Matter of Union Indem. Ins. Co. of N.Y.

Issue Discussed: Insolvency Issues

Submitted by Michael R. Kuehn

Date Promulgated: November 14, 1996

Court:   New York Court of Appeal

Issues Decided:  (1) Whether a reinsurer may assert common law claims for fraud and rescission against the liquidator of the underlying insurer; and (2) whether an insurer’s failure to disclose its insolvency is a material fact that warrants the remedy of rescission.

In a published opinion dated November 4, 1996, New York’s highest court held that an insurer’s insolvency is a material fact that must be disclosed to a potential reinsurer and that the reinsurer’s failure to do so supports voiding of the reinsurance contracts, both against the insurer’s liquidator and other beneficiaries of the insurer’s estate.  The Court held that the duty of “utmost good faith” included a basic obligation to disclose all material facts regarding the original risk of loss, including the fact of insolvency.

The Union Indemnity Insurance Company of New York (“Union”) was placed into liquidation in 1985 based on a judicial determination of insolvency.  The liquidation order prohibited any action against Union’s estate, which was represented by the liquidator.

Michigan National Bank-Oakland (“Michigan”) was the beneficiary of a $2 million surety bond issued by Union.  Michigan brought an action on the bond against Union’s reinsurers, including American Centennial Insurance Company (“Centennial”). (the “First Action”)   Union’s liquidator intervened claiming that the reinsurance proceeds were assets of Union’s estate and should be paid to the liquidator directly for the benefit of all policy holders.  The reinsurers then asserted counterclaims for rescission alleging that the reinsurance agreements had bene procured by fraud because Union had failed to disclose its insolvency.

The liquidator subsequently brought an action against Union’s parent company, affiliates, Union’s director and offices and outside auditors (the “Second Action.”)  The liquidator alleged mismanagement, failure to disclose Union’s insolvency, breach of fiduciary duty and violations of NY Insurance Law.  The liquidator supported the allegations in the action with affidavits drafted by Union officers and directors that testified to an active scheme to defraud by Union and its parent company.

The reinsurers in the First Action moved for summary judgment on their claims for rescission.  The reinsurers submitted the affidavits of Union’s officers and directors from the Second Action as informal judicial admission of fraud and failure to disclose material facts.  The trial court granted the reinsurers motion for rescission holding that Union’s insolvency was a material fact concerning the original risk and the failure to do so entitled the reinsurer’s to rescission both as to the liquidator and Michigan.

The liquidator appealed arguing that New York’s statutory liquidation scheme precluded the remedy of rescission as against the liquidator.  Similarly, Michigan argued that the reinsurer’s rescission defense against Union would not constitute a defense to the surety bond claims.

The Court of Appeals upheld the grant of summary judgment to the reinsurers.  The Court held that Union owed the reinsurers the duty of utmost good faith, including the duty to disclose all material facts regarding the original risk of loss.  The Court explained that the ceding insurer’s failure to abide by this duty rendered the reinsurance agreement voidable or rescindable.

The Court then tackled the “more nuanced question” of whether insolvency constituted a material fact.  The Liquidator argued that the issue of Union’s solvency was immaterial to the underlying risk.  The reinsurers contended that insolvency is a material fact because it indicates that the ceding company is writing substandard and underpriced risks.  The reinsurers also contended that had they been aware of Union’s insolvency they would have never underwritten reinsurance for it.  The Court reasoned that “insolvency … has a potential impact on the reinsurers’ risk sufficient to trigger” the obligation of disclosure.

The Court also rejected the liquidator’s argument that New York’s statutory liquidation scheme precluded the common law defense of fraud and rescission. The Court held that the liquidation order could not place the liquidator in a better position than the company he had taken over.  The Court reasoned that the liquidator “stands in the shoes” of the insolvent insurer and the reinsurers were free to assert any affirmative defenses they might have had against the insolvent company.

The Court also held that the reinsurers were equally entitled to assert the defense of fraud against Michigan.  The Court acknowledged that N.Y. Insurance Law § 4118(a) required the reinsurance agreement to provide Michigan with a direct right of action against the reinsurers, that right of action was subject to whatever defenses the reinsurers might have had against the insolvent Union.