of policyholders superior to the claims of other insurers. To this specific argument, he adds the more general one that it is unfair that policyholders—as opposed to reinsurers—bear the lion’s share of Mission’s insolvency, while implying even more broadly that the entire business of reinsurance was developed to permit original insurers to avoid their obligations to California policyholders.
CIGA, as amicus curiae in support of the Commissioner, asserts that allowing reinsurers to exercise their setoff rights ignores specific language in section 1033 that expressly denies them priority. CIGA relies on an exception to section 1033 discussed below.
Ranked fifth in section 1033, subdivision (a) priority, after expense of administration, certain unpaid charges, taxes, and claims entitled to federal preference, are “(5) All claims of the California Insurance Guarantee Association . . . and associations or entities performing a similar function in other states, together with claims for refund of unearned premiums and all claims of policyholders of an insolvent insurer that are not covered claims. . . .” Ranked sixth and last are “All other claims.” A subpаragraph of the fifth rank provides, in addition, that “Claims excluded by paragraph [ ] (3) (except claims for refund of unearned premiums) ... of subdivision (c) of section 1063.1 . . . shall be excluded from this priority.” Paragraph 3 of subdivision (c) of section 1063.1 provides, inter alia, that “‘[cjovered claims’ shall not include any obligations of the insolvent insurer arising out
Such a conclusion, however, is clear without reference to section 1033, subdivision (a)(5). A reinsurer’s claim is not a claim of CIGA or of an association or an entity performing a similar function, or any otherwise uncovered claim asserted by a policyholder of the insolvent. To the extent the reinsurer submits a claim for a refund of unearned premiums, that claim is not subject to the exclusion. Accordingly, the apparent exclusion of a reinsurer’s claim from subdivision (a)(5) effects no substantive change: that claim was already within the residual sixth rank—“All other claims.”
It is true that the claims of policyholders are generally entitled to priority over the claims of reinsurers. Nonetheless, the Legislature has created an exception to the general rules of priority in situations in which the claimant and the insolvent have mutual debts; that exception is codified in section 1031. We cannot ignore its broad mandate.
In a related context, the Commissioner and Justice Kline’s dissent assert that because the doctrine of setoff is based on equitable principles, it should be denied when it would “harm the public.” As we explain, there is no evidence that the section 1031 setoff “harms the public” and the cases on which Justice Kline and the Commissioner rely to support their arguments are distinguishable.
First, in Federal Deposit Ins. Corp. v. Bank of America (9th Cir. 1983)
In deciding the case under Puerto Rican law, the Federal Deposit court observed that the portion of the subordinated capital agreement that provided there shall be no waiver of the right of setoff, violated the language of the Puerto Rican statute and regulations promulgated under it. The court stated,
The Court of Appeal herein rejected the reasoning of Federal Deposit because it concerned Puerto Rican law without any reference to the statutory right of setoff or to section 1031, and because the setoff discussion focused on analogous stock subscription debts, which are not allowed in California. (§ 1031, subd. (c); Kaye v. Metz (1921)
The Commissioner and Justice Kline’s dissent also rely on Kruger v. Wells Fargo Bank (1974)
Kruger was decided on the basis of a public policy of protecting those who require welfare and disability benefits for their subsistence, and it was those benefits that were taken by setoff. (See also Jess v. Herrmann (1979)
The Commissioner and Justice Kline also assert the insolvency statutes were adopted to protect the interests of policyholders and the public in general and setoff would abrogate that protection. Such is not the case. As Midland observed, “An important reason offset has been recognized as desirable is that it provides a form of security to insurers.” (Midland, supra,
Finally, Justice Kline’s dissent charges us with favoring reinsurers over insureds in an economic contest over the limited resources in the estate of an insolvent insurance carrier. We plead not guilty. The reinsurers prevail in this case because our Legislature has expressly and broadly recognized their right of setoff, along with the similar right of others who have dealt with insolvent carriers. Our conclusion in this respect is in accordance with those of the United States Court of Appeals for the Seventh Circuit and the New York Court of Appeals, both of which have construed statutory schemes similar to ours. In contrast, the dissent would employ what it labels equitable considerations to favor “invariably unsophisticated” policyholders over “highly sophisticated” reinsurers.
We do not perceive the issue to be one of relative levels of commercial sophistication. Nor is it one that calls for judicial favoritism of one group of claimants over another on supposed “equitable” grounds having nothing to do with the historic concerns of equity jurisprudence in this area. Instead, the issue is one calling for construction оf a comprehensive broadly phrased statute permitting setoff and admitting no exception for reinsurance relationships. The types of economic arguments made by the dissent are best addressed to the Legislature. “[W]e are unwilling to engage in complex economic regulation under the guise of judicial decisionmaking.” (Harris v. Capital Growth Investors XIV (1991)
Once the Commissioner declared Mission insolvent, Prudential Reinsurance had a legal, statutory right to set off unearned premiums against the amount it owed Mission. The mere fact that a liquidator was appointed did not impair or affect that right. Accordingly, we affirm the Court of Appeal’s judgment.
Panelli, J., Arabian, J., and Baxter, J., concurred.
Notes
Although the federal government has the power to regulate insurance as part of interstate commerce (U.S. v. Underwriters Assn. (1944)
Section 1033, subdivision (a), lists the priority of claims in liquidation in pertinent part as follows:
“1. Expense of administration.
“2. Unpaid charges due under the provisions of Section 736.
“3. Taxes due to the State of California.
“4. Claims having preference by the laws of the United States and by laws of this state.
“5. All claims of the California Insurance Guarantee Association . . . and associations or entities performing a similar function in other states, together with claims for refund of unearned premiums and all claims of policyholders of an insolvent insurer that are not covered claims.
“6. All other claims. . . .”
As discussed below, we conclude the statutory right of setoff is independent of section 1033 priorities.
Following oral argument, counsel for the Commissioner requested the court consider Foster v. Mutual Fire Ins. (1992)_Pa._[
The Commissioner also cites Bluewater Ins. Ltd. v. Bolzano (Colo. 1992)
The Melco decision has questionable effect on the issues before us because in 1971, 13 years after Melco was decided, the Alabama Legislature enacted a statutory right of setoff substantially identical to that of section 1031. (Ala. Ins. Code § 27-32-29 (1986).)
Concurrence Opinion
I concur in Justice Kline’s excellent dissenting opinion. I write separately, however, to make one additional point: the majority’s interpretation of Insurance Code section 1031 renders part of that statute meaningless, contrary to accepted principles of statutory construction.
Insurance Code section 1031
Subdivision (a) of section 1031 prohibits a setoff if the entity claiming the setoff is not entitled “to share as a claimant in the assets” of the insolvent insurer. In other words, only those entities that are entitled to share in the insolvent insurer’s assets may exercise the right of setoff. What, then, does the statute mean by an entitlement “to share as a claimant in the assets” of the insolvent insurer?
According to the majority, subdivision (a) of section 1031 means only that a reinsurer (or any other party seeking to exercise a setoff) must possess a claim against the insolvent insurer. The reinsurer does not, under the majority’s view, have to actually receive, or share in, any portion of the insolvent insurer’s assets. As the majority readily acknowledges, this interpretation
The majority’s conclusion violates these precepts of statutory construction: to give independent meaning and significance whenever possible to each word, phrase, and sentence in a statute (see, e.g., Dyna-Med, Inc. v. Fair Employment & Housing Com. (1987)
It is not necessary, as the majority has done, to read subdivision (a) of section 1031 as having the identical meaning as the general rule to which it is an exception. There is, as the Insurance Commissioner correctly notes, another construction of section 1031 that gives independent meaning and purpоse to subdivision (a) and harmonizes section 1031 both internally and with other components of the statutory scheme. Under this construction, subdivision (a) bars setoff by those entities that have claims against the insolvent insurer but do not actually share in the insolvent insurer’s assets.
Reading section 1031 this way gives its words—particularly the phrase “to share as a claimant in the assets”—their ordinary and traditional meaning. It recognizes that subdivision (a) prohibits setoffs in a clearly defined situation. Finally, it harmonizes section 1031 both internally and, as ably demonstrated by Justice Kline (dis. opn., post, pp. 1145-1150), with the statutory scheme of which it is a part. In brief, this reading of section 1031 is preferable to the majority’s when judged by the neutral criteria traditionally used for statutory construction. I perceive no sound basis for rejecting it.
Mosk, J., concurred.
Section 1031 states in full: “In all cases of mutual debts or mutual credits between the person in liquidation under Section 1016 and any other person, such credits and debts shall be set off and the balance only shall be allowed or paid, but no set-off shall be allowed in favor of such other person where any of the following facts exist: fi[] (a) The obligation of the person in liquidation to such other person does not entitle such other person claiming such set-off to share as a claimant in the assets of such person in liquidation. [1] (b) The obligation of the person in liquidation to such other person was purchased by, or transferred to, such other person. [5] (c) The obligation of such other person to the person in liquidation is to pay an assessment levied against such other person or to pay a balance upon a subscription for shares of the capital stock of the person in liquidation.” (Italics added.)
Dissenting Opinion
The majority’s allowance of setoff—which elevates the economic interests of reinsurers over the legislatively preferred and
Permitting reinsurer setoff will result in the disallowance of many justifiable claims and have a ruinous effect on many individual policyholders, who reasonably believed they were protected against injury. As a consequence, policyholders, injured claimants and the public will bear costs of insolvency that tiie Legislature intended to impose, and which would much more fairly be imposed, on reinsurers, which were paid to assume the risk of the insolvency they are now unconscionably permitted to turn to their advantage. The majority opinion will also discourage self-regulation within the industry and exacerbate the growing problem of insurance insolvency now plaguing this nation.
I.
The majority says that “[t]he reinsurers prevail in this case because our Legislature has expressly and broadly recognized their right of setoff. . . .” (Maj. opn., ante, at p. 1142.) The Legislature has done no such thing. It is the intention of this court, opposed to that of the Legislature, that carries the day for the reinsurers.
It is elemental that in ascertaining the intent of the Legislature, “ ‘every statute should be construed with reference to the whole system of law of which it is a part so that all may be harmonized and have effect.’ ” (Select Base Materials v. Board of Equal. (1959)
Insurance Code sections 1031 and 1033,
Section 1031, which does not specifically refer to reinsurers or any other particular class of creditors, is a general statute providing that “mutual debts or mutual credits” between an insolvent insurance company in liquidation and “any other person” may be set off and the balance only allowed, provided that “no set-off shall be allowed in favor of such other person where . . . H] (a) The obligation of the [insolvent insurer] to such other person does not entitle such other person claiming such set-off to share as a claimant in the assets of such person in liquidation.”
Section 1033 is a much more specific statute that does refer to reinsurer claims. Subdivision (a) of section 1033, the pertinent portion of which is set forth in the margin below,
Because the exclusion of reinsurer claims is so obviously inimical to its view of this case, the majority belittles it, stating that “the apparent exclusion of a reinsurer’s claim from subdivision (a)(5) effects no substantive change.” (Maj. opn., ante, at p. 1140.) Reinsurer claims were already within the residual sixth rank, the majority explains, because a reinsurer’s claim “is not a claim of CIGA ... or any otherwise uncovered claim asserted by a policyholder of the insolvent.”
The setoff allowed by the majority under section 1031 frustrates this manifest legislative purpose because it provides reinsurers the very priority that the Legislature prevented. (See Baker v. Gold Seal Liquors (1974)
The precedence the majority accords section 1031 also violates the rule that insolvency statutes should not be construed to create creditor preferences not expressly specified by the Legislature, as such preferences “are regarded with extreme disfavor.” (3A Sutherland, Statutory Construction (4th ed. 1986) § 69.07, p. 469; 3 Collier on Bankruptcy (15th ed. 1992) § 507.02[2], p. 507-11 [“Priorities are to be fixed by Congress. Courts are not free to fashion their own rules . . . .”}; see also, discussion, post, at pp. 1167-1168.) If a setoff may be denied that merely provides a bankrupt’s creditor a preference over another of equal rank (see, e.g., Walker v. Wilkinson (5th Cir. 1929)
Acknowledging “that the claims of policyholders are generally entitled to priority over the claims of reinsurers” (maj. opn., ante, at p. 1140), the majority contends that “[nonetheless, the Legislature has created an exception to the general rules of priority in situations in which the claimant and
First of all, as a general rule of statutory construction, courts cannot create exceptions to rules of general application in the absence of an explicit legislative intention to do so. (Stockton Theatres, Inc. v. Palermo (1956)
Furthermore, the provision of section 1033 giving the claims of policyholders and certain other creditors priority over the claims of reinsurers (§ 1033, subd. (a)(5)) was added to that statute in 1979 (Stats. 1979, ch. 384, § 1, p. 1445), 45 years after enactment of section 1031. The precedence given to section 1031 thus also violates the rule that if new provisions cannot be reconciled with earlier provisions of an entire scheme, the new provisions should prevail. “[W]here two statutes deal with the same subject matter, the more recent enactment prevails as the latest expression of the legislative will.” (2B Sutherland, Statutory Construction (5th ed. 1992) § 51.02, p. 122, fn. omitted); Stafford v. L.A. etc. Retirement Board, supra,
Equally untenable is the majority’s alternative view that the reinsurers have a “contractual entitlement” that supersedes section 1033 because “the
The inordinately broad and dispositive effect the majority opinion accords section 1031 reflects not only its indifference to related statutes that specifically address and subordinate the rights of reinsurers, but the majority’s basic misunderstanding of the concept of setoff generally.
II.
Section 1031 derives not simply “from the equitable right of setoff established in 17th century England” (maj. opn., ante, at p. 1124), but more venerably from the concept of compensation, or compensatio, known to preclassic Roman procedural law. (See, generally, Comment, Automatic Extinction of Cross-Demands: Compensatio From Rome to California (1965) 53 Cal.L.Rev. 224; Loyd, The Development of Set-off (1916) 64 U.Pa.L.Rev. 541.) From the beginning, compensation and setoff have been permitted only when, due to the particular circumstances of the case, it is fair to do so. Compensation is never permitted under the civil law “where its operation would involve a deception and a disappointment of the just expectation and confidence of the party against whom it is set up.” (3 Story, Commentaries on Equity Jurisprudence (14th ed. 1918) § 1877, p. 479.) Similarly, “a set-off is ordinarily allowed in equity only when the party, seeking the benefit of it, can show some equitable ground for being protected against his adversary’s demand; the mere existence of cross demands is not sufficient.” (Id., § 1872, p. 474.) As the United States Suрreme Court has explained, courts do not allow setoff “except under very special circumstances, and where the proofs are clear and the equity is very strong. (Scammon v. Kimball (1875)
Judicial discretion to deny setoff that would have unfair consequences exists even if, like section 1031, the applicable statute provides that setoff
Thus, in California cases in which the right to setoff has been at issue, the court was governed, “ ‘not by the statute of setoff, but by the general principles of equity.’ ” (Pendleton v. Hellman Com. etc. Bank (1922)
The two most recent opinions of this court involving setoff—Jess v. Herrmann (1979)
Jess v. Herrmann, supra, involved cross-actions for personal injuries arising out of a collision between the parties’ vehicles, in which both plaintiff and defendant were injured. After deductions for comparative negligence, the plaintiff (Jess) was awarded $60,000 in damages and an award of $5,600 was made to the defendant (Herrmann). The trial court invoked a mandatory setoff rule (Code Civ. Proc., §§ 431.70, 666) and, over the objection of both parties, offset the two awards and rendered judgment for plaintiff only in the amount of $54,400. Concluding that the trial court erred in setting off the parties’ respective judgments, this court vacated the judgment and remanded. In doing so the court observed that “both the public policy of California’s financial responsibility law and considerations of fairness clearly support a rule barring a setoff of one party’s recovery against the other. . . . [E]quitable considerations would best be served by remanding the matter to the trial court so that it may ascertain the parties’ actual
The unfairness that concerned the court was that, assuming both parties were adequately insured, Jess’s recovery from Herrmann’s insurer would be limited to $54,400 but Herrmann would be denied any recovery whatsoever from Jess’s insurer. In that common situation setoff “diminishes both injured parties’ actual recovery and accords both insurance companies a corresponding fortuitous windfall at their insureds’ expense. Indeed, in this context, application of a mandatory setoff rule produces the anomalous situation in which a liability insurer’s responsibility under its policy depends as much on the extent of the injury suffered by its own insured as on the amount of damages sustained by the person its insured has negligently injured.” (Jess v. Herrmann, supra,
Kruger v. Wells Fargo Bank, supra,
This court’s opinion in Kruger v. Wells Fargo Bank, supra,
Preliminarily, the circuit court of appeals observed that the subordination of the note was required by Puerto Rican law “for the protection of the depositors and creditors of Banco Credito” (Federal Deposit, supra,
Denying setoff, the Ninth Circuit pointed to this court’s emphasis on the equitable nature of setoff. “As Justice Tobriner, speaking for a unanimous California Supreme Court, remarked, ‘The creditor’s right to setoff is not absolute, but may be restricted by judicial limitations imposed to uphold a state policy of protecting the rights of the debtor.’ [Citing Kruger v. Wells Fargo Bank, supra,
The majority’s attempt to distinguish Federal Deposit, supra, on the ground that it contains no “reference to the statutory right of setoff” and because stock subscription debts are not allowed in California (maj. opn., ante, at p. 1141) fails dismally. The application of a statute is inconsequential; as already explained, statutes authorizing or even mandating setoff have never been permitted to enlarge the right to setoff beyond that permitted by the applicable equitable principles. Such statutes do not “enable a party to make a set-off in cases where the principles of legal or equitable set-off did not previously authorize it.” (Sawyer v. Hoag (1873)
III.
The majority offers two reasons the allowance of setoff in this case does not offend public policy: (1) under the insurance insolvency statutes “original insureds have no interest or right in a contract of reinsurance (§ 623), and no rights against the reinsurer (§ 922.2) [maj. opn., ante, at p. 1142];” and (2) the interests of policyholders and the general рublic are advanced by spreading the risk through reinsurance, and this will not effectively occur if the offsetting of debts is disallowed. The Court of Appeal offered the additional reason that the losses of primary policyholders will be covered by CIGA, which is financed by the insurance industry.
A.
The majority’s reliance on provisions of the insolvency statutes declaring that original insureds have no interest in a contract of reinsurance (§ 623) and cannot proceed directly against the reinsurer (§ 922.2) is ironic, because these statutes were intended to protect policyholders and other creditors of an insolvent insurer against reinsurers.
The reason third parties ordinarily have no rights in reinsurance agreements, which ostensibly are contracts for indemnity rather than liability, flows not simply from their lack of privity (see, generally, Annot. (1936)
Moreover, as the Supreme Court of Colorado has recognized, “because the public interest is implicated in reinsurance contracts . . . such contracts may not be considered pure indemnity contracts . . . .” (Bluewater Ins. Ltd. v. Balzano (Colo. 1992)
The court in Corcoran v. Ardra Ins. Co., Ltd., supra,
Section 922.2, which prevents policyholders from proceeding directly against reinsurers, was enacted in response to the opinion of the United States Supreme Court in Fidelity & Deposit Co. v. Pink (1937)
Though section 922.2 was chiefly designed to address a problem different from that presented in this case,
By ignoring the general purpose of the statute—which was to prevent reinsurers from turning insolvency to their own advantage—and by misconceiving the reason for the language preventing a particular policyholder from proceeding directly against a reinsurer—which was to protect the rights of all other policyholders and creditors—the majority opinion has given section 922.2 precisely the opposite effect it was intended to have.
The interests of policyholders in an insolvent insurer’s contract of reinsurance are prоtected under section 1037, which requires the Commissioner of Insurance, as liquidator, to marshall the assets of the insolvent company for the benefit of all creditors, and section 1033, which, as we have seen, provides policyholders and certain other creditors priority over reinsurers in
Reinsurers are highly sophisticated entities whose complex commercial arrangements are largely unregulated by government.
B.
The majority’s policy justification for setoff is that it will facilitate risk-spreading and permit smaller insurers to remain in business. The majority reasons that reinsurer setoff “not only spreads risk but also acts as mutual
With respect to the need for mutual security, the majority, quoting Judge Easterbrook of the Seventh Circuit, says that “ ‘if the large firms [participating in reinsurance pools] could not count on the netting of balances [through setoff] to satisfy obligations, they would be more likely to exclude smaller or tottering firms—making new entry harder and precipitating failures of firms in difficulty.’ ” (Maj. opn., ante, at p. 1142, quoting Stamp v. Insurance Company of North America (7th Cir. 1990)
It is probably true that the disallowance of reinsurer setoff would increase the cost of reinsurance and that this increase would be passed on to the insurance-buying public. Diffusion of the increased cost among millions of consumers is, however, much more bearable and equitable than visiting the equivalent cost upon the much smaller group of policyholders and others with claims against insolvent insurers.
The misguided public policy theory posited by the majority, which is inconsistent with the legislative assignment of the lowest priority to the
The deductions from liabilities that have this salutary economic effect on the reinsurance business are authorized by sections 922.1 and 922.15. The deductions are not, however, automatically available. Their use is explicitly conditioned on the protection of policyholders by inclusion of the insolvency clause in the reinsurance agreement. (§ 922.2.) Thus, the insolvency clause should be construed “not only to thwart the kind of windfall sanctioned by [Fidelity & Deposit Co. v.] Pink, [supra,
Allowing reinsurer setoff permits a reinsurer to reap the considerable benefit of section 922.2 without the attendant burdens consumers and other creditors assumed it would bear. The reinsurer is or should be aware that
The unusual relationship that often exists between primary insurers and their reinsurers may also invite exploitation of the availability of setoff, to the disadvantage of the public. “While professional reinsurers may be independent companies, they frequently are subsidiaries or affiliates of primary insurance companies within a holding company family.” (1 Cal. Insurance Law & Practice, supra, § 11.01 [3][b], p. 11-9.) As earlier pointed out, “[mjost large primary insurers maintain their own divisions to handle their reinsurance needs exclusively.” (Id., § 11.01[3][c], p. 11-10.) The “treaties” in the present case provide an excellent illustration of the unusually close business relationship that typically exists. Not only is Gibraltar, one of the two reinsurers under the “Relation A” contracts, the subsidiary of the other reinsurer, Prudential Reinsurance, but these two reinsurers are themselves reinsured under the “Relation B” contracts by Mission Insurance Company and its affiliate, Mission National Insurance Company, the primary insurers. Thus the affiliated Mission companies provide both primary policies of insurance to the public and reinsurance contracts to other insurers or reinsurers.
Allowing the setoff of debts incurred under the “Relation B” contracts to which Mission companies were parties subsidizes largely unregulated commercial transactions between parties whose common interests are in some measure inimical to those of policyholders. Allowing such setoff will not only encourage self-serving arrangements harmful to consumers, but dis-serve the overall long-term interests of the insurance industry. As one thoughtful commentator has written, the availability of setoff “diminishes the reinsurer’s incentive to continually scrutinize and assess the financial
The inevitable response of reinsurance companies to the holding of the majority will be to enter into reciprocal insurance agreements or to issue policies of insurance only when they have potentially offsetting policies of reinsurance from the original insurers with which they do business. In this manner they will be able to largely insulate themselves from the risk of loss due to insolvency, shifting it instead to the unfortunate individuals who purchased policies from the insolvent insurer, as well as injured claimants, other creditors and the insurance-buying public.
Reinsurance companies do not need this protection. Because of their expertise and superior access to information,
Acknowledging the reality the majority avoids, the Court of Appeal in effect conceded reinsurer setoff would diminish assets available to cover the losses of primary policyholders. The Court of Appeal nevertheless rejected the Commissioner’s public policy argument that setoff should for this reason be disallowed because it believed such policyholder losses would for the most part be covered by CIGA
First of all, CIGA’s expenses will not be borne by the insurance industry. The Insurance Code specifically provides that CIGA’s “plan of operation” (see § 1063) “shall contain provisions whereby each member insurer is required to recoup over a reasonable length of time a sum reasonably calculated to recoup the assessments paid by the member insurer under this article by way of surcharge on premiums charged for insurance policies to which this article applies.” (§ 1063.14, subd. (a), italics added; see also § 1063.145.) Because, as the Chief Justice has elsewhere pointed out, “CIGA in effect spreads the loss among other insureds, in the form of increased costs to the insurance-buying public” (Isaacson v. California Ins. Guarantee Assn. (1988)
The majority effectively requires CIGA—that is, the insurance-buying public—to absorb the debts of an insolvent insurance company to its rein-surer, because setoff will result in CIGA having to pay all or a portion of claims that would otherwise have been satisfied by reinsurance payables. The Legislature clearly intended to prevent this. “CIGA is limited to the payment of ‘covered claims’ which are defined in relevant part as ‘obligations of an insolvent insurer, . . . imposed by law and arising out of an insurance policy of the insolvent insurer . . . which were unpaid by the insolvent insurer . . . .’ (Ins. Code, § 1063.1, subd. (c) (1).)” (In re Imperial Ins. Co. (1984)
If there were any doubt about the Legislature’s intent to insulate CIGA and consumers from liability for a primary insurer’s obligations under a
Moreover, entirely apart from the fact that CIGA’s expenses are really borne by consumers, CIGA does not in any event wholly protect policyholders and injured claimants. The legislation creating guarantee associations places maximum limits on the amounts that can be paid out on a policy underwritten by an insolvent insurer.
The manner in which reinsurers escape payment of amounts over guarantee association ceilings has been described in the following way. “If a claimant settles with the guaranty association, she forfeits any possibility of obtaining an amount over the ceiling. The claimant’s only alternative is to reject settlement, proceed to judgment and, if she wins, to collect the guaranty association cоmpensation up to the ceiling and attempt to collect the balance from the liquidator. Claimants will rarely choose the latter alternative because they would be risking a defense verdict. Further, even if they were to win, claimants would likely have incurred significant litigation expenses and recover very little from the liquidator at some time in the distant future. Thus, even claimants with potential damages significantly higher than the ceiling will settle with the guaranty association. Such settlements cause paradoxical results: first, the injured claimant is not fully compensated; second, the reinsurers on the risk above the ceiling escape without paying anyone; third, the failure of the claimant to bring a claim in liquidation for amounts over the guaranty association ceiling deprives the liquidator, and therefore all of the general creditors, of reinsurance proceeds above the ceiling. In short, guaranty associations protect reinsurers and help
As the Commissioner correctly contends, setoff contravenes the overarching purpose of the insurance laws: effectuating payment of policyholders’ losses. There is no persuasive public policy or equitable reason to allow it in this case.
IV.
The result the majority reaches is compelled neither by Downey v. Humphreys (1951)
The court permitted the agent to set off the amount of the premiums he collected on the basis of legal and equitable factors not present here. Setoff was approved in Downey because, among other things, “[t]he fact that the policyholders received their unearned premiums did not create an unlawful preference.” (Downey, supra,
It bears noting, finally, that, like Downey, supra,
Though it does involve a reinsurer’s right to setoff in connection with an insurance insolvency, O’Connor v. Insurance Co. of North America, supra,
O’Connor, supra,
A setoff cannot be allowed that would have the effect of altering the priorities assigned the eight classes of creditors established under the Bankruptcy Code. Because “[t]he bankruptcy code attempts to ensure that all creditors similarly situated receive equal treatment” (In re C-L Cartage Co., Inc. (6th Cir. 1990)
The opinion in O’Connor, supra,
Mosk, J., and Kennard, J., concurred.
Presiding Justice, Court of Appeal, First Appellate District, Division Two, assigned by the Acting Chairperson of the Judicial Council.
All statutory references are to the Insurance Code unless otherwise indicated.
Brief of amici curiae American Council of Life Insurance, Reinsurance Association of America, American Insurance Association, the Alliance of American Insurers, and the National Association of Independent Insurers.
The majority also misrepresents the trial court’s ruling, stating that “The trial court granted the Commissioner’s summary judgment motion on the ground that section 1031 allows a setoff only when the assets of the liquidating estate are sufficient to pay in full all the claims asserted by claimants in priority classes higher than the claimant asserting the setoff right.” (Maj. opn., ante, at pp. 1125-1126.) Although this is the effect of the judgment of the trial court it was not the rationale. The trial judge summed up his reasoning as follows: “All counsel acknowledge that a setoff amounts to a legislative grant of an otherwise disfavored preference. As such a preference is inconsistent with the otherwise equal treatment of all others within any applicable priority, it therefore must be strictly construed. As sought to be applied here, it would also prefer a priority six creditor to all priority five claimants, a result irreconcilable with the purpose of Article 14 of the Insurance Code.” As the trial court correctly noted, “The overriding purpose of Article 14 is to protect insureds first."
Section 1033 employs the following language to determine thе order in which claims against an insolvent insurer are to be allowed:
“(a) Claims allowed in a proceeding under this article shall be given preference in the following order:
“(1) Expense of administration.
“(2) Unpaid charges due under the provisions of Section 736 [i.e., the costs of the commissioner’s examination of the books of the insolvent insurer].
“(3) Taxes due to the State of California.
“(4) Claims having preference by the laws of the United States and by the laws of this state.
“(5) All claims of the California Guarantee Association . . . , together with claims for refund of unearned premiums and all claims of policyholders of an insolvent insurer that are not covered claims.
“Claims excluded by paragraph [ ] (3) (except claims for refund of unearned premiums). . . of subdivision (c) of Section 1063.1 [i.e., claims “arising out of any reinsurance contract”] . . . shall be excluded from this priority.
“(6) All other claims.” (Italics added.)
The majority also says that the exclusion does not apply “[t]o the extent the reinsurer submits a claim for a refund of unearned premiums.” (Maj. opn., ante, at p. 1140.) This statement is baffling. The reinsurer claims against a reinsured are for a percentage of the earned premium received by the reinsured, not a refund of unearned premiums. Such reinsurer claims arise entirely out of the reinsurance contract and are therefore clearly excluded from the fifth class.
The court cited the following cases: McKean v. German-American Savings Bank (1897)
The rule, which has its source in French law, was first established in this country in Mutual Safety Ins. Co. v. Hone (1849)
“The only recognized exception to the principle that reinsurance is a general asset for the benefit of all policyholders is when the reinsurance agreement specifically indicates an intent on the part of the reinsurer to become directly liable to an original insured. This assumption of direct liability is technically a novation, but is commonly called a ‘cut-through endorsement.’ ” (1979 Fed’n. of Ins. Couns. Q. at pp. 374-375.)
A derivative purpose of the insolvency clause, which does address a problem presented by this case, is discussed, post, at page 1160.
It may also result in the denial of tax and other claims of the State of California and the federal government, if any, which are in the third and fourth priorities specified by section 1033. With respect to any federal claims that may be frustrated, the setoff allowed by the majority conflicts not only with section 1033, but apparently as well with the so-called “superpriority statute,” 31 United States Code section 3713(a)(1), which provides that “A claim of the United States Government shall be paid first when—[!](A) a person indebted to the Government is insolvent and—. . . [5] (iii) an act of bankruptcy is committed[.]”
A congressional committee has described reinsurance as “the ‘black hole’ of solvency regulation.” (Failed Promises: Insurance Company Insolvencies, Rep. by the Subcom. on Oversight & Investigations of the House Com. on Energy & Commerce, H.R. Rep., Committee Print 101-P (101st Cong., 2d Sess.) p. 60 (1990) [hereinafter Failed Promises].) As the supreme courts of many states have noted, the relatively unregulated nature of the reinsurance business is one of the reasons the reinsurance obligations of an insolvent insurer are almost universally assigned a lower priority than an insolvent’s obligations to policyholders under primary policies. For example, in Neff v. Cherokee Ins. Co. (Tenn. 1986) 704 S ,W.2d 1, the Tennessee Supreme Court observed that “contracts of reinsurance are not subjected to the strictures and requirements of most of the insurance statutes [,]... although the statutes do place certain financial obligations on companies that seek credit under reinsurance agreements for losses or unearned premiums on their liability. . . . [I]f reinsurers want the protections and advantages of the statute, they must also assume the liabilities and obligations of these provisions, including the attendant tax burden. To do otherwise would place reinsurance in a wholly preferred position to direct policies, which would be clearly contrary to the statutory scheme . . . .” (Id., at p. 6; accord In re Liquidations of Reserve Ins. Co. (1988) 122 I11.2d 555 [
Because it is limited to debts arising under “cross-reinsurance” contracts, this case does not address other types of reinsurer setoff presenting different equitable considerations, such as, for example, whether a reinsurer should be allowed to offset the unpaid premium on a policy against its obligation to pay a loss on that policy.
A congressional inquiry into the insolvency of the Mission Insurance Company concluded that the chief reason “a company with less than $240 million in capital surplus [could] write enough bad business to cause a $1.6 billion failure” was its “excessive use of reinsurance.” (Failed Promises, supra, at p. 12.) The committee report states that at one point more than 600 reinsurers were involved in reinsuring Mission’s direct business. Very few were admitted to do business in California and 75 percent were foreign companies, based in Europe, the Middle East, Africa, Australia, India and elsewhere. (Id., at pp. 12-13.) It was claimed “that the unlicensed reinsurers conspired to use Mission as a front to gain access to lucrative premiums in the United States marketplace.” (Id., at p. 14.)
Pursuant to section 700.02, “surplus means the excess of admitted assets over the sum of (1) liabilities for lossеs reported, expenses, taxes and all other indebtedness and reinsurance of outstanding risks as provided by law, and (2) paid-in capital, in the case of an insurer issuing or having outstanding shares of capital stock, or (3) the minimum paid-in capital required, in the case of any other insurer.”
The Commissioner of Insurance’s interpretation of the insolvency clause in this manner cannot easily be dismissed. Noting that there is “a degree of ambiguity in the insolvency clause,” the court in Bluewater Ins. Ltd. v. Balzano, supra, deferred to the judgment of the Colorado Insurance Commissioner that the clause barred reinsurer setoff in circumstances similar to those presented here, because such a “construction of the insolvency clause is consistent with what is reasonably allowed or required by other provisions of the reinsurance statute and, for that reason, merits deference.” (
A 1989 study by the National Association of Independent Insurers states that “over 150 property/casualty insurance companies have become insolvent since 1969, with nearly half of them occurring during the past 5 years. The number of companies designated for regulatory attention by the National Association of Insurance Commissioners because of financial problems has more than quadrupled in the past 10 years, and the cost of insurance insolvencies is growing at an alarming rate.” (Failed Promises, supra, at p. 2.)
Section 622 provides that “Where an insurer obtains reinsurance, he must communicate all the representations of the original insured, and also all the knowledge and information he possesses, whether previously or subsequently acquired, which are material to the risk.” (Italics added.) See also, Staring, The Law of Reinsurance Contracts in California in Relation to Anglo-American Common Law (1988) 23 U.S.F.L.Rev. 1, 5-8; Firemen’s F. I. Co. v. Aachen & Munich F. I. Co. (1906)
For a detailed description of CIGA, see Barger, California Insurance Guarantee Association (1970) 45 State Bar J. 475.
CIGA only pays certain covered claims arising out of an insurance policy to a maximum of $500,000 per claim. (§ 1063.1, subd. (c)(1), (6).) The California Health Insurance Guaranty Association pays on covered policies to a maximum of $200,000 (adjusted for inflation as necessary) per injured person. (§ 1066.2, subd. (c).) The California Guaranty Life Insurance Association pays on covered policies to a maximum of $250,000 in life insurance death benefits for any one life. (§ 1067.02, subd. (c)(2).)
“Whether a reinsurer’s debts are “owed” prior to liquidation, and therefore mutual in time with the preliquidation debts of the reinsured, usually turns on whether a court believes the reinsurer’s debts are sufficiently mature. Liquidators argue that such debts are contingent until insolvency occurs and payment compelled by an order of the liquidator or a court. Reinsurers, on the other hand, argue that temporal mutuality is satisfied because the event giving rise to the liability occurred upon the execution of the reinsurance agreement, prior to insolvency. The case law does not satisfactorily resolve the issue. Some courts have tended to deny setoff on the ground that the reinsurer’s debt is unripe prior to actual insolvency. (See, e.g., Melco System v. Receivers of Trans-America Ins. Co. (1958)
The statement from Professor Collier’s 1978 treatise that is the gravamen of the opinion in O’Connor is qualified in the most recent (1992) edition of that treatise by the observation “that the earlier setoff provision [since amended] is now considered to have been too broad. The result was that in too many cases, certain creditors received a preference to the detriment of other creditors and the debtor’s estate. Consequently, [11 U.S.C. § 553, as amended] has restricted the right of setoff beyond what was done in earlier acts, and contains restrictions in some ways parallel to those found in the preference section [11 U.S.C. § 547].” (4 Collier on Bankruptcy (15th ed. 1992) 1 553.02, p. 553-10, fns. omitted.)
Collier’s acknowledgment of the inequities that often result from setoff is mild compared to that of some other commentators. It has been persuasively contended that the allowance of setoff in the bankruptcy context is “unsound,” inimical to “ ‘natural justice and equity’ ” and primarily reflects the “organized and powerful voice in legislative halls” of banks and other institutional creditors that benefit from the doctrine. (McCoid, Setoff: Why Bankruptcy Priority'? (1989) 75 Va.L.Rev. 15, 43; see also, Note, Setoff in Bankruptcy: Is the Creditor Preferred or Secured? (1979) 50 U.Colo.L.Rev. 511 and Murray, Banks versus Creditors of Their Customers: Set-Offs Against Customers’ Accounts (1977) 82 Com.L.J. 449.)
Section 205 of the Illinois Insurance Code grants “[c]laims by policyholders, beneficiaries, insureds and liability claims against insureds” priority over “[a] 11 other claims of general creditors . . . .” The Illinois Supreme Court has held that claims arising out of reinsurance contracts are claims of general creditors, and therefore subordinate to the claims of policyholders and injured claimants and others. (In re Liquidations of Reserve Ins. Co., supra, 122 I11.2d 555 [