Onset of An Offset Revolution: The Application of Set-Offs

Volume 95 Issue 3 Dickinson Law Review - Volume 95, 1990-1991

3-1-1991

Onset of An Offset Revolution: The Application of Set-Offs in Onset of An Offset Revolution: The Application of Set-Offs in

Insurance Insolvencies Insurance Insolvencies

Stephen W. Schwab

Debra J. Anderson

Carolyn S. Reed

David E. Mendelsohn

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Recommended Citation Recommended Citation Stephen W. Schwab, Debra J. Anderson, Carolyn S. Reed & David E. Mendelsohn, Onset of An Offset Revolution: The Application of Set-Offs in Insurance Insolvencies, 95 DICK. L. REV. 449 (1991). Available at: https://ideas.dickinsonlaw.psu.edu/dlra/vol95/iss3/2

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ARTICLES

Onset of An Offset Revolution: TheApplication of Set-Offs in InsuranceInsolvencies

Stephen W. Schwab*Debra J. Anderson**Carolyn S. Reed***David E. Mendelsohn****

TABLE OF CONTENTS

I. Introduction .................................... 451

* Stephen W. Schwab, B.A., Northwestern University; J.D., Dickinson School of Law;

partner in the law firm of Rudnick & Wolfe, Chicago, Illinois.** Debra J. Anderson, B.A., Southern Illinois University; J.D., John Marshall Law

School; Chief General Counsel in the Office of the Special Deputy Receiver, Chicago, Illinois.*** Carolyn S. Reed, B.A., J.D., University of North Carolina at Chapel Hill; associate

attorney with Rudnick & Wolfe, Chicago, Illinois.**** David E. Mendelsohn, J.D., IIT Chicago-Kent College of Law; LL.B., University

College of London; associate attorney with Rudnick & Wolfe, Chicago, Illinois.tReprinted in part from the Journal of Insurance Regulation, Vol. 8, No. 4 (June 1990) at464-533. Reprinted with permission of the Journal of Insurance Regulation and the NationalAssociation of Insurance Commissioners.

This article is adapted from a paper that was presented at the Third International Rein-surance Congress, Hamilton, Bermuda in November 1989. The views expressed herein arethose of the authors alone and do not represent the express or implied opinions of the IllinoisDepartment of Insurance, the Office of the Special Deputy Receiver, Rudnick & Wolfe, orany of their clients.

The authors gratefully acknowledge the assistance of Dorian R. Williams, an associate ofRudnick & Wolfe, and Susan Umbdenstock, the firm's assistant librarian.

95 DICKINSON LAW REVIEW SPRING 1991

II. Set-Offs in the United States ..................... 453A . D efi nition ................................. 453B. Historical Development ...................... 455

1. Development in England ................ 4552. Development in the U.S ................. 458

C. U.S. Codification ........................... 459D. Recoupment and Counterclaim Distinguished... 462E. Application of Set-Offs in Insurance Insolvency

Proceedings ................................ 4641. Post-Insolvency Enforcement of Pre-Insol-

vency Set-Off Agreements ............... 464(a) Constitutional implications ......... 467

(i) Contract Clause ............ 467(ii) Due Process ................ 469(iii) Equal Protection ........... 472

2. Court A uthority ....................... 4733. Set-Offs in Nonliquidation Proceedings .... 477

F. M utuality of Capacity ...................... 4781. General R ules ......................... 4782. Application of the General Rules ......... 483

(a) Set-offs by agents ................. 483(b) Premium set-offs by insureds ....... 488(c) Set-offs between affiliated companies. 489(d) Set-offs of assessments and capital

contributions ..................... 490(e) Set-offs of salvage and subrogation re-

coveries .......................... 49 1G. M utuality of Time ......................... 494

I. The Pre- versus Post-Liquidation Contro-versy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 9 5

2. Set-Off of Contingent, Unliquidated, andImmature Claims ...................... 499

3. The Prohibition Against After-AcquiredSet-Off s .............................. 503

H. Recent Set-Off Developments in the U.S ........ 5041. The Battle Over Reinsurance Set-Offs ..... 5042. Priority Distribution Statutes and Public

P o licy ................................ 50 8(a) Set-off of federal government claims . 511

III. C onclusion ..................................... 5 13

SET-OFFS IN INSURANCE INSOLVENCIES

Appendix A Statutory Insurance Insolvency Set-OffProvisions of the United States and Territories ...... 515

I. Introduction

The statistics that document the rise of insurance company in-solvency are all too familiar to those associated with the insuranceindustry.' The recent failure of Executive Life Insurance Company- with a projected shortfall in the billions of dollars - is only themost recent addition to an ever-expanding list of failed insurers. Thecauses of such insolvencies have been the subject of much discussion,debate, and analysis. In view of the large number of insolvencies andthe public outcry against the insurance industry, the federal govern-ment is considering whether it should assume regulatory responsibil-ity of insurance companies.

Amidst the fracas, U.S. receivers' are faced with the adminis-

1. In the United States alone, 59 of the 140 insolvencies of property and casualty com-panies recorded from 1969 through 1986 occurred in the last three years of that period. U.S.GENERAL ACCOUNTING OFFICE, INSURER FAILURES: PROPERTY/CASUALTY INSURER INSOL-VENCIES AND STATE GUARANTEE FUNDS 3 (1987) [hereinafter INSURER FAILURES]. The num-ber of insolvencies increased from 4 in 1983 to 21 in 1985, then fell to 13 in 1987. CONGRES-SIONAL RESEARCH SERVICE, INSURANCE COMPANY SOLVENCY (1989). Although the number ofinsolvencies in 1987 was less than the two preceding years, the number was high by historicalstandards. Between 1970 and 1983 there was an average annual rate of six insolvencies. Id.

2. With few exceptions, the regulation of insurance companies and their insolvencies inthe United States is left to the several states. See 15 U.S.C. § 1012 (1983) (regulation of thebusiness of insurance excluded from the antitrust laws); 11 U.S.C. § 109(b)(2), (3) (1983)(insurers exempted from bankruptcy proceedings).

The House Subcommittee on Oversight & Investigations recently reported its findingsfrom an extensive investigation into the causes of insurance company failures in the UnitedStates. The subcommittee found that the current state system of regulating solvency is "seri-ously deficient" and vowed to review proposals for various types of federal intervention into thecurrent regulatory process. SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS, HOUSECOMM. ON ENERGY AND COMMERCE, 101ST CONG., 2D SESS., FAILED PROMISES: INSURANCECOMPANY INSOLVENCIES (Comm. Print 1990) [hereinafter FAILED PROMISES].

3. For purposes of this article, the term "receiver" shall mean the state or court-desig-nated individual or entity charged with the administration of insurance or reinsurance compa-nies in conservation, rehabilitation, or liquidation proceedings.

"Conservation" (or "supervision") refers to the procedure whereby the receiver takes pos-session of an insurer or reinsurer's assets, business, and affairs to conserve them for the benefitof the company's creditors. See, e.g., Illinois Insurance Code § 197, ILL. REV. STAT. ch. 73,para. 809 (1965). This procedure is most often used to preserve the status quo while the re-ceiver evaluates the company's financial status; for example, when the company's surplus hasfallen below minimum statutory requirements, but could be raised to the required amount byan infusion of capital. See INSURERS REHABILITATION AND LIQUIDATION MODEL ACT § 9(National Ass'n of Ins. Commissioners 1987) [hereinafter MODEL ACT].

"Rehabilitation" has been defined as the "preservation, whenever possible, of the businessof an insurance company threatened with insolvency." People ex rel. Schacht v. Main Ins. Co.,114 Il1. App. 3d 334, 336-37, 448 N.E.2d 950, 952 (1983); accord Smalls v. Weed, 293 S.C.364, 360 S.E.2d 531 (Ct. App. 1987); New York Title & Mortgage Co. v. Friedman, 153Misc. 697, 276 N.Y.S. 72 (N.Y. Mun. Ct. 1934).

"Liquidation" precludes the transaction of further business by the company and results in


tration of insolvent insurance and reinsurance companies or "es-tates." Along with the dramatic increase in the number of insolven-cies, the nature and extent of the estates has changed as well, furthercomplicating the administration of insolvency proceedings. Past in-solvencies mainly affected "small companies handling mostly auto-mobile insurance and operating in one state or on a regional basis."'A review of more recent insolvencies, however, indicates that "failingcompanies have become more diverse, and now reflect more fully thewhole range of operating companies." 5 Further compounding theproblem, the size of insolvent estates has increased dramatically inthe last few years.'

Unfortunately, a substantial portion of the U.S. laws that gov-ern insurance insolvency were enacted in the 1930s and weredesigned to address only the straightforward problems that con-fronted receivers at that time. Those laws do not adequately dealwith the myriad of complex issues that arise in today's receiverships.Among other things, most states' statutes fail to address the insol-vency of reinsurers, or of primary carriers with reinsurance books ofbusiness. In particular, the statutes either fail to or inadequately ad-dress the assertion of set-offs by reinsurers of insolvent companies.These problems have been exacerbated by inconsistent state and fed-eral court decisions construing set-off statutes, and by a perceptionthat reinsurance is one of the root causes of insurance insolvencies.7

The circumstances in which set-offs may be asserted are a criti-cal issue for many U.S. receivers. The issue is of particular impor-tance to those charged with the administration of large estates be-cause set-offs can deprive an estate of funds that otherwise would beused for the payment of administrative costs and expenses, and forthe benefit of the insolvent's insureds. Set-offs are equally importantto reinsureds and general creditors8 of the insolvent company whoare eager to minimize the loss sustained as a result of the insolvency.

a final distribution of its assets. See generally Illinois Insurance Code §§ 187-221.13, ILL.REV. STAT. ch. 73, paras. 799 - 833.13 [1965 & Supp. 1990] (rehabilitation and liquidationprovisions); see also MODEL ACT, supra at § 12 (rehabilitation and liquidation provisions).

4. INSURER FAILURES, supra note 1, at 15.5. CONGRESSIONAL RESEARCH SERVICE, INSURANCE COMPANY SOLVENCY 9 (1989). The

General Accounting Office has found that one-third of the insolvent companies studied in thepost-1976 period operated in 20 or more states.

6. FAILED PROMISES, supra note 2, at 2.7. Id. at 9-10, 60-61.8. Reinsureds, unlike primary policyholders, are considered general creditors under the

priority distribution schemes of most states. See e.g., In re Liquidations of Reserve Ins. Co.,122 Ill. 2d 555, 524 N.E.2d 538 (1988), and cases cited therein. For a general discussion ofpriority distribution schemes, see infra notes 341-69 and accompanying text.


Given these conflicting interests, the proper application of set-offs inan insolvent insurance estate is not an issue susceptible to easyresolution.

Fundamental changes in the law of set-offs are being proposedby industry and regulators and tested in the courts. Nothing lessthan a set-off revolution is at hand. This article traces the onset ofthat revolution by examining the application of set-offs in insuranceinsolvencies in the light of American law, both from a common lawand statutory perspective, and then reviewing the current controver-sies surrounding set-offs in the United States.

II. Set-Offs in the United States

A. Definition

The right to assert set-off in the United States arises by statute,common law, and contract. In its simplest form, set-off is the rightbetween two parties to net their respective debts when each partyowes the other an obligation." The general rule is that mutual debtsand credits'0 between two parties may be set off, even though theyarise from different contracts or transactions. In other words, thedebits and credits of a mutual account constitute cross-demands andare deemed to compensate each other." In litigation, a set-off is usedto reduce or extinguish a plaintiff's claim.'" For example, if A owes

9. R. Mabey, Setoff in a Non-Insurance Commercial Setting I (unpublished manuscript1989).

Articulating a precise definition of the term set-off is difficult, as a definition wide enoughto encompass all situations is unworkable, whereas a definition narrowed to the essence isincomplete. In substance, set-off operates as a payment or discharge of reciprocal claims: thedebtor pays the creditor's claim pro tanto to the extent of his cross-claims against the creditor,thus using his own assets to pay his liability. P.R. WOOD, ENGLISH AND INTERNATIONAL SET-OFF 5 (1989) [hereinafter P.R. WOOD]. It is the analysis and application of this deceptivelysimple concept that has caused much confusion and debate.

In his exhaustive treatise on the subject, English solicitor Philip R. Wood defined set-offas the discharge of reciprocal obligations to the extent of the smaller obligation. Recognizingthat the legal meaning and purpose of set-off vary according to the circumstances, he distin-guished between six main classes of set-off: (a) independent set-off (sometimes called legal orstatutory set-off), so called because it may be invoked when reciprocal claims do not arise outof the same transaction (but are independent), and generally are available only in judicialproceedings; (b) current account set-off (sometimes called combination), a self-help remedy;(c) transaction set-off, so called because the reciprocal claims arise out of the same transac-tion, also a self-help remedy; (d) contractual set-off; (e) insolvency set-off, applicable whenone of the claimants is insolvent, and generally governed by statute; and (f) retainer or fundset-off (sometimes called impounding), applicable when a contributor to a fund which is not alegal entity is entitled to a share of the fund. Id. at 6-13. The focus of this article is "insol-vency set-off."

10. The concept of mutuality is addressed infra, subsections F and G.11. Downey v. Humphreys, 102 Cal. App. 2d 323, 227 P.2d 484 (1951).12. 4 COLLIER ON BANKRUPTCY 1 68.03 (J. Moore 14th ed. 1978):


B one hundred dollars, and B owes A seventy-five dollars, the doc-trine of set-off allows A, under certain conditions, to net the liabili-ties and pay B only the balance, twenty-five dollars.

Set-offs encourage equitable and economically efficient businesstransactions. On the one hand, set-off is a procedural device em-ployed to avoid multiplicity of actions. 18 On the other hand, it is asubstantive right designed to avoid the injustice of requiring an insol-vent's debtor to pay the full measure of his obligation while receivingonly a portion of the amount owed to him. In the contemporary busi-ness world, set-off promotes economy of time and efficiency ofmethod in resolving debt between parties. As a matter of commonsense, a person should not be compelled to pay one moment what hewill be entitled to recover back the next. In sum, set-off can be saidto further the two public policies that are commonly known as fair-ness and commercial necessity. 4

Whereas the allowance of set-offs furthers some public policies,it may conflict with other public policies that guide the administra-tion of insolvent estates: the prohibition of preferences (the preferen-tial treatment of one creditor over another), and the guarantee of apro rata distribution of estate assets. There is no question that insome circumstances, the application of set-off principles works to theadvantage of one particular creditor, or class of creditors, and to thedisadvantage of others. For nearly two thousand years, however,courts and legislatures have resolved the tension between these com-peting public policies in favor of set-offs.' Today, set-off may beviewed as a specie of lawful preference.16 In economic terms, set-offis a form of security permitted by law.17

13. Loyd, The Development of Set-Off, 64 U. PA. L. REV. 541, 569 (1916).14. R. Mabey, supra note 9, at 1.15. See P.R. WOOD, supra note 9, at 271-72 (explaining that while equality of treatment

is one of the fundamental policies of insolvency law, the dominant international view favors theallowance of set-offs in insolvencies); see also Scott v. Armstrong, 146 U.S. 499, 511 (1892)(holding that when set-offs conflict with the principle that all creditors should be treatedequally, "the equity of equality among creditors is either found inapplicable to such set offs oryields to their superior equity").

16. Barnett Bank of Jacksonville v. State ex rel. Dep't of Ins., 507 So. 2d 142 (Fla. Dist.Ct. App. 1987) (set-off is a preference). But see Scott v. Armstrong, 146 U.S. 499, 510 (1892)("Where a set-off is otherwise valid, it is not perceived how its allowance can be considered apreference"), and Willing v. Binenstock, 302 U.S. 272, 276 (1937) (holding that set-off doesnot effect a preference with respect to distribution of an insolvent's assets because "only thebalance, after deduction of the set-off, constitutes part of the assets of the insolvent").

17. In re Elcona Homes Corp., 863 F.2d 483, 485 (7th Cir. 1988). But see FLA. STAT. §631.281(4) (Supp. 1990) ("No claim of offset shall operate to create a secured claim."); seegenerally P.R. WooD, supra note 9, at 17-19.


B. Historical Development

Set-off is the contemporary form of an ancient Roman doc-trine. 18 During the golden age of the Roman empire, a type of crossdemand cancellation called compensatio was sometimes applied toclaims that grew out of the same transaction. 1 In England, wherethe doctrine of compensatio did not exist and the doctrine of set-offwas not recognized until the seventeenth century,2" mutually con-flicting demands were redressed by alternative means.21

1. Development in England.-Set-offs obtained a foothold inEnglish law through bankruptcy proceedings.22 In Powel v. Stuff,2"an action on the assignment of a debt was brought under the prevail-ing Statute of Bankruptcy.24 Chief Justice Flanning is reported tohave said, "If the plaintiff had been in debt in as great a sum as thebankrupt was indebted unto him, and yet his debt assigned, this as-signment had not been good." Another early statement of the rightof set-off is found in Anonymous,25 in which Chief Justice Northstated:

If there are accounts between two merchants, and one of thembecome bankrupt, the course is not to make the other, who per-haps upon stating the accounts is found indebted to the bank-rupt, to pay the whole that was originally entrusted to him, andto put him for the recovery of what the bankrupt owes him, intothe same condition with the rest of the creditors; but to makehim pay that only which appears due to the bankrupt on the footof the account; otherwise it will be for accounts betwixt themafter the time of the other's becoming bankrupt, if any suchwere.

2 6

At the time of the Anonymous decision, the English bankruptcy stat-ute did not contain a set-off provision.27 Two other decisions that

18. For excellent discussions of the historical background of this subject, see Loyd,supra note 13, and P.R. WooD, supra note 9, at 282-87. See also Note, Recoupment - Set-off- and Counterclaim, 28 W. VA. L.Q. 139 (1922).

19. Loyd, supra note 13, at 541.20. Id. at 543.21. Id. at 544-45. Actions of account and rights of recoupment provided redress for

mutually conflicting claims. At the time, recoupment was a right to have payments and suchshown in deduction or mitigation of damages as a means of arriving at actual damages. Re-coupment had less significance than in modern law. Id. See infra subsection D.

22. P.R. WOOD, supra note 13, at 282; Loyd, supra note 13, at 547.23. (1612) 2 Bulst. 26, 10 Jac. 1.24. 1 JAC. 1, c. 15, s. 13.25. 1 Mod. 215, 86 Eng. Rep. 837 (K.B. 1675).26. Id.27. (1570) 13 Eliz. c. 7. Section 2, however, required the commissioners in bankruptcy


followed Anonymous allowed set-offs before an insolvency set-offclause was added to the bankruptcy statute in 1705.28

The modern English law of set-off is an amalgamation of thecommon law and equitable rights of set-off.2 As a general rule, set-off may be raised as a defense only to monetary claims, and is allow-able whether the exact amount to be set off is ascertainable or not. 80

Set-off prevents cross-actions. 3' In the context of bankrupt individu-als and insolvent companies, it avoids the injustice of compelling acreditor to pay a liquidator the full amount of a debt, while the in-solvent debtor might only pay the creditor a portion of the debtowed.

832

English law of set-off requires that competing claims must be

to pay "to every of the said creditors a portion, rate and rate alike, according to the quantityof his or their debts." P.R. WOOD, supra note 9, at 282.

28. 4 & 5 ANNE, C. 17, s. I.; Curson v. African Co., 1 Vera. 121, 23 Eng. Rep. 358(Ch. 1682); Chapman v. Derby, 2 Vera. 117, 23 Eng. Rep. 684 (Ch. 1689). It should be notedthat the bankruptcy statute and subsequent provisions applied to the bankruptcy of persons.The insolvency set-off clause was first applied to the liquidation of insolvent companies bysection 10 of the Judicature Act 1875. P.R. WOOD, supra note 9, at 283-86.

29. "[Tlhe streams of common law and equity have flown together and combined so asto be indistinguishable . . . [wie have to ask ourselves: what should we do now so as to ensurefair dealing between the parties?" Lord Denning M.R. in In The Nanfri, (1978] 3 All E.R.1066. 42 HALSBURY'S LAWS OF ENGLAND, Set-off and Counterclaim, at 248. See, e.g., AriesTanker Corp. v. Total Transport Ltd., [1977] 1 All E.R. 398. "Equitable right to setoff,"however, is not a clearly defined legal term and various other meanings have been ascribed toit. See, e.g., In re Willis Percival & Co., (1879) 12 Ch. D 491. See also P.R. WOOD, supranote 9, at 9, comparing the English concept of equitable set-off to the American concept ofrecoupment. The equitable right of set-off has been described as

[w]here a cross-complaint for a sum of money is so closely connected with theclaim that it goes to impeach the plaintiff's title to be paid and raises an equityin the defendant, making it unfair that he should pay the plaintiff without de-duction, the general rule is that the defendant may deduct with impunity theamount of the cross-complaint, or raise it by way of equitable defence whensued.

30. HALSBURY'S LAWS OF ENGLAND, supra note 34, at 248. It is "uncertain whether itmay be raised only in defense to a liquidated money claim. It is . . . submitted that in generala defendant should be permitted an equitable set-off against an unliquidated money claim." Id.A right of set-off may be created by express or implied agreement, provided it is supported byconsideration. Prior dealings between parties permitting mutual debts to be set-off is sufficientevidence from which to imply an agreement. Jeffs v. Wood, (1723) 2 P Wms 128.

31. As in American law (see supra note 68 and accompanying text), English set-offsmust be distinguished from the similar but distinct concepts of cross-actions and counter-claims. Examples best illustrate the differences between the concepts. When A brings an ac-tion against B, and B, before final judgment is given, brings an action against A arising out ofthe same subject matter, B is said to have brought a "cross-action." Davies v. Hedges (1871)L.R.-Q.B. 687. Set-off is limited to money claims and may be raised only as a defense. Unlikeset-off, a counterclaim affords no defense to A's claim. If in an action brought by A against B,B has a claim against A which he might have asserted by bringing a separate action (whetheror not a claim for a sum of money) against A, he may raise it in the existing action by addingto his statement of defense a statement of the facts upon which he bases his claim. The claimbrought by B against A is a "counterclaim."

32. In re Charge Card Services Ltd., [1988] 3 All E.R. 702. See also Anonymous, 86E.R. 837 (K.B. 1675).


mutual, because "one man's money shall not be applied to pay an-other man's debt."" a That is, claims may arise out of unrelatedtransactions, but must exist between persons of the same legal ca-pacity and in the same right.3" Joint and several obligations may notbe set off against individual debts. For a set-off to be allowed, eachparty must be solely and personally liable on the claim he owes andbe clearly and beneficially entitled to the claim that is owed to him.385

In England, the Insolvency Act 1986 governs both personal andcorporate insolvencies.3 6 The detailed procedural aspects of corporate

33. Jones v. Mossop (1844), 3 Hare 568.34. See, e.g., Pedder v. Preston Corp., (1862) 12 CBNS 535. There are, however, excep-

tions to this rule. For example, if a defendant is sued by an agent (e.g., a broker), the defend-ant cannot set off a debt due from the principal unless it can be shown that the agent hasassented to such a set-off. Jarvis v. Chapple, (1815) 2 Chit. 387.

Although the competing claims may arise out of unrelated transactions or events and bothcompeting claims need not be contractual, mutuality must either exist at the fixing date orhave existed prior to and be compulsorily reestablished after that date. In some circumstances,"sums owing between a reinsurer and a reinsured may be set-off against each other under the1986 Rules, even if arising under different treaties." J.J. BUTLER & R.M. MERKIN, REINSUR-ANCE LAW § D.2.2-22 (1988). See also In re City Equitable Fire Ins. Co., [1930] 2 Ch. 293.For a discussion of circumstances in which competing claims are not deemed to be "mutual"at the time of insolvency, see P.R. WOOD, supra note 9, at 770, 772.

Until recently, creditors of an insolvent reinsurance company could not set off claims paidafter the fixing date against premiums payable prior to that date or vice versa. See Singer, TheBritish Approach to Reinsurance Insolvency, in 1988 A.B.A. SEc. TORT & INS. PRACTICE,Law and Practice of International Reinsurance Collections and Insolvency, at 643. It nowappears, however, to be settled that

to disallow the set-off of a provable debt merely because it was still contingent atthe [fixing date] ...where the contingency has since occurred and the liabilitywhich has arisen is exclusively referable to and has resulted in the natural courseof events from a transaction between the same parties entered into before the[fixing date], would ...be productive of the very injustice [set-off is] designedto prevent.

In re Charge Card Services Ltd., [1988] 3 All E.R. 702. Thus, once the contingency has beenvalued and is, therefore, provable in the liquidation, the valued amount is capable of being setoff, even if the claims are paid after the fixing date. This new rule appears to complementvarious cases which establish that a claim against an insolvent company existing at the fixingdate is available for set-off, even though it is unquantifiable at that date. See, e.g., Shand v.M.J. Atkinson Ltd. [1966] N.Z.L.R. 551 (N.Z.C.A.). Nevertheless, an insured may not gainan advantage after the fixing date by buying up the insolvent reinsurer's liabilities in order toobtain the benefit of a set-off. In re Charge Card Services Ltd., [1988] 3 All E.R. 702.

35. See P.R. WooD, supra note 9, at 25. A person is not solely and personally liable on aclaim if the liability is shared with another. Similarly, a person is not a clear beneficial ownerof a claim if the beneficial ownership is vested in him jointly with another. Legal, nominal, andtitular ownership and the identity of the person in whom the right to sue is vested are notcontrolling. Generally, the courts permit severance of property among its co-owners for pur-poses of set-off. In re Gross, (1871) 5 Ch. App. 632.

36. INSOLVENCY ACT 1986. For a general discussion of the derivation and application ofthe Insolvency Act 1986, see Anderson, Amreco: A Step Towards International Rehabilita-tions, 7 J. INs. REG. 388 (1989). English law provides a number of procedures whereby aninsolvent company can effect a compromise (rehabilitation) with its creditors and members insatisfaction of its debts, and thereby avoid "winding up" (liquidation). Winding up proceduresare detailed in the Insolvency Act 1986 §§ 73-251. There are "schemes of arrangement," acompromise that may include a restructuring of the insolvent's obligations, regardless of


insolvency proceedings are governed by the Insolvency Rules 1986("1986 Rules"),3 7 which provide for the application of set-offs.38

Two important consequences follow from these provisions. First, sub-ject to paragraph (3), the 1986 Rules render set-off compulsory ifthe creditor asserts a claim in the liquidation of the insolvent com-pany. Second, set-off may be asserted only in liquidation proceed-ings, and not against companies subject to an administration order orto various voluntary compromises and arrangements. 9

2. Development in the U.S.-Notwithstanding the commonlaw developments in England, the American colonies were the first toenact a set-off statute. As civil war raged in England, the VirginiaAssembly seized the opportunity to express its hostility against law-yers by enacting legislation to curtail the multiplicity of actions.'0Thus, seventy years before England codified an insolvency set-offclause, Virginia enacted set-off provisions in the Act of 1645."' Penn-

whether the company is in liquidation; "voluntary arrangements," a more detailed procedurethan schemes of arrangement with less court involvement; and "administration orders," pursu-ant to which a court-appointed administrator manages the company's affairs. For a generaldiscussion of the differences between schemes, voluntary arrangements and administration or-ders, see Anderson, supra, at 404-13.

37. Insolvency Rules 1986, S.I. 1986, No. 1925 (as amended by the Insolvency (Amend-ment) Rules 1987, S.I. 1987, No. 1919 and S.I. 1989, No. 397). See Anderson, supra note 36,at 407 n.75.

38. 1986 Rules, r.4.90. 1986 Rules r.4.90 applies only to companies that have gone intoliquidation and does not, therefore, apply to companies subject to an administration order:

(1) This Rule applies where, before the company goes into liquidation therehave been mutual credits, mutual debts or other mutual dealings between thecompany and any creditor of the company proving or claiming to prove for adebt in the liquidation.

(2) An account shall be taken of what is due from each party to the other inrespect of the mutual dealings, and the sums due from one party shall be set offagainst the sums due from the other.

(3) Sums due from the company to another party shall not be included inthe account taken under paragraph (2) if that other party had notice at the timethey became due that a meeting of creditors had been summoned [to vote on aresolution for winding-up the company] or (as the case may be) a petition forthe winding-up of the company was pending.

(4) Only the balance (if any) of the account is provable in the liquidation.Alternatively (as the case may be) the amount shall be paid to the liquidator aspart of the assets.

For a brief discussion as to whether administration orders apply to reinsurance companies, seeAnderson, supra note 36, at 411.

39. But see 1986 Rules r.4.90(3). In such circumstances, the right of set-off cannot beexcluded by agreement unless the creditor renounces his right to make any claim against theinsolvent. P.R. WOOD, supra note 9, at 293. This applies equally to foreign creditors whogenerally may prove a foreign debt in an English insolvency in the same way an English credi-tor proves an English debt. In re Wiskemann, (1923) 92 L.J. Ch. 349; P.R. WooD, supra note9, at 274.

40. Loyd, supra note 13, at 553-60.41. February 17, 1644-5, 1 HENING'S LAWS 294. See Loyd, supra note 13, at 554-55.


sylvania followed suit with a similar act in 1682, as did New York in1714 and New Jersey in 1722.42 By that time, England had enacteda statute that established an optional right of set-off applicable tothe colonies. s

American law of set-off applicable to insurance insolvencies be-gan to develop in the late 1800s." The United States Supreme Courtfirst addressed the issue in the context of an insurance insolvencyproceeding in 1873, recognizing the right but denying its applicationunder the particular facts presented. In Sawyer v. Hoag,4 stockhold-ers of an insolvent insurer sought to set off their unpaid stock sub-scriptions against losses they had sustained in The Great ChicagoFire of 1871, relying on the set-off provision of the Federal Bank-ruptcy Act of 1867. The Court denied their request, finding thatsuch debts were a trust fund for the benefit of all creditors. TheCourt noted that the set-off provision in the bankruptcy act "was notintended to enlarge the doctrine of set-off, or to enable a party tomake a set-off in cases where the principles of legal or equitable set-off did not previously authorize it. The debts must be mutual; mustbe in the same right." '46

Subsequently, in Carr v. Hamilton,4 the Court held that evenwhen no statutory set-off was applicable, mutual debts and creditscould be set off between an insolvent insurer in liquidation and oneof its policyholders. The Court found that the bankruptcy acts codemerely incorporated and preserved the common law right to set-off.48

C. U.S. Codification

Because insurance companies have long been excluded from theoperation of federal bankruptcy laws, the application of set-offs in

42. Loyd, supra note 13, at 555-61 (citing CHARTER and LAWS OF PENNA., 118; Act of1714, BRADFORD'S LAWS (1726), at 93; LAWS OF NEW JERSEY (Ed. of 1752), at 98; ALLIN-

SON'S LAWS OF N.J. (1776), at 66).43. See supra note 28 and accompanying text.44. Initial recognition of the doctrine in American bankruptcy law came in the Act of

1800, and every federal bankruptcy statute since then has recognized the right of set-off. SeeBankruptcy Acts of 1800, 1841, 1867, 1898, 1938 and 1978; 4 COLLIER ON BANKRUPTCY,supra note 12, at 68.01[11].

45. 84 U.S. 610 (1873).46. See also Forsythe v. Kimball, 91 U.S. 291 (1875) (insured was entitled to set off his

loss against a loan made by the insolvent insurer); Scammon v. Kimball, 92 U.S. 362 (1875)(private banker who served as director of insolvent insurer was entitled to set off againstamount he held as the insurer's banker losses he sustained in The Great Chicago Fire, but notan obligation given by him as security for stock subscription balances).

47. 129 U.S. 252 (1889).48. Id. at 256. Accord Scott v. Armstrong, 146 U.S. 499, 507 (1892); Van Schaick v.

Astor, 154 Misc. 543, 277 N.Y.S. 394 (1935).


insurance insolvency proceedings developed largely as a matter ofstate law. 9 States began to enact procedures for the dissolution ofinsurers in the nineteenth century, 50 and statutory guarantees of theright of set-off in such proceedings first appeared in 1909.51 Sincethen, states have codified many of the well-developed set-off rulesthat existed at common law into their insurance insolvencystatutes.

52

In 1967, Wisconsin enacted The Wisconsin Liquidation Act, thefirst comprehensive legislation concerning insurance insolvencies,which contained a provision that allowed set-offs. 53 In 1968, the Na-tional Association of Insurance Commissioners ("NAIC") passed aresolution to adopt the Wisconsin Liquidation Act as the basis formodel legislation. 5' As a result, the NAIC adopted the Insurers Su-pervision, Rehabilitation and Liquidation Model Act in 1977. 55

Designed to serve as a model for state insolvency statutes, Sec-tion 29 of the Model Act currently provides 6 that:

A. Mutual debts or mutual credits, whether arising out ofone or more contracts between the insurer and another person inconnection with any action or proceeding under this Act, shall

49. In Paul v. Virginia, 75 U.S. (8 Wall.) 168 (1868), the Supreme Court upheld thestate regulation of interstate insurance business, finding that insurance contracts were not "ar-ticles of commerce." Although the Court overruled Paul in United States v. South-EasternUnderwriters Ass'n, 322 U.S. 533 (1944), in 1945 Congress reserved the regulation of insur-ance for the states in the McCarran-Ferguson Act, Pub. L. No. 20-15, 59 Stat. 33 (codified asamended at 15 U.S.C. §§ 1011-1015 (1983)).

50. See, e.g., Laws of 1851, ch. 95, § 6, contained in Denio & Tracy's Revised Statutesof the State of New York 1: 1288, § 30 (1852) (authorizing the New York comptroller toapply to the supreme court for an order of dissolution of a life insurance company); ILL. REV.

STAT. ch. 73, paras. 84-92 (1874) (providing for voluntary and involuntary dissolution of do-mestic insurance companies). For a general discussion of the history of insurance insolvencyproceedings, see Kimball, History and Development of the Law of State Insurer DelinquencyProceedings: Another Look After 20 Years, 5 J. INS. REG. 6, 12 (1986).

51. New York was the first state to enact a set-off provision applicable to insurer insol-vencies, see N.Y. INS. LAW § 7427 (formerly § 538) (McKinney 1985), followed by Californiain 1935, CAL. INS. CODE § 1031 (West 1972). See Downey v. Humphreys, 102 Cal. App. 2d323, 227 P.2d 484,.492 (1951).

52. Many state statutes codified the prohibition against set-off of capital contributionsestablished by the United States.Supreme Court in Sawyer v. Hoag, 84 U.S. 610 (1873). Seealso ILLINOIS STATE BAR ASSOCIATION, ILLINOIS INSURANCE CODE ANNOTATED 377-80(1939) (commenting on the bankruptcy and common law bases for Illinois' statutory set-offprovision).

53. For a detailed discussion of the history of the Wisconsin proposal, see NATIONAL

ASSOCIATION OF INSURANCE COMMISSIONERS PROCEEDINGS [hereinafter NAIC PROCEED-

INGS], REPORT OF THE STUDY GROUP ON REINSURANCE SETOFF, 1:476 (1989).54. Kimball, supra note 50, at 28; NAIC PROCEEDINGS, supra note 53, 1969, I: 241,

271.55. NAIC PROCEEDINGS, supra note 53, 1978, 1: 238-75.56. The set-off provision of the Model Act was extensively modified in 1990. For a dis-

cussion of the derivation of Section 29, see supra notes 327-40 and accompanying text.


be set off and the balance only shall be allowed or paid . . . 7

The Model Act imposes certain restrictions, however, on the right ofset-off:

B. No set-off shall be allowed in favor of any person where:(1) the obligation of the insurer to the person

would not at the date of the filing of a petition for liqui-dation entitle the person to share as a claimant in theassets of the insurer;

(2) the obligation of the insurer to the person waspurchased by or transferred to the person with a view toits being used as a setoff;

(3) the obligation of the insurer is owed to an affili-ate of such person, or any other entity or associationother than the person;

(4) the obligation of the person is owed to an affili-ate of the insurer, or any other entity or associationother than the insurer;

(5) the obligation of the person is to pay an assess-ment levied against the members or subscribers of theinsurer, or is to pay a balance upon a subscription to thecapital stock of the insurer, or is in any other way in thenature of a capital contribution; or

(6) the obligations between the person and the in-surer arise from business which is both ceded to andassumed from the insurer except that the rehabilitatormay with regard to such business, allow certain setoffsin rehabilitation if he/she shall find the allowance ofsaid setoffs appropriate. 8

57. MODEL ACT, supra note 3, § 29.A (emphasis added).58. MODEL ACT, supra note 3, § 29.B. Section 29 further provides as follows:

C. The liquidator shall provide persons that assumed business from the in-surer with accounting statements identifying debts which are currently due andpayable. Such persons may set off against such debts only mutual credits whichare currently due and payable by the insurer to such persons for the period cov-ered by the accounting statement.

D. A person that ceded business to the insurer may set off debts due theinsurer against only those mutual credits which the person has paid or whichhave been allowed in the insurer's delinquency proceedings.

E. Notwithstanding the foregoing, a setoff of sums due on obligations in thenature of those set forth in Subsection B(6) shall be allowed for those sumsaccruing from business written where: the contracts were entered into, renewedor extended with the express written approval of the Commissioner of Insuranceof the state of domicile of the now insolvent insurer, when in the judgment ofsuch Commissioner it was necessary to provide reinsurance in order to prevent ormitigate a threatened impairment or insolvency of domiciliary insurer in connec-tion with the exercise of the Commissioner's regulatory responsibilities.

F. These amendments shall become effective six (6) months from the dateof enactment and shall apply to all contracts entered into, renewed, extended or


With seven exceptions, the U.S. states and territories have codi-fied the right of set-off in insurer insolvency proceedings. The stat-utes are generally fashioned after the predecessor version of section29 of the Model Act.59 Only three states have enacted statutes spe-cifically related to reinsurance set-offs: Oregon, Oklahoma, andUtah. Oregon generally prohibits set-offs, "except for cases of policyloans and cases of reinsurance."" Oklahoma prohibits set-offs of ob-ligations arising under "life or accident and health reinsuranceagreements that contain terms or conditions structured to avoid rea-sonable risk transfer and indemnification criteria."61 Utah specifi-cally preserves set-offs of "amounts due from the direct insureragainst reinsurance proceeds to be paid to the direct insurer or itsrehabilitator or liquidator. 62

D. Recoupment and Counterclaim Distinguished

As previously noted,68 principles of set-off allow the netting of

amended on or after that date, and to debts or credits arising from any businesswritten or transactions occurring after the effective date pursuant to any con-tract including those in existence prior to the effective date, and shall supersedeany agreements or contractual provisions which might be construed to enlargethe setoff rights of any person under any contract with the insurer. For purposesof this section any change in the terms of, or consideration for, any such contractshall be deemed an amendment.

59. The predecessor version of Section 29 was contained in Section 30. Section 30 pro-vided as follows:

A. Mutual debts or mutual credits between the insurer and another personin connection with any action or proceeding under this Act shall be set off andthe balance only shall be allowed or paid . . .

B. No set-off or counterclaim shall be allowed in favor of any person where:(1) the obligation of the insurer to the person would not at the date

of the filing of a petition for liquidation entitle the person to share as aclaimant in the assets of the insurer;

(2) the obligation of the insurer to the person was purchased by ortransferred to the person with a view to its being used as a setoff;

(3) the obligation of the person is to pay an assessment levied againstthe members or subscribers of the insurer, or is to pay a balance upon asubscription to the capital stock of the insurer, or is in any other way inthe nature of a capital contribution; or

(4) the obligation of the person is to pay premiums whether earnedor unearned, to the insurer.

See infra Appendix A, in which those states with set-off language identical to Section 30 ofthe Model Act set-off provision in whole or in part are designated "MA" (Model Act), andthose states with a modified form of the Model Act are referenced as "MMA" (ModifiedModel Act). Jurisdictions that do not appear to have provided for any right of set-off in insur-ance insolvency proceedings are so noted.

60. OR. REV. STAT. § 734.370 (1987).61. OKLA. STAT. ANN. tit. 36, § 1928B.4 (West 1990).62. UTAH CODE ANN. § 31A-27-323(3) (1986). See also VT. STAT. ANN. tit. 8, § 3604

(Supp. 1990) (allowing set-offs if "provided for otherwise in a final order for liquidation issuedby the commissioner or approved by a court of competent jurisdiction").

63. See supra notes 10-11 and accompanying text.


liabilities between parties to an insurance or reinsurance insolvency,as long as the debts and credits are "mutual." In general, mutualdebts and credits between parties may be set off, even if they arisefrom different contracts or transactions.6'

In sharp contrast to these principles of set-off is the proceduralremedy of recoupment. 61 Recoupment allows the abatement or re-duction of one party's debt to the other by the netting of mutualobligations to the extent sufficient to satisfy the claim, providedthose debts arise from the same contract or transaction. 6 Recoup-ment is thus much narrower than set-off. Debts and credits that maybe recouped can also be set off, but the reverse is not necessarilytrue. Courts and commentators sometimes confuse principles of re-coupment and set-off.67

Counterclaim presents a broader problem than set-off and re-coupment. Counterclaim is a procedural device which embracesclaims that a defendant may wish to assert, not merely to reduce theplaintiff's claim, but also to obtain affirmative relief.68 Counterclaimis sometimes included as a part of statutory provisions governing set-off.

The distinction between set-off, recoupment, and counterclaimis important to receivers, reinsureds, and reinsurers. Adherence tothe narrower recoupment doctrine may deprive parties of all but afew set-offs, whereas application of counterclaim principles may ex-pand set-offs because counterclaims are not restricted by notions ofmutuality. Confusion between set-off and recoupment is of particularconcern. Whereas recoupment disallows a reduction of mutual obli-

64. See supra notes 171-72 and accompanying text.65. Bull v. United States, 295 U.S. 247, 262 (1935) (recoupment "is in the nature of a

defense arising out of some feature of the transaction upon which the plaintiff's action isgrounded").

66. R. Mabey, supra note 9, at 1; In re Klingberg Schools, 68 Bankr. 173, 178-79(N.D. Ill. 1986), af'd, 837 F.2d 763 (7th Cir. 1988). As Mabey points out, the distinctionbetween set-off and recoupment is not limited to a conceptual difference:

In the context of bankruptcy, there are important procedural distinctions be-tween recoupment and setoff as well. For example . . . setoff, except in certaincommodities contracts, is clearly restrained by the automatic stay of I I U.S.C. §362(a). According to some commentators and courts, recoupment is not re-strained by the automatic stay and may be exercised after a bankruptcy petitionis filed without court intervention.

R. Mabey, supra note 9, at I n.2 (citing 4 COLLIER ON BANKRUPTCY, 553.03 (15th ed.1988); In re B&L Oil Co., 782 F.2d 155 (10th Cir. 1986)).

Wood includes recoupment within the class of "transaction set-off." P.R. WooD, supranote 9, at 9-11.

67. See supra notes 185-97 and accompanying text.68. P.R. WooD, supra note 9, at 9-11; Schenck v. Coordinated Coverage Corp., 50

A.D.2d 50, 376 N.Y.S.2d 131 (1975). For a general discussion of the history of counterclaim,see Loyd, supra note 13, at 563-68.


gations arising under different contracts and thus denies a reinsuredthe opportunity to abate its obligations owed to the insolvent undermultiple contracts or as a retrocessionnaire, set-off would allow suchreductions. Unfortunately, the distinction between set-off and re-coupment is often ignored, causing confusion and controversy aboutthe proper application of set-offs in insolvencies.

E. Application of Set-Offs in Insurance Insolvency Proceedings

To determine when the right to set-off against an insolvent in-surance company may be invoked,69 several related questions arise.First, of how much relevance or effect does a pre-insolvency agree-ment or course of dealing of the parties have with respect to post-insolvency assertions of set-off? In other words, is a statutory set-offright governed by the parties' pre-insolvency dealings? Second, whatare the powers of a court to control the application of statutory set-off rights? May set-offs be asserted only in proceedings before thecourt supervising the insolvency proceedings ("supervising court")?May the supervising court restrict, enlarge, or eliminate statutoryset-off rights? Finally, may set-offs be asserted in rehabilitation pro-ceedings, as well as in liquidations? Each of these issues is addressedin turn below.

1. Post-Insolvency Enforcement of Pre-Insolvency Set-OffAgreements.-Most courts have held that set-off is a right, the exer-cise of which should be enforced, regardless of a court's discretion,when the requirement of mutuality is satisfied. 0 Few courts, how-

69. This is not to be confused with the question of when a set-off must be asserted. See,e.g., People v. Progress Ins. Ass'n, 8 Ill. App. 2d 75, 130 N.E.2d 526 (1955) (when reciprocalinsurance company's attorney-in-fact did not assert in proceeding to appoint receiver that in-solvent owed it any debt, court entered judgment against attorney-in-fact and attorney-in-factdid not appeal, attorney-in-fact could not assert as a set-off in action against insolvent theamount allegedly owed).

70. See, e.g., Cumberland Glass Mfg. Co. v. Dewitt, 237 U.S. 447 (1915) ("While theoperation of this privilege of set-off has the effect to pay one creditor more than another, it is aprovision based upon the generally recognized right of mutual debtors, which has been enactedas part of the Bankruptcy Act, and when relied upon should be enforced by the court.") Ac-cord Downey v. Humphreys, 102 Cal. App. 2d 323, 336, 227 P.2d 484, 493 (1951) ("It is wellsettled that the insolvency of a party against whom a setoff claimed constitutes a sufficientground for the allowance of a setoff not otherwise available."); Semple & Hall, Liquidationsand Reinsurance: Liability of Reinsurers When Property and Casualty Insurers Become In-solvent, 5 J. INs. REG. 156, 173 (1986) ("The right of offset applies despite the absence of aspecific provision in the relevant state's liquidation law recognizing the right of offset."); Nut-ter, Reinsurance Issues in the Liquidation of Insolvent Insurers, 18 FORUM 290, 295-97(1983) ("even in the absence of a statutory provision, and even in the absence of a contractualright, the insolvency does not void the right of offset . . . .Statutory or contractual rights ofoffset merely enhance the legal support for this [right]"). But see supra note 286 and casescited therein (distinguishing between set-offs in liquidation versus reorganization bankruptcy


ever, have squarely addressed the question of the effect of pre-insol-vency set-off agreements in insurance insolvencies. 71

One of the first courts to struggle with this issue was the Penn-sylvania Supreme Court in 1919. In O'Neil v. Burnett,"7 the Ameri-can Union Fire Insurance Co. of Philadelphia ("American Union")entered into written agreements with L.A. Burnett ("Burnett"), em-powering Burnett to act as American Union's agent.7 a Subsequently,a Pennsylvania court entered a rule to show cause why AmericanUnion's business should not be liquidated, and entered an injunctionrestraining the transaction of further business.74 Unaware of the in-junction, Burnett collected two mortgages for American Unionworth over nine thousand dollars.75 Thereafter, the court entered aformal order finding American Union insolvent and directing that itbe liquidated. 6 When the liquidator sued Burnett for the mortgagefees, Burnett asserted a set-off against moneys owed him based on apre-insolvency agreement with American Union's officers that hewould be allowed such a set-off.7 7 Because the liquidators failed tofile a sufficient affidavit in defense of the set-off the court dismissedthe action. 78

On appeal, the Pennsylvania Supreme Court reversed and or-dered that judgment be entered in the liquidator's favor.79 The courtheld that the order of dissolution annulled Burnett's pre-insolvencyset-off agreement with American Union's officers, and that upon itsissuance, Burnett's only claim was to share in the company's assetswith other creditors. 80 The court reasoned that the set-off arrange-ment amounted to a preference and that although a company has theright to prefer creditors before insolvency, the right cannot be ex-

proceedings).It appears, however, that the courts have yet to address the assertion of set-offs by a party

who by contract expressly waived its statutory set-off rights before insolvency. Some courtshave held in other circumstances that a party may waive statutory rights. See, e.g., Meyer v.Meyer, 333 Ill. App. 450, 77 N.E.2d 556, 563 (1948) ("It is a fundamental legal principlethat parties may waive substantive rules of law, statutes and even constitutional provisionsenacted for their benefit."). Whether a waiver of statutory set-off rights could be enforcedagainst an insolvent insurer remains to be seen.

71. See Magnusson v. American Allied Ins. Co., 290 Minn. 465, 189 N.W.2d 28(1971); O'Neil v. Burnett, 263 Pa. 216, 106 A. 246 (1919).

72. 263 Pa. 216, 106 A. 246 (1919).73. Id. at 218, 106 A. at 247.74. Id.75. Id. at 218-19, 106 A. at 247.76. Id. at 218, 106 A. at 247.77. O'Neil v. Burnett, 263 Pa. 216, 219, 106 A. 246, 247 (1919).78. Id. at 219, 106 A. at 247.79. Id. at 221, 106 A. at 248.80. Id. at 220, 106 A. at 248.


tended by agreement to a time when, because of insolvency, the com-pany has been restrained from disposing of any property or transact-ing further business.8

This same issue was also addressed by the Minnesota SupremeCourt in 1971. In Magnusson v. American Allied Insurance Co.,"a

American Allied Insurance Company ("Allied") agreed to reinsureUnited Benefit Fire Insurance Company ("United") pursuant to awritten contract.83 The contract contained a clause providing a mu-tual right of set-off, "except that in the case of Liquidation or Re-ceivership this Clause shall have no force or effect." '84 Both compa-nies were adjudicated insolvent.85 United's liquidator filed a claim inAllied's liquidation proceedings, and Allied's liquidator asserted aset-off against United.86 United invoked the set-off clause of the par-ties' pre-insolvency agreement in order to defeat Allied's post-insol-vency assertion of a set-off. Noting that Minnesota had a statutethat related to set-offs in insurance company receiverships, the courtheld that the statutory set-off provision would control regardless ofwhether there was a contractual right of set-off.87

Thus, at least as a matter of common law, a pre-insolvencyagreement governing set-offs between an insurer and another is notcontrolling after the insurer is adjudicated insolvent.88 As one courtrecently observed, "contractual terms are not sacrosanct when an in-surance company is insolvent." 89

81. Id.82. 290 Minn. 465, 189 N.W.2d 28 (1971).83. Id. at 467, 189 N.W.2d at 30.84. Id. at 474, 189 N.W.2d at 34.85. Id. at 467, 189 N.W.2d at 30.86. Id. at 467, 189 N.W.2d at 31.87. Magnusson v. American Allied Insurance Co., 290 Minn. 465, 474, 189 N.W.2d 28,

34 (1971).88. Accord Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227

Cal. App. 3d 293, 265 Cal. Rptr. 386 (1989), review granted, 268 Cal. Rptr. 542, 789 P.2d342 (1990) (Opinion in 216 Cal. App. 3d 1321 omitted. Reprinted without charge in 227 Cal.App. 3d 293, to permit tracking pending review by the supreme court.) (parties' pre-insolvencypractice of netting balances due between groups of affiliated reciprocal reinsurers may notenlarge statutory set-off right, at least absent a written agreement authorizing such set-offs);see also Ratchford v. United States Cent. Underwriters Agency, Inc., 492 F. Supp. 137 (E.D.Mo. 1980) (a pre-insolvency course of conduct of net balance accounting with respect to pre-miums collected by agents did not justify an agent's asserted set-off of premiums because (i) itwas a mere matter of administrative convenience which imposed additional burdens on theagent rather than benefits, and contemplated an on-going relationship with a solvent insurer;(ii) it would effect a preference; and (iii) allowing a set-off of unearned premium would un-justly enrich the agent, who thereby would be allowed to retain unearned commissions). Ac-cord O'Hern v. De Long, 298 Ill. App. 375, 19 N.E.2d 214 (1939).

89. Grode v. Mutual Fire, Marine & Inland Ins. Co., No. 3483 C.D. 1986, slip. op. at5 (Pa. Commw. Ct. Jan. 23, 1990); accord Fabe v. Facer Ins. Agency, Inc., 588 F. Supp.1330 (C.D. Ill. 1984), affd, 773 F.2d 142 (7th Cir. 1985), cert. denied, 475 U.S. 1013 (1986)


One state, however, appears to have resolved the issue by stat-ute, at least with respect to insurance agents. Section 40-3602(b) ofthe Annotated Kansas Statutes provides that:

The provisions of any contract between an insurance agent andan insolvent insurer shall apply for the duration of all policies ineffect and until all accounts are settled with the insolventinsurer. 90

Although this provision appears to have been drafted in order to pre-serve an agent's pre-insolvency obligation to pay the insurer'sunearned premium, it could be argued that the plain language pre-serves set-off rights contained in the agent's contract with theinsurer.

(a) Constitutional implications.-Consideration of the effect ofpre-insolvency set-off agreements must include consideration of theconstitutional dimensions of the issue.91 There are at least three pro-visions common to the federal and most state constitutions that maybe implicated with respect to the application of set-offs: (i) the con-tract clause, (ii) the due process clause, and (iii) the equal protec-tion clause.

(i) Contract Clause.-The Constitution of the United Statesprovides that "[n]o State shall . . pass any . . . Law impairing theObligation of Contracts .... "'I Similarly, the Illinois state consti-tution, provides that "[no . . . law impairing the obligation of con-tracts . . . shall be passed."9 A literal reading of these provisionssuggests that no statutory provision or receiver's plan for liquidatingor resolving the financial difficulties of an insolvent insurer may beimplemented which limits the set-off provisions of a pre-insolvencyagreement between an insurer and its debtors or creditors.

Constitutional contract clauses are not, however, to be enforcedliterally.94 Nor do they operate to obliterate the police power of thestate, which is paramount to any rights under contracts between in-

(agent has no claim for breach of agency agreement when the breach is occasioned by court-supervised liquidation); O'Hern v. De Long, 298 II. App. 375, 19 N.E.2d 214 (1939) (same).

90. KAN. STAT. ANN. § 40-3602(b) (1986).91. See R. Mabey, supra note 9, at 3: "Insofar as setoff rights involve property rights,

they may be constitutionally protected. Impairment of setoff rights by state law such as insur-ance insolvency statutes may violate the constitutional prohibition on impairment by the statesof contract rights." (Citations omitted).

92. U.S. CONST. art. I, § 10, cl. 1.93. ILL. CONST. art. I, § 16.94. Keystone Bituminous Coal Ass'n v. DeBenedictis, 480 U.S. 470, 502-03 (1987).


dividuals.95 The federal contracts clause is directed against legisla-tive action only and cannot be invoked against a change in decisionby a court.96 The same limitations apply to contract clauses con-tained in state constitutions.9 7 Thus, the federal and state constitu-tion contract clauses would be applicable only if a state insurancecode provision was enacted that changed the existing contractual ob-ligations of an insolvent insurance company and its debtors orcreditors.

To determine whether the federal contract clause is implicated,the threshold inquiry is "whether the state law has, in fact, operatedas a substantial impairment of a contractual relationship."98 To de-termine the extent of the impairment, a court must consider whetherthe industry affected by the statute has been regulated in the past.99

"If the State regulation constitutes a substantial impairment, theState, in justification, must have a significant and legitimate publicpurpose behind the regulation, such as the remedying of a broad andgeneral social or economic problem."100 Once a legitimate publicpurpose has been identified, the next area of judicial inquiry iswhether the challenged adjustment of the rights and responsibilitiesof contracting parties is based upon reasonable conditions and is of acharacter appropriate to the public purpose justifying the legisla-tion's adoption. 101 Unless the state itself is a contracting party,courts have deferred to the state's legislative judgment as to the ne-cessity and reasonableness of a particular measure.102

95. Home Bldg. & Loan Ass'n v. Blaisdell, 290 U.S. 398, 440-44 (1934); accord Mee-gan v. Village of Tinley Park, 52 I11. 2d 354, 288 N.E.2d 423 (1972); Memorial GardensAss'n, Inc. v. Smith, 16 Ill. 2d 116, 156 N.E.2d 587 (1959), appeal dismissed, 361 U.S. 31(1959).

96. Barrows v. Jackson, 346 U.S. 249, 260 (1953); National Mut. Bldg. & Loan Ass'nof New York v. Brahan, 193 U.S. 635, 647 (1904).

97. See, e.g., Phelps v. Elgin, Joliet & Eastern Ry. Co., 28 Ill. 2d 275, 280, 191 N.E.2d241, 244 (1963); People ex rel. Palmer v. National Bankers Ins. Co., 369 III. 605, 608-09, 17N.E.2d 579, 581 (1938) (upholding the constitutionality of the Illinois Insurance Code);Thomson v. Thomson, 293 Ill. 584, 588, 127 N.E. 882, 884 (1920) (quoting New OrleansWater Works Co. v. Louisiana Sugar Refining Co., 125 U.S. 18 (1887)) ("[t]he prohibition isaimed at the legislative power of the State and not at the decisions of its courts or the acts ofadministrative or executive boards or officers or the doings of corporations or individuals").

98. Energy Reserves Group, Inc. v. Kansas Power & Light Co., 459 U.S. 400, 411(1983) (quoting Allied Structural Steel Co. v. Spannaus, 438 U.S. 234, 244 (1978)).

99. Id. at 411.100. Id. at 411-12 (citations omitted).101. United States Trust Co. v. New Jersey, 431 U.S. 1, 25 (1977) ("an impairment

may be constitutional if it is reasonable and necessary to serve an important public purpose").102. Energy Reserves, 459 U.S. at 412-13 (citation omitted). The test is the same under

the Illinois contract clause. See, e.g., Royal Liquor Mart, Inc. v. City of Rockford, 133 Ill.App. 3d 868, 877, 479 N.E.2d 485, 491 (1985).

In 1881, the Illinois Supreme Court explicitly held that the statutory predecessor to theIllinois Insurance Code was not unconstitutional as impairing the obligation of contracts. Chi-


A supervising court in Pennsylvania recently examined the pro-visions of a proposed plan of rehabilitation for an insurance companyin light of objections raised by various debtors and creditors whocontended that the plan impaired their constitutional contractrights. 103 In determining the extent of the alleged impairment, thecourt observed that contract terms are not sacrosanct when an insur-ance company is insolvent. The court also held that the insuranceindustry is strictly regulated, and that the rehabilitation of insolventinsurers serves an important public purpose. In regards to the adjust-ment of contractual rights wrought by the rehabilitation plan, thecourt found the alleged impairment to be insubstantial and reasona-bly necessary to implement the rehabilitation. Thus, the court foundthere was no contract clause violation.10 4

(ii) Due Process.-The United States Constitution provides thatstate action shall not "deprive any person of life, liberty, or property,without due process of law."'0 5 State action includes action by a gov-ernmental agency, and government employees are deemed to be act-ing for the government unless their actions are clearly outside theirformal and de facto authority. 0 6

Two types of due process rights are protected from state action:procedural and substantive. Substantive due process assures that thesubstance of a law does not impinge upon protected interests, such asthe liberty to contract or property rights.10 7 Although the federal due

cago Life Ins. Co. v. Auditor of Public Accounts, 101 Ill. 82, 87 (1881) (citing Ward v. Far-well, 97 Ill. 593 (1881)). Accord Neblett v. Carpenter, 305 U.S. 297 (1938) (rehabilitationplan for insurer under which less favorable terms of new policies substituted for old ones heldnot to impair the parties' obligations of contract); Community Renewal Foundation, Inc. v.Chicago Title & Trust Co., 44 II1. 2d 284, 255 N.E.2d 908 (1970) (statute providing thatcourt may authorize court appointed receiver to recover the costs of repair and rehabilitationof building by issuance and sale of notes or receiver's certificates that would become a first lienon the property held not to impair contractual obligations even though prior lienholders' rightsand positions would be changed thereby).

103. Grode v. Mutual Fire, Marine & Inland Ins. Co., 132 Pa. Commw. 196, 572 A.2d798 (1990).

104. Id. at 5. See also Bockover v. Superintendent of Ins. Dep't, 91 Mo. 177, 3 S.W.833 (1887) (statute providing that claimants of insolvent insurer having rights to be paid outof assets the insolvent deposited with the state may not be paid on their claims against theinsolvent until other claimants have received payments of percentages equal to that paid out ofthe deposited assets held constitutional).

105. U.S. CoNsT. amend. XIV. The Illinois Constitution contains a similar guarantee:"No person shall be deprived of life, liberty or property without due process of law nor bedenied the equal protection of the laws." ILL. CONST. art. I, § 2. Although the Illinois consti-tutional provision is not explicitly limited to state action, the courts have interpreted it to applyonly to state action. Sargent v. Illinois Inst. of Technology, 78 Ill. App. 3d 117, 397 N.E.2d443 (1979).

106. Griffin v. Maryland, 378 U.S. 130 (1964).107. Slochower v. Board of Higher Educ., 350 U.S. 551 (1956); Ohio Bell Tel. Co. v.


process clause was once used to strike down a variety of economicregulations, today state action involving only economic rights (i.e.property, contract) will be upheld, so long as it is "rationally re-lated" to a legitimate interest or objective of government. 108 Thus,substantive due process is rarely used as a means to attack state ac-tion relating to commercial or economic matters. For example, in1938, the Illinois Supreme Court specifically held that the state In-surance Code's insolvency provisions are not unconstitutional as adeprivation of substantive due process. 09

Procedural due process does not question the content of a law oraction, but instead simply assures that no one will be deprived of aninterest or right without fair procedures. Due process is a flexibleconcept, and what process is due depends on the circumstances ofeach situation. 110 Judicial proceedings are not always necessary tosatisfy due process, nor is a hearing always essential. 1 To deter-mine what procedures are required in a particular case, the courtsapply a balancing test and consider: the private interest affected, therisk of erroneous deprivation through the use of current procedures,the degree to which additional procedures would reduce that risk, aswell as the government's interest in the matter, and how great a bur-den additional procedures would pose." 2 The fundamental require-ments of due process are notice and a meaningful opportunity to beheard.

11 3

Public Utilities Comm'n, 301 U.S. 292 (1937); Lochner v. People of New York, 198 U.S. 45(1905).

108. See J. NOWAK, R. ROTUNDA & J. YOUNG, CONSTITUTIONAL LAW 331-61 (3d ed.1986) [hereinafter J. NOWAK].

The test as articulated by Illinois' courts is that due process is not violated so long as thechallenged law or action "bears a reasonable relationship to a proper legislative purpose and isneither arbitrary or discriminatory." Kidd v. Industrial Comm'n, 85 I11. 2d 534, 538, 426N.E.2d 822, 824 (1981); Torres v. Butz, 397 F. Supp. 1015, 1024 (N.D. III. 1975) ("Substan-tive due process requires that governmental action have some factual relationship to its goalwhich is neither trivial nor capricious."); Evans v. City of Chicago, 522 F. Supp. 789, 800 n.8(N.D. Ill. 1980) (to satisfy substantive due process, state statute need only "rationally relate tosome legitimate end of government").

109. People ex rel. Palmer v. National Bankers Ins. Co., 369 I11. 605, 17 N.E.2d 579(1938).

110. United States ex rel. Miller v. Twomey, 479 F.2d 701 (7th Cir. 1973), cert. denied,414 U.S. 1146 (1974); Scott v. Department of Commerce and Community Affairs, 84 Il. 2d42, 416 N.E.2d 1082 (1981); In re Stephenson, 67 III. 2d 544, 367 N.E.2d 1273 (1977).

I11. Stanley v. Illinois, 405 U.S. 645 (1972); People ex rel. Radium Dial Company v.Ryan, 371 I11. 597, 21 N.E.2d 749, appeal dismissed, 308 U.S. 504 (1939).

112. Mathews v. Eldridge, 424 U.S. 319, 334-35 (1976).113. Illinois Crime Investigating Comm'n v. Buccieri, 36 III. 2d 556, 224 N.E.2d 236,

cert. denied, 389 U.S. 848 (1967); Rehbock v. Dixon, 458 F. Supp. 1056 (N.D. Ill. 1978); seealso Wood River Drainage and Levee Dist. v. Alton Box Board Co., 26 Ill. 2d 53, 186 N.E.2d49 (1962) (individuals who objected to payments made to an attorney in assessment proceed-ings filed written objections but never requested a hearing on their objections until long after


Two recent cases from federal courts sitting in Iowa illustratedue process considerations applicable to set-offs asserted in insuranceinsolvency proceedings. The first, Hager v. Davis Transport, Inc.,114

presented a procedural due process challenge. The liquidator of Car-riers Insurance Company ("Carriers") sued Carriers' insured, DavisTransport, Inc. ("Davis") to recover unpaid premiums. 15 Davis con-tended that it was entitled to a set-off or counterclaim for Carriers'breach of its obligations to defend and indemnify Davis under insur-ance policies that were cancelled by Carriers' insolvency."' The liq-uidator, on the other hand, maintained that Iowa's statutory set-offprovision 7 prohibited set-offs of premium obligations."' Davis chal-lenged the Iowa set-off provision and argued that it deprived him ofdue process. The court was not persuaded. Instead, the court foundthat due process was protected because Davis could present to theliquidator any 'claims for damages that arose from Carriers' allegedmishandling or failure to pay claims." 9

The second case, Hager v. Anderson-Hutchinson InsuranceAgency, 20 also involved a claim to recover unpaid premiums, butpresented a substantive due process question. The liquidator of IowaNational Mutual Insurance Company ("Iowa National"), relied onset-off provisions in Iowa's insurance code and sued 575 Iowa Na-tional agents seeking, inter alia, uncollected, unearned premiums. 2'The agents urged the court to find that insofar as the statutory set-off provision required them to pay the liquidator unearned premiums

filing; held not to have been denied a fair hearing); see, e.g., Neblett v. Carpenter, 305 U.S.297, 303-05 (1938) (statutory proceedings for rehabilitation of insurance company upheldagainst due process challenge).

114. 715 F. Supp. 939 (S.D. Iowa 1989), aff'd, 901 F.2d 1470 (8th Cir. 1990).115. Id. at 940.116. Id.117. IOWA CODE ANN. § 507C.30(2)(d) (West 1988).118. Hager, 715 F. Supp. at 940.119. Id. at 941-42.120. Civil No. 86-841-E, slip. op. (S.D. Iowa July 19, 1989).121. IowA CODE ANN. § 507c.33(l)(a) (West 1988) provides that:

An agent, broker, premium finance company or any other person responsible forthe payment of a premium is obligated to pay an unpaid premium for the fullpolicy term due the insurer at the time of the declaration of insolvency, whetherearned or unearned, as shown on the records of the insurer. The liquidator shallalso have the right to recover from the person any part of an unearned premiumthat represents commission of the person. Credits or setoffs or both shall not beallowed to an agent, broker, or premium finance company for amounts advancedto the insurer by the agent, broker, or premium finance company on behalf of,but in the absence of a payment by, the insured.

Compare CAL. INS. CODE § 1030.6 (Deering Supp. 1990) (absolving agents of liability foruncollected unearned premiums and commissions); and KAN. STAT. ANN. § 40-3602 (1986)(granting agents the right to set off unearned premiums).


that they did not-and for all practical purposes could not-collectfrom policyholders, the statute effected an unconstitutional taking ofproperty without just compensation. 2' The court agreed that the ef-fect of the statute was unconstitutional. The court rejected the liqui-dator's arguments that because the use to which the premiums wouldbe put (pro rata distribution to all claimants) bore a reasonable rela-tionship to a legitimate power of government, i.e., the liquidation ofinsurance companies, the premiums were being taken for a publicpurpose or use. The court also rejected arguments that the taking ofpremiums by the state was constitutional because the liquidatorwould distribute the premiums to Iowa National's creditors, therebypromoting the common good; that the statute did not impose a newobligation on agents, but merely confirmed their pre-insolvency con-tractual obligations; and that the amounts involved were small. 123

(iii) Equal Protection.-The equal protection clauses of the fed-eral and state constitutions ensure that similarly situated parties willbe treated in a similar manner by the government. 2" Classificationsbetween persons, whether arising out of a statute or its enforcement,may not be based on impermissible criteria or be used arbitrarily toburden or discriminate against a particular group.' 25 When no fun-damental rights are at issue, classifications are analyzed under a ra-tional basis test: to establish a violation, invidious discriminationmust be demonstrated against one person or group in favor of an-other person or group with no rational or reasonable basis for differ-entiation in treatment.'26 Every minor difference in the applicationof a statute to different groups is not an equal protection violation. 7

Instead, equal protection is limited to acts of invidious discriminationand does not apply to mere acts of inequality or to erroneous or evenarbitrary administration of state powers. Thus, a statute will not beset aside if any state of facts reasonably may be conceived to justifyit.'

28

122. Anderson-Hutchinson, Civil No. 86-841-E, slip op. at 45.123. Id. at 37-41.124. See generally J. NOWAK, supra note 108, at 521-801.125. Id. at 525.126. See, e.g., Schweiker v. Hogan, 457 U.S. 569 (1982); United States R.R. Retire-

ment Bd. v. Fritz, 449 U.S. 166 (1980); Exxon Corp. v. Governor of Maryland, 437 U.S. 117(1978); Murphy v. Wheaton, 381 F. Supp. 1252 (N.D. II1. 1974).

127. Baum v. Lunding, 535 F.2d 1016, 1018-19 (7th Cir. 1976); accord Carpenter v.Pacific Mut. Life Ins. Co., 10 Cal. 2d 307, 74 P.2d 761 (1937), afl'd sub nora., Neblett v.Carpenter, 305 U.S. 297 (1938).

128. United States v. Weatherford, 471 F.2d 47 (7th Cir. 1972), cert. denied, 411 U.S.972 (1973); Contemporary Music Group, Inc. v. Chicago Park Dist., 57 Ill. App. 3d 182, 372


The courts in Davis Transport"9 and Anderson-Hutchinson 130

both ruled on asserted deprivations of equal protection, reaching dif-ferent results on different facts. In Davis Transport, the court up-held the constitutionality of Iowa's statutory set-off provision andfound a rational basis for the provision in the substantial concern ofstate legislatures that the process of liquidating an insurance com-pany be carried out in an orderly and efficient manner.13

1 In Ander-son-Hutchinson, however, the court found that the statute, which re-quired agents to pay the liquidator all unearned premiums whileinsureds were not so obligated, violated equal protection because in-sureds and the agents were similarly situated groups who weretreated differently. Unlike the agents, insureds had no statutory dutyto pay unearned, uncollected premiums to the liquidator.'

2. Court Authority.-Whether a court other than the super-vising court has authority to rule on set-offs asserted in an insolvencyproceeding depends upon a number of factors and considerations.One consideration is whether the court has jurisdiction over the sub-ject matter of the dispute and the parties to it. Courts consideringthe issue in light of the statutory provisions governing the insurer'sinsolvency have reached differing results. In Davis Transport, thecourt limited jurisdiction to the supervising court. The court readIowa's statutory scheme in general, and the set-off provision in par-ticular, to preclude a party "from asserting defenses and claimsother than through the liquidation proceeding."'13 3 When the applica-ble statutory set-off provision authorizes the assertion of set-offs butdoes not mention counterclaims, courts have held that no jurisdictionexists for the resolution of counterclaims in an action brought by the

N.E.2d 982 (1978); Doolin v. Korshak, 39 II. 2d 521, 236 N.E.2d 897, appeal dismissed, 393U.S. 127 (1968); see, e.g., Carpenter v. Pacific Mut. Life Ins. Co., 10 Cal. 2d 307, 74 P.2d761 (1937), aff'd sub nom., Neblett v. Carpenter, 305 U.S. 297 (1938).

129. 715 F. Supp. 939 (S.D. Iowa 1989), af'd, 901 F.2d 1470 (8th Cir. 1990).130. Civil No. 86-841-E, slip op. (S.D. Iowa July 19, 1989).131. Hager v. Davis Transport, Inc., 715 F. Supp. 939, 941 (S.D. Iowa 1989), aff'd, 901

F.2d 1470 (8th Cir. 1990).132. Hager v. Anderson-Hutchinson Ins. Agency, Civil No. 86-841E, slip op. at 51

(S.D. Iowa July 19, 1989).133. Davis Transport, 715 F. Supp. at 940. Accord CALIF. INS. CODE § 1058 (West

1972) (giving the supervising court jurisdiction to hear and determine "all actions or proceed-ings"). But see Kinder v. Superior Court, 78 Cal. App. 3d 574, 144 Cal. Rptr. 291 (1978);People ex rel. Gerber v. Central Casualty Co., 37 Ill. 2d 392, 226 N.E.2d 862 (1967) (super-vising court may not adjudicate in summary proceeding claim of preferential transfer of prop-erty to party not involved in liquidation proceeding); Sachs v. Sachs, 181 Ill. App. 342 (1913)(set-off claimed by defendant bank in turnover proceeding must be decided in plenaryproceeding).


receiver of an insolvent to recover funds owed the insolvent. 13

Whereas some courts have looked to their own state statutes todetermine jurisdiction, other courts have focused on the provisions ofthe Uniform Insurer's Liquidation Act ("Uniform Act"). 135 TheUniform Act was created to provide a uniform multistate system forthe orderly and equitable administration of the assets and liabilitiesof defunct insurers3 6 and has been adopted by over 30 states.Among other things, the Uniform Act provides that controvertedclaims may be filed either in the company's domiciliary state as pro-vided by law, or in ancillary proceedings in another state. Somecourts sitting in states that have adopted the Uniform Act have heldthat the Act divests courts in that state of the power to hear actionsthat involve controverted claims against out-of-state insurers unlessancillary proceedings have been commenced in the state."3 7

In addition to the Uniform Act, another factor in the jurisdic-tion equation is the existence of an order entered by the supervisingcourt that stays the prosecution of actions or claims against the in-solvent except in the insolvency proceedings. At least one court thathas considered the issue has held that the pendency of such an orderbars claimants from asserting actions against the receiver outside theinsolvency proceedings.' Not all courts, however, have been de-

134. See, e.g., Commonwealth ex rel. Sheppard v. Central Penn Nat'l Bank, 31 Pa.Commw. 190, 375 A.2d 874 (1977); Harnett v. National Motorcycle Plan, Inc., 59 A.D. 2d870, 399 N.Y.S.2d 242 (1977); Schenck v. Coordinated Coverage Corp., 50 A.D. 2d 50, 376N.Y.S.2d 131 (1975). When the state statute provides for both set-offs and counterclaims,some courts have ruled otherwise. See, e.g., O'Connor v. Insurance Co. of North Am., 622F.Supp. 611 (N.D. Ill. 1985), affld sub nom., Stamp v. Insurance Co. of North Am., 908 F.2d1375 (7th Cir. 1990).

135. See infra 137 and cases cited therein.136. Anderson-Hutchinson, slip op. at 9; G.C. Murphy Co. v. Reserve Ins. Co., 54 N.Y.

2d 69, 77, 429 N.E.2d 111, 115, 444 N.Y.S. 2d 592, 596 (1981).137. See, e.g., Emons Indus., Inc. v. Liberty Mut. Fire Ins. Co., 545 F. Supp. 185

(S.D.N.Y. 1982); Insurance Affiliates, Inc. v. O'Connor, 522 F. Supp. 703 (D. Colo. 1981);G.C. Murphy Co. v. Reserve Ins. Co., 54 N.Y.2d 69, 429 N.E.2d 111, 444 N.Y.S.2d 592(1981); Clark v. Standard Life & Accident Ins. Co., 68 111. App. 3d 977, 386 N.E.2d 890(1979); Zullo Lumber v. King Constr., 146 N.J. Super. 88, 368 A.2d 987 (1976); accordThacher v. H.C. Baldwin Agency, Inc,, 283 F.2d 857 (7th Cir. 1960). But see Smalls v. Weed,293 S.C. 364, 360 S.E.2d 531 (Ct. App. 1987) (statutory provision prohibiting actions againstliquidators did not deprive court of subject matter jurisdiction to hear action againstrehabilitator).

138. Janak v. Allstate Ins. Co., 319 F. Supp. 215 (W.D. Wis. 1970). See also Thacherv. H.C. Baldwin Agency, Inc., 283 F.2d 857 (7th Cir. 1960); Pink v. Title Guarantee & TrustCo., 274 N.Y. 167, 8 N.E.2d 321, reargument denied, 274 N.Y. 610, 10 N.E.2d 575 (1937);Harnett v. National Motorcycle Plan, Inc., 59 A.D.2d 870, 399 N.Y.S.2d 242 (1977); Schenckv. Coordinated Coverage Corp., 50 AD.2d 50, 376 N.Y.S.2d 131 (1975); Commonwealth exrel. Sheppard v. Central Penn Nat'l Bank, 31 Pa. Commw. 190, 375 A.2d 874 (1977); VanSchaick v. Lincoln Dye Works, Inc., 146 Misc. 342, 263 N.Y.S. 114 (Sup. Ct. 1933). But seeRobertson v. Malone, 190 F,2d 756 (5th Cir. 1951) (defendant entitled to assert counterclaimagainst receiver absent order staying the assertion of claims against the receiver except in the


terred from considering the merits of an asserted set-off by a stayorder. Some courts have reasoned that an order enjoining the prose-cution of "claims" does not apply to set-offs because a set-off is not aclaim. 139

Finally, most federal courts presented with claims against insur-ers who are involved in insolvency proceedings have either stayedprosecution of the claims, or have dismissed them under the federaldoctrine of abstention. 140 In doing so, however, the courts have beenmindful of the disadvantage at 'which set-off claimants are placed bysuch rulings, and have acted to protect set-off rights. In Crist v. J.Henry Schroder Bank & Trust Co., 4 ' the court granted summaryjudgment in favor of the receiver of Transit Casualty Company withrespect to letters of credit issued by a bank at the request of CandonSyndicate N.V. ("Candon"), a third party defendant in the case.1"2

Candon filed a motion for leave to file an "offset" claim against thereceiver and the receiver objected. The court balanced the equitiesand found that Candon would be prejudiced if it had to pay the re-ceiver whole dollars and then file a separate claim with the receiver

insolvency proceedings).139. See, e.g., New York Title & Mortgage Co. v. Irving Trust Co., 241 A.D. 246, 271

N.Y.S. 775 (1934), affd, 268 N.Y. 547, 198 N.E. 397 (1935). Accord O'Connor v. InsuranceCo. of North America, 622 F. Supp. 611 (N.D. 111. 1985), aJfd sub nom., Stamp v. InsuranceCo. of North Am., 908 F.2d 1375 (1990); Schenk v. Coordinated Coverage Corp., 50 A.D. 2d50, 376 N.Y.S.2d 131 (1975).

140. See, e.g., Grimes v. Crown Life Ins. Co., 857 F.2d 699 (10th Cir. 1988), cert.denied, 489 U.S. 1096 (1989); Brown v. Link Belt Division of FMC Corp., 666 F.2d 110 (5thCir. 1982); Blackhawk Heating & Plumbing Co., Inc. v. Geeslin, 530 F.2d 154 (7th Cir.1976); Crist v. J. Henry Schroder Bank & Trust Co., 696 F. Supp. 981 (S.D.N.Y. 1988);Mathias v. Lennon, 474 F. Supp. 949 (S.D.N.Y. 1979).

There are at least three different branches of abstention doctrine upon which the courtsrely: (I) Burford abstention, named for the case that articulated the rule, Burford v. Sun OilCo., 319 U.S. 315 (1943), which provides that federal courts will not intervene in an areaalready occupied by a complex state regulatory apparatus, like the regulation of insurance; (2)Pullman abstention, named after Railroad Comm'n v. Pullman, 312 U.S. 496 (1941), whichapplies to cases in which state action is challenged in federal court on federal constitutionalgrounds but difficult questions of state law are raised that may be dispositive of the action; and(3) Younger abstention, named after Younger v. Harris, 401 U.S. 37 (1971), which providesthat a federal court will not entertain an action challenging state law on federal constitutionalgrounds when the state has already instituted proceedings in state court to enforce its law, andthe federal plaintiff may raise his claims in that forum. Mathias, 474 F. Supp. at 954-56.

For general discussions of jurisdiction, venue, and abstention in insurance insolvency pro-ceedings, see Stinson, Insurance Insolvency - Jurisdiction of the State and Federal Courts, in1989 A.B.A. SEC. TORT & INS. PRACTICE. LAW AND PRACTICE OF INSURANCE COMPANY IN-

SOLVENCY REVISITED; Gavin, Competing Forums for the Resolution of Claims Against anInsolvent Insurer, 23 TORT & INS. L.J. 604 (1988).

Abstention is not to be confused with the federal constitutional requirement that courtsmust give full faith and credit to the laws of other states. See, e.g., Clark v. Williard, 292 U.S.112 (1934).

141. 696 F. Supp. 981 (S.D.N.Y. 1988).142. Id. at 981.


in order to recover only pennies on the dollar when the Transit estatewas distributed. 14 3 The court thus allowed Candon to file its claim.144

The receiver moved to dismiss Candon's claim, but by then the re-ceiver had placed the moneys it had recovered on the letters of creditinto an escrow account. 14 As a result, the court ultimately abstainedfrom deciding the set-off issue."'

Even if jurisdiction is established, a court cannot eliminate astatutory right to set-off, but is instead bound to enforce the right.The lack of authority to restrict or eliminate statutorily guaranteedset-offs is based in part on the statutory directives generally provid-ing that mutual debts and credits "shall be set off."' 4 As a generalrule, when a supervising court's jurisdiction over insolvency proceed-ings is derived from statute, the court has no power to dispense withthe plain requirements of the statute. 4 A recent decision of the fed-eral district court sitting in Chicago, however, might be construed ascasting doubt on this elementary proposition.

In O'Connor v. Insurance Co. of North America,'4 9 the liquida-tor of Reserve Insurance Co. ("Reserve") sued Reserve's reinsurersto recover amounts owed to Reserve by the reinsurers. '0 The rein-surers moved for summary judgment and requested a declarationthat they were entitled to set off Reserve's claims against debts thatReserve owed to the reinsurers. The reinsurers relied on Section 206of the Illinois Insurance Code, which provides that: "In all cases ofmutual debts or mutual credits between the company and anotherperson, such credits and debts shall be set off or counterclaimed andthe balance only shall be allowed or paid . . . .

The court ultimately held that the defendants could assert theirset-offs. In reaching its decision, the court looked to the Illinois In-

143. Id. at 981-82.144. Id. at 982-83.145. Id. at 982.146. Crist v. J. Henry Schroder Bank & Trust Co., 696 F. Supp. 981, 983 (S.D.N.Y.

1988).147. See MODEL ACT, supra note 3, at § 29.A. (emphasis added). See also Newman v.

Hatfield Wire & Cable Co., 113 N.J.L. 484, 174 A. 491 (1934) (observing that it is the"duty" of an insolvent insurer's receiver to settle and adjust debts and credits by means of set-off); see also In re Manson, 24 Wis. 2d 673, 130 N.W. 2d 182 (1964) (court must abide bystatutory requirement that debts to be set-off "must have existed" at the time of the com-mencement of the action).

148. See, e.g., First Fed. Say. & Loan Ass'n v. Walker, 91 III. 2d 218, 227, 437 N.E.2d644, 648 (1982) (quoting Stone v. Gardner, 20 III. 304, 309 (1858)).

149. 622 F. Supp. 611 (N.D. 111. 1985), affd sub nora., Stamp v. Insurance Co. ofNorth Am., 908 F.2d 1375 (7th Cir. 1990).

150. Id. at 613.151. ILL. REV. STAT. ch. 73, para. 818 (Supp. 1990).


surance Code and observed that "[a]lthough the statutory languageappears to be mandatory, it has been held that the right of set-off ispermissive, not mandatory, and that its application lies with the dis-cretion of the trial court, which exercises such discretion under thegeneral principles of equity."' 52 A careful reading of the opinion,however, reveals that the O'Connor court's interpretation of the set-off statute as "permissive" appears to be merely an oversimplifica-tion of the general principles applicable to set-offs. In his bankruptcytreatise, relied upon by the court in O'Connor, Collier writes, "it hasbeen stated frequently that the privilege of set-off under [the Bank-ruptcy Code] is permissive, not mandatory."' 53 Cumberland GlassMfg. Co. v. DeWitt,' 4 the Supreme Court decision cited in supportof that proposition, reveals that the permissive nature of the rightlies not in the court's discretion to eliminate set-offs, but only to de-termine whether there are "mutual debts or mutual credits" suffi-cient to allow set-offs in a particular case.' 55

3. Set-Offs in Nonliquidation Proceedings.-Courts constru-ing statutory set-off provisions have held that the right to set-off isapplicable to insurers in rehabilitation as well as those in liquidation.In New York Title & Mortgage Co. v. Irving Trust Co.,'5 6 the NewYork Superintendent of Insurance argued that Section 420 of NewYork's statute referred only to liquidations, and that permitting set-offs in rehabilitation would violate the provisions of a court injunc-tion against preferences and bringing actions against the insolventinsurer.157 The Appellate Division of the New York Supreme Courtdisagreed, however, and reasoned that the provision was contained inan article of New York's insurance law, which made it generallyapplicable to both liquidations and to rehabilitations. The courtstated that

[iut has long been the law that the equity of equality amongcreditors is either found inapplicable to such setoffs or yields totheir superior equity. Scott v. Armstrong, 146 U.S. 499, 511,13 S. Ct. 148, 152, 36 L.Ed. 1059. There is nothing in the na-

152. O'Connor, 622 F. Supp. at 616 (citing 4 COLLIER ON BANKRUPTCY, supra note 12,at 1 68.02[1]) (emphasis added).

153. 4 COLLIER ON BANKRUPTCY, supra note 12, at 68.02[1).154. 237 U.S. 447 (1915).155. Id. at 455 (citing New York County Nat'l Bank v. Massey, 192 U.S. 138 (1904)).156. 241 A.D. 246, 271 N.Y.S. 775 (1934), aftid, 268 N.Y. 547, 198 N.E. 397 (1935).157. Id. at 248, 271 N.Y.S. at 778. Section 420 read: "In all cases of mutual debts or

mutual credits between the insurer and another person, such credits and debts shall be set offand the balance only shall be allowed or paid."


ture of a rehabilitation which should upset this well-establishedprinciple. We think that Section 420 was passed to express thelegislative intention that the old rule should still be followed. 158

Similarly, in Muir v. Transportation Mutual Insurance Co.,159

the Pennsylvania Commonwealth Court approved a rehabilitationthat allowed for set-offs of claims against premiums owed to thecompany. 160 Although the Pennsylvania statutory provisions ex-pressly prohibited any set-offs of premiums in liquidations, the courtfound that those provisions were not applicable to rehabilitations." 1

F. Mutuality of Capacity

1. General Rules.-To determine whether a set-off will begranted, courts analyze set-offs on a claim-by-claim, rather thanwholesale, basis.0 2 In insurance insolvencies, the fundamental in-quiry is whether the debts sought to be set off are "mutual.' 63

There are two requirements of mutuality that must be satisfiedbefore a set-off will be allowed: mutuality of capacity and mutualityof time.""'

The mutuality of capacity requirement derives from bankruptcylaw, and is recognized in the U.S. by both common law and stat-ute. 65 Simply stated, the mutuality of capacity requirement meansthat in order for debts to be set off in an insurance insolvency, theparties between whom the set-off is to be made must stand in thesame relationship or capacity to each other. That is, if the debt to be

158. Id.159. 105 Pa. Commw. 156, 523 A.2d 1190 (1987). Accord Grode v. Mutual Fire,

Marine & Inland Insurance Co., No. 3483 C.D. 1986, slip op. (Pa. Commw. Ct. Jan. 23,1990); see also Smalls v. Weed, 293 S.C. 364, 360 S.E.2d 531 (Ct. App. 1987) (statutoryprovisions concerning actions against liquidators held inapplicable to actions against companiesin rehabilitation).

160. Muir, 105 Pa. Commw. at 162, 523 A.2d at 1193.161. Id. at 159-60, 523 A.2d at 1192.162. See, e.g., Stamp v. Insurance Co. of North Am., 622 F. Supp. 611 (N.D. III. 1985).163. Stamp v. Insurance Co. of North Am., 908 F.2d 1375, 1379 (7th Cir. 1990).164. Some courts also require mutuality of "identities," see, e.g., Prudential Reinsur-

ance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal. App. 3d 293, 265 Cal. Rptr. 386(1989), review granted, 268 Cal. Rptr. 542, 789 P.2d 342 (1990) (Opinion in 216 Cal. App.3d 1321 omitted. Reprinted without change in 227 Cal. App. 3d 293, to permit tracking pend-ing review by the supreme court), while others speak of mutuality of obligation, see, e.g.,O'Connor v. Insurance Co. of North Am., 622 F. Supp. 611, 618-19 (N.D. III. 1985), affd subnom., Stamp v. Insurance Co. of North Am., 908 F.2d 1375 (7th Cir. 1990). "Mutuality ofobligation" merely refers to the concept of mutuality in general, see O'Connor, 622 F. Supp. at618-19, aff d sub nom., 908 F.2d at 1380 (where the trial and appellate courts focused onmutuality of time, in particular), while "mutuality of identities" appears to be a subset of themutuality of capacity requirement.

165. See, e.g., 4 COLLIER ON BANKRUPTCY 553-01 to -17 and cases cited therein (L.King 15th ed. 1990); ILLINOIS STATE BAR ASSOCIATION, supra note 52, at 377-80.


set off arose between the parties when those parties were acting indifferent capacities, the debt will not be considered mutual and noset-off will be allowed. 1" The "capacity" that must be present toallow set-offs is legal capacity, that is, principal, agent, trustee, bene-ficiary. 167 Contracting principals, who are debtors and creditors ofeach other by virtue of entry into a contract or contracts of insur-ance or reinsurance, have the same legal capacity and may set offdebts against each other. 68

An example helps to illustrate the point. If at the time of liqui-dation a reinsured party owes a premium to its reinsurer and thereinsurer owes payments on losses to the reinsured, the premium ob-ligation may be set off against the loss obligation because, as debtorand principal under a contract, the parties stand in the same capac-ity relative to each other.10 9 Set-offs of this type between two partiestypically have not been limited to a single contract: as long as thedebt arose while both parties were acting in the same capacities(e.g., both as principals to the contract), set-offs are allowed betweendebts arising out of any of the contracts between the parties.170 Inaddition, set-offs are available to a party who is both a reinsured to

166. For the principle that mutuality of capacity is a prerequisite for the allowance ofset-offs, see for example Sawyer v. Hoag, 84 U.S. (17 Wall.) 610 (1873); Manchester Pre-mium Budget Corp. v. Manchester Ins. & Indemnity Co., 612 F.2d 389 (8th Cir. 1980); Har-nett v. National Motorcycle Plan, Inc., 59 A.D. 2d 870, 399 N.Y.S.2d 242, 244 (1977); Gar-rison v. Edward Brown & Sons, 25 Cal. 2d 473, 154 P.2d 377 (1944); In re ConsolidatedIndemnity & Ins. Co., 287 N.Y. 34, 38-39, 38 N.E.2d 119, 120-21 (1941); Pink v. AmericanSurety Co., 283 N.Y. 290, 28 N.E.2d 842 (1940); Pink v. Title Guar. & Trust Co., 274 N.Y.167, 8 N.E.2d 321 (1937).

167. To permit set-off, "the claims must be owed between the same persons-that is, thesame legal persons-and in the same right." P.R. WOOD, supra note 9, at 25.

168. Semple & Hall, supra note 70, at 174.169. The statutes of some states, however, expressly prohibit set-offs of premium obliga-

tions, regardless of whether the premium is earned or unearned. See, e.g., CONN. GEN. STAT.ANN. § 38-450(b)(4) (West 1987); HAW. REV. STAT. § 431:15-319(b)(4) (1988); IDAHOCODE § 41-3330(2)(d) (Supp. 1990); IND. CODE ANN. § 27-9-3-28(b)(4) (Burns Supp. 1990);IOWA CODE ANN. § 507C.30.2.d. (West 1988); Ky. REV. STAT. ANN. § 304.33-330(2)(d)(Baldwin 1987); MINN. STAT. ANN. § 60B.34 Subd.2(d) (West 1986); MONT. CODE ANN. §33-2-1359(2)(d) (1989); N.H. REV. STAT. ANN. § 402-C:34 11(d) (1983); N.M. STAT. ANN. §59A-41-45B.(4) (1988); 40 PA. CONS. STAT. ANN. § 221.32.(b)(4) (Purdon Supp. 1990); S.C.CODE ANN. § 38-27-490(b)(4) (Law. Co-op. 1989); UTAH CODE ANN. § 31A-27-323(2)(d)(1986); VT. STAT. ANN. tit. 8, § 3604(b)(4) (Supp. 1989); WIs. STAT. ANN. § 645.56(2)(d)(West 1980).

170. MODEL ACT, supra note 3, § 29.A. Not all states follow this approach. The NewYork Insurance Department has taken the position that set-offs may be taken only betweendebts and credits arising under the same contract. See, e.g., In re Liquidation of Midland Ins.Co., Index No. 41294/86, slip op. (N.Y. Sup. Ct. Jan. 31, 1990), reversed, Midland Reinsur-ance Co. v. Corcoran, Index No. 42550, slip op. (N.Y. Ct. App. May 14, 1991); Corcoran v.Universal Reinsurance Corp., Index No. 40924/86, slip op. (N.Y. Sup. Ct. Dec. 1990). Seealso Semple & Hall, supra note 70, at 174-75 n.60. As a matter of pure legal theory, thisapproach is flawed in that it improperly engrafts the narrow requisites of recoupment onto thebroader concept of set-off.


and a retrocessionnaire of an insolvent company. That is, if the partyceded business to and is owed losses from the insolvent, and theparty also assumed business from the insolvent upon which the partyowes loss payments, the party may set off its obligations as a re-trocessionnaire against its obligations as a reinsured, because theparties' respective reinsurance obligations arose by contract.1 7 1

When a party attempts to set off obligations that arose whilethe parties were acting in nonmutual capacities, courts have deniedset-offs.172 Thus, set-offs are denied when a party seeks to set off anobligation incurred as a contracting principal against funds held in afiduciary capacity. As noted by Judge Learned Hand in Topas v.John McGregor Grant, Inc., ' 7 to allow such set-offs would be to al-low a fiduciary or trustee to treat the debt improperly as a securitygiven by the debtor:

No one would think it just that a bailee should keep the chattelbailed as a set-off for a debt, even after the debtor becomes in-solvent. Indeed, were it not so, the chattel would be a pledge forthe debt, and the bailee get security though he had assumed therisk of the bailor's credit in the counter-transaction. A trust isno different; when a trustee accepts his beneficiary's promise, hetakes the risk of his insolvency. 17

4

Thus, when one party to a transaction acts in the capacity of a fidu-ciary or trustee, that party cannot set off debts incurred by the otherparty acting as a principal to the contract. Only one state, Texas,has specifically addressed such situations by statute: "No offsetsshall be allowed in favor of any person where . . .(4) the obligationof such person is as a trustee or fiduciary. "175

A recent California decision addressed several mutuality of ca-pacity issues that may arise in an insurance insolvency. In Pruden-tial Reinsurance Co. v. Superior Court,176 Prudential and the insol-

171. See, e.g., MODEL ACT, supra note 3, § 29.B.6; Prudential Reinsurance Co. v. Supe-rior Court, 216 Cal. App. 3d 1321, 227 Cal. App. 3d 293, 265 Cal. Rptr. 386 (1989), reviewgranted, 268 Cal. Rptr. 542, 789 P.2d 342 (1990) (Opinion in 216 Cal. App. 3d 1321 omitted.Reprinted without change in 227 Cal. App. 3d 293, to permit tracking pending review by thesupreme court); O'Connor v. Insurance Co. of North Am., 622 F. Supp. 611 (N.D. Ill. 1985),aff'd sub nom., Stamp v. Insurance Co. of North Am., 908 F.2d 1375 (7th Cir. 1990).

172. See, e.g., Lloyd v. Cincinnati Checker Cab Co., 67 Ohio App. 89, 36 N.E.2d 67(1941) (set-off denied to policyholders of a mutual company because set-off cannot be allowedbetween a contractual and statutory obligation and because assessments were deemed a trustfund for purpose of paying the debts of the corporation).

173. 18 F.2d 724 (2d Cir.), cert. denied, 274 U.S. 754 (1927).174. Id. at 726.175. TEx. INS. CODE ANN. § 21.28(g) (Vernon Supp. 1990).176. 216 Cal. App. 3d 1321, 227 Cal. App. 3d 293, 265 Cal. Rptr. 386 (1989), review

granted, 268 Cal. Rptr. 542, 789 P.2d 342 (1990) (Opinion in 216 Cal. App. 3d 1321 omitted.


vent insurer had acted as cross-reinsurers. The liquidator contendedthat set-offs between Prudential and the insolvent should be deniedon the basis that no mutuality of capacity existed.177 The trial courtdenied the set-offs and the reinsurer appealed. The liquidator con-tended that because a reinsured acts in the capacity of "ceding in-surer," whereas the reinsurer acts in the capacity of "assuming in-surer," no set-off should be allowed. 178 The appellate court rejectedthis argument and found that the distinction was a "technical onehaving no impact on the mutuality issue. The significant relationshipin reciprocal reinsurance is that both insurers act as debtor-creditorprincipals ... . 17 The liquidator next argued that upon appoint-ment of the liquidator in an insolvency, there occurs a novation ofthe reinsurance contracts that alters the identity'8" and capacity ofthe parties and renders set-off improper. 18' The liquidator contendedthat upon issuance of a liquidation order, debts owed to the insolventin its capacity as a debtor-creditor principal become debts owed tothe liquidator in her capacity as trustee for the liquidation estate.'82

The appellate court firmly rejected these arguments, holding that the

liquidator assumes all the rights of the insolvent insurer subjectto all legal defenses and set-offs to which the insolvent was sub-ject at the time of insolvency and liquidation orders. The liqui-dator does not disturb the status of mutual debts nor do debtsalter in nature upon issuance of a liquidation order. 183

The court also noted that under the liquidator's theory, no set-offscould ever be permitted in an insurance insolvency because mutual-

Reprinted without change in 227 Cal. App. 3d 293, to permit tracking pending review by thesupreme court).

177. 227 Cal. App. 3d at 306-07, 265 Cal. Rptr. at 393.178. Id.179. Id.180. Id. at 306-07, 265 Cal. Rptr. at 393-94. The court observed that the right of set-off

requires that the subject debts and credits be mutual in three respects: mutuality of capacity,mutuality of time, and mutuality of identities. The court explained that "mutuality of identi-ties requires that debts must be owed between the same persons or entities ... [while mutual-ity of capacity requires that] these persons must owe and be owed the debts in the same legalcapacities." Id. at 300-01, 265 Cal. Rptr. at 390. Identity thus appears to be a subset ofcapacity.

181. Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.App. 3d 293, 307, 265 Cal. Rptr. 386, 394 (1989), review granted, 268 Cal. Rptr. 542, 789P.2d 342 (1990) (Opinion in 216 Cal. App. 3d. 1321 omitted. Reprinted without change in227 Cal. App. 3d 293, to permit tracking pending review by the supreme court).

182. Id.183. This result is consistent with statutory and case law holding that upon entry of an

order of rehabilitation or liquidation, the receiver is authorized to deal with the insolvent'sproperty and business in his own name or that of the company. See, e.g., ILL. REV. STAT.ch. 73, paras. 803-05 (1965); MODEL ACT, supra note 3, at § 20; In re All Star Ins. Corp.,112 Wis. 2d 329, 332 N.W.2d 8,28 (Wis. App. 1983).


ity of capacity would always be destroyed.1 84 Such an "absurd re-sult," according to the court, would render meaningless state statutesallowing set-offs.

The California liquidator would have fared no better in NewYork. In a recent decision,188 the Appellate Division of the NewYork Supreme Court rejected an argument remarkably similar tothat rejected in Prudential. Kemper Reinsurance Company ("Kem-per") was a reinsurer of insolvent Midland Insurance Company("Midland") under a facultative contract and under a treaty.18 Thefacultative contract contained a set-off provision reserving to Kemperthe right to set off any balances due between it and Midland, as wellas an insolvency clause requiring Kemper to pay Midland's liquida-tor without diminution in the event of Midland's insolvency. 87 Atthe time it was declared insolvent, Midland had not paid premiumsto Kemper owed under the treaty, but had paid its own insuredunder the facultative contract. 188 Midland requested that Kemperpay its share under the facultative contract, but Kemper claimed aset-off of the premiums due under the treaty.189

Kemper sued for a declaration that it could utilize the set-off.Midland's liquidator counterclaimed to recover the moneys dueunder the facultative contract and filed a cross motion for summaryjudgment.190 Kemper argued that the facultative contract granted aright of set-off and that it would not violate the the New York Insur-ance Law set-off provision.' 91 The liquidator countered that thedebts to be set off were not mutual because they arose out of differ-ent contracts and were owed in different capacities. 92

The trial court agreed with the liquidator on both counts. First,the court held that the insolvency clause revised Kemper's obliga-tions and altered its capacity: upon Midland's insolvency, Kemperowed its reinsurance obligations to the liquidator directly, who then

184. Prudential, 227 Cal. App. 3d at 307, 265 Cal. Rptr. at 394.185. In re Liquidation of Midland Ins. Co., Index No. 42550, slip op. (N.Y. App. Div.

May 14, 1991).186. Id., slip op. at 3.187. Id., slip op. at 3, 4.188. Id., slip op. at 4.189. Id.190. In re Liquidation of Midland Ins. Co., Index No. 42550, slip op. at 4 (N.Y. App.

Div. May 14, 1991).191. In re Liquidation of Midland Ins. Co., Index No. 41294/86, slip op. at 3 (N.Y. S.

Ct. Jan. 31, 1990). The set-off provision, N.Y. INs. LAW § 7427 (McKinney 1985), providesthat: "In all cases of mutual debts or mutual credits between the insurer and another person inconnection with any action or proceeding under this article, such credits and debts shall be setoff and the balance only shall be allowed or paid ....

192. Liquidation of Midland, slip. op. at 3.


was acting not as a creditor of Kemper, but rather as trustee for thebenefit of all of Midland's claimants 193 Next, the trial court ac-cepted the liquidator's argument that the debts sought to be set offarose out of different transactions and therefore could not be setoff. 19' The court also found that allowing the requested set-offswould give the reinsurer a greater share of the reinsurance pro-ceeds, 195 a result contrary to the principle that all creditors of aninsolvent insurer are to be paid equally in proportion to their claims.

The Appellate Division recently reversed the trial court.' 96 Thecourt held that unlike recoupment, debts need not arise out of thesame transaction in order to be set off. 197 The court also found errorin the trial court's reliance upon the insolvency clauses altering theparties' capacity: "While the reinsurer makes the payment to theLiquidator in the case of insolvency, this does not make the debtsnon-mutual. Both parties were acting in the same capacity at thetime the debts were contracted and the debts arose before liquida-tion."' 9 8 Indeed, the court determined that denying such offsetswould render any set-off in a liquidation proceeding impossible, andwould eviscerate New York's set-off statute. 99 Finally, the courtfound reinsurer set-offs to be in the interests of policyholders and thegeneral public as a form of protection of reinsurance pools. 200

2. .Application of the General Rules.-The issues raised byPrudential and Midland are not the only instances in which mutual-ity of capacity disputes must be resolved. As will be seen below, mu-tuality of capacity frequently arises as an issue in determining set-offs between agents or brokers and an insolvent insurance company,set-offs between affiliated companies, set-offs when a mutual com-pany is involved, set-offs of salvage and subrogation recoveries, andset-offs of governmental claims or obligations.

(a) Set-offs by agents.-Traditionally, set-offs between agents

193. Id., slip op. at 4.194. Id., slip op. at 5.195. In re Liquidation of Midland Ins. Co., Index No. 41294/86, slip op. at 5 (N.Y. S.

Ct. Jan 31, 1990); accord Corcoran v. Universal Reinsurance Corp., Index No. 40924/86, slipop. at 3 (N.Y. Sup. Ct. Dec. 1990).

196. In re Liquidation of Midland Ins. Co., Index No. 42550, slip op. (N.Y. App. Div.May 14, 1991).

197. Id., slip op. at 5.198. Id. slip op. at 8-9.199. Id., slip op. at 9.200. Id., slip op. at 10-11 (quoting Stamp v. Insurance Co. of North Am., 908 F.2d

1375, 1380 (7th Cir. 1990)).


and insolvents were denied on mutuality of capacity grounds, as theagent's role was viewed not as a party to an insurance or reinsurancecontract with the insolvent, but rather as a fiduciary.210 As discussedabove, fiduciary obligations, such as the holding of an insurer's pre-miums in trust by an agent,20 2 generally may not be set off againstobligations arising out of the insolvent's contracts with the agent.Accordingly, an agent may not set off claims arising in a personalcapacity against obligations assumed in a fiduciary capacity.20 3

Disputes over set-offs often arise in insurance insolvencies thatinvolve a set-off of earned and unearned premiums held by an agentor a broker.2 0 ' In most cases, the courts have prohibited an agentfrom setting off its obligation to remit earned or unearned premiumsto an insurer against claims for future commissions or other dam-ages.205 Aside from the difference in the parties' capacities, 0 6 there

201. See, e.g., In re New York Title & Mortgage Co., 260 A.D. 729, 23 N.Y.S.2d 303(1940) (set-off denied because the relationship between trustees, holders of first mortgage par-ticipation certificates, and the liquidator of an insurance company was one of trustee and ces-tui que trust, while the obligation sought to be set off was one of contract). See also Garrisonv. Edward Brown & Sons, 25 Cal. 2d 473, 154 P.2d 377 (1944) (noting that no set-off wouldbe allowed for breach of contract claims against fiduciary obligations); Harnett v. NationalMotorcycle Plan, Inc., 59 A.D.2d 870, 399 N.Y.S. 2d 242 (1977) (no set-off for breach ofcontract damages against fiduciary obligations). See generally 4 COLLIER ON BANKRUPTCY

553.04[2] (L. King 15th ed. 1990).202. The statutes of some states expressly provide that an insurance agent or broker

holds moneys due the insurer in a trust or fiduciary capacity. See, e.g., ILLINOIS INSURANCE

CODE § 508.1, ILL. ANN. STAT. ch. 73, 1065.55-1 (Smith-Hurd Supp. 1990); Bohlinger v.Zanger, 306 N.Y. 228, 117 N.E.2d 338 (1954).

203. In some circumstances, however, an agent may set off costs expended in performinghis fiduciary duties. Garrison v: Edward Brown & Sons, 28 Cal. 2d 28, 168 P.2d 153 (1946)(agent may set off costs of collecting premium as agent for insolvent insurer against unremit-ted premium owed to insolvent when agency agreement specifically established relationshipbetween agent and insolvent as one of trust).

204. See, e.g., Bohlinger v. Kagan, 147 F. Supp. 910 (D.R.I. 1956); Bushnell & Mitch-ell, 160 F. Supp. 608 (S.D. Ala. 1958); Maloney v. Rhode Island Ins. Co., 115 Cal. App. 2d238, 251 P.2d 1027 (1953); Trimble v. Coppage, 259 Md. 176, 269 A.2d 563 (Ct. App. 1970);United Benefit Fire Ins. Co. v. Earl, 186 Neb. 175, 181 N.W.2d 841 (Sup. Ct. 1970);Bohlinger v. Ward, 34 N.J. Super. 583, 113 A.2d 38 (1955), af'd, 20 N.J. 331, 120 A.2d I(1956); Newman v. Hatfield Wire & Cable Co., 113 N.J.L. 484, 174 A. 491 (1934); Shoup v.Mayerson, 454 P.2d 666 (Okla. 1969).

205. See, e.g., Sheeran v. Sitren, 168 N.J. Super. 402, 403 A.2d 53 (1979) (agent wasnot a debtor or creditor of insolvent, but merely an agent and conduit for premium paymentsand refunds, and was therefore not entitled to set off unearned premiums against earned butnot yet paid premiums); Bohlinger v. Ward & Co., 20 N.J. 331, 120 A.2d 1 (1956) (courtdenied set-off of premiums and rejected agent's argument that the principal-agent relationshipbetween the parties had been changed into a debtor-creditor relationship through a course ofbusiness between the parties); Bohlinger v. Zanger, 306 N.Y. 228, 117 N.E.2d 338 (1954)(agent holds earned premiums as fiduciary and therefore may not set off, but has no obligationto pay unearned premiums to liquidator); Ainsworth v. Cincotta, 79 Or. App. 574, 721 P.2d455 (1986) (enforcing statutory prohibition); Gambrell v. Cox, 250 S.C. 228, 157 S.E.2d 233(1967) (same); Insurance Premium Serv., Inc. v. Wood, 57 Tenn. App. 514, 420 S.W.2d 595(1967). But see Hershey v. Kennedy & Ely Ins. Inc., 294 F. Supp. 554 (S.D. Fla. 1967), affd,405 F.2d 888 (5th Cir. 1968) (agent allowed to deduct proportionate commission from uncol-


are two reasons for this rule. First, insolvency effects a cancellationof policies and gives rise to an obligation of the insolvent insurer toreturn unearned premiums to policyholders and an obligation ofagents to return unearned commissions to the insolvent.207 Second,the right to unearned or renewal commissions is conditioned on thecontinued existence of the insurance company and the continued col-lection of premiums. When the company is placed into liquidation,the agreement is terminated by operation of law reasonably withinthe parties' contemplation, and not by an actionable breach on thepart of the company.20 8

Some states have statutes that specifically allow agents to set offpremiums. Florida, for example, allows set-offs in favor of an agentwho has paid the unearned portion of a premium to a policy-holder.209 Illinois allows such a set-off only if the policy was can-

lected or partially uncollected premiums); Downey v. Humphreys, 102 Cal. App. 2d 328, 227P.2d 484 (1951) (agent allowed to set off unearned premiums against his obligations to theinsurer when the court found the relationship between the insolvent insurer and general agentto be that of debtor and creditor, not trustee and beneficiary); Bushnell v. Krafft, 133 Ind.App. 474, 183 N.E.2d 340 (1962) (agents acted as general debtor, not in fiduciary capacity);McFarling v. Demco, Inc., 546 P.2d 625 (Okla. 1976) (relationship between broker and in-surer was one of debtor-creditor); Korlann v. E-Z Pay Plan, Inc., 247 Or. 170, 428 P.2d 172(1967) (same); see discussion of Garrison v. Edward Brown & Sons, 28 Cal. 2d 28, 168 P.2d153 (1945), supra note 203.

Although unearned premium held by an agent may not be set off against commissionsowed to the agent, see, e.g., Ratchford v. United States Cent. Underwriting Agency, Inc., 492F. Supp. 137 (E.D. Mo. 1980), they could be netted through recoupment. As one commentatorobserved:

The doctrine of recoupment has been overlooked in the insurance company liqui-dation setting. Liquidators have been successful in denying agents the right tosetoff debts owed to the agent against premiums held by the agents as trustfunds. Since both debts arise under the agency agreement, the doctrine of re-coupment, not the doctrine of offset should be applicable.

Wolke, Voidable References, Fraudulent Conveyances, Offsets and Recoupment or How CanA Liquidator Use Your Money To Build Up The Estate?, in 1986 A.B.A. SEC. TORT. & INS.PRACTICE, LAW & PRACTICE OF INSURANCE COMPANY INSOLVENCY, 349, 366-67.

206. The courts are not uniform in the view that set-offs of unearned premium are de-nied to agents because the agent holds such funds in a fiduciary capacity. Some courts regardthat an agent who procures replacement coverage for insureds using unearned premiums is notentitled to a set-off because he has acted as a volunteer. See, e.g., Wheeler v. Clark, 306S.W.2d 158 (Tex. Civ. App. 1957); Eng. v. Wheeler, 302 S.W. 2d 263 (Tex. Civ. App. 1957).But see Ratchford v. United States Cent. Underwriters Agency, 492 F. Supp. 137, 140 (E.D.Mo. 1980) (observing that if agent had paid policyholders unpaid premium, then "it would, ofcourse, have been subrogated to the policyholders' right of recovery in the liquidationproceeding").

207. Ratchford, 492 F. Supp. at 140; Hershey v. Kennedy & Ely Ins., Inc., 294 F.Supp. 554 (S.D, Fla. 1967); Gambrell v. Cox, 250 S.C. 228, 157 S.E.2d 233 (1967); Wheelerv. Clark, 306 S.W.2d 158 (Tex. Civ. App. 1957); Eng. v. Wheeler, 302 S.W.2d 263 (Tex. Civ.App. 1957).

208. See, e.g., Fabe v. Facer Ins, Agency, Inc., 588 F. Supp. 1330 (C.D. II1. 1984),aff'd, 773 F.2d 142 (7th Cir. 1985), cert. denied, 475 U.S. 1013 (1986); O'Hern v. De Long,298 Ill. App. 375, 19 N.E.2d 214 (1939).

209. FLA. STAT. ANN. § 631.281(3) (West 1984). Accord KAN. STAT. ANN. § 40-3602


celled and premiums refunded prior to the insolvency:

No set-off shall be allowed in favor of an insurance agent orbroker against his account with the company, for the unearnedportion of the premium on any cancelled policy, unless that pol-icy was cancelled prior to the entry of the Order of Liquidationor Rehabilitation, and unless the unearned portion of the pre-mium on that cancelled policy was refunded or credited to theassured or his representative prior to the entry of the Order ofLiquidation or Rehabilitation. 10

Similarly, the Model Act provides that "[n]o set-off or counterclaimshall be allowed in favor of any person where . . . the obligation ofthe person is to pay premiums whether earned or unearned, to theinsurer."21 The Model Act further provides that:

An agent, broker, premium finance company, or any other per-son, other than the insured, responsible for the payment of apremium shall be obligated to pay any unpaid premium for thefull policy term due the insurer at the time of the declaration ofinsolvency, whether earned or unearned, as shown on the recordsof the insurer. The liquidator shall also have the right to recoverfrom such person any part of an unearned premium that repre-sents commission of such person. Credits or set-offs or both shallnot be allowed to an agent, broker, or premium finance companyfor any amounts advanced to the insurer by the agent, broker, orpremium finance company on behalf of, but in the absence of apayment by, the insured.21 2

The law on set-off as it relates to agents, brokers, and otherintermediaries2 13 is far from settled, however, and courts and com-mentators only recently have begun to focus on the roles such per-sons play in the relationship between insureds, insurers, and reinsur-

(1986) (guaranteeing to agents set-offs for unearned premiums upon payment of the agent'saccount to the insolvent); LA. REV. STAT. ANN. § 22:747(3) (West 1978); N.C. GEN. STAT. §58-30-160(c) (1984).

For an extensive discussion of agents and their statutory duties to pay premiums to aliquidator, see Hager v. Anderson-Hutchinson Ins. Agency, Civil. No. 86-841-E, slip op. (S.D.Iowa 1989).

210. Illinois Insurance Code § 206, ILL. ANN. STAT. ch. 73, para. 818 (Smith-HurdSupp. 1990). See also Fabe v. Facer Ins. Agency, Inc., 588 F. Supp. 1330 (C.D. Ill. 1984),aff'd, 773 F.2d 142 (7th Cir. 1985), cert. denied, 475 U.S. 1013 (1986) (relying on Sec-tion 206 of the Illinois Insurance Code to deny insurance agent's right of set-off when agentsought to set off unearned premiums against commissions returned by agent to policyholder).

211. MODEL ACT, supra note 3, at § 30.B.(4).212. MODEL ACT, supra note 3, at § 32.A.(I).213. For purposes of this section of the article, the term "intermediary" is used broadly

to include agents, brokers, and managing general agents.


ers. 21 One interesting set-off issue involving intermediaries ariseswhen an insurance company, acting as either reinsured or reinsurer,becomes insolvent while funds paid by the company are still in thepossession of the intermediary:215 Can moneys held by the intermedi-ary be set off against other obligations due to or from the insolventcompany? The "intermediary clause, '2 16 now commonly used in theU.S. to shift the risk in these situations to the reinsurer, may holdthe answer. This clause, inserted in contracts of insurance and rein-surance, explicitly makes the intermediary the agent of the reinsurerfor purposes of receipt of funds. Therefore, in cases in which theintermediary clause applies, payment of premiums by the reinsuredto the intermediary is deemed payment to the reinsurer, while pay-ment of losses by the reinsurer to the intermediary is not consideredpayment to the reinsured. Set-off rights are thus complicated by theoperation of the intermediary clause, as the intermediary will holdsome payments in a fiduciary capacity, and may hold other funds ina nonfiduciary capacity.

Another developing issue involving intermediaries is that of"prefunding." An example of prefunding arises when an intermedi-ary receives a claim by a reinsured for payment of losses, notifies thereinsurer of the loss, but does not wait to collect from the reinsurerbefore paying the loss. In effect, the intermediary "prefunds" theobligation for the reinsurer. But if the reinsurer becomes insolventbefore sending payment on the prefunded claim to the broker, whatare the set-off rights of the various parties? May the intermediaryset off the prefunded amount against any claim of the insolventagainst the intermediary? Some have taken the position that fundsprefunded by intermediaries are voluntary and gratuitous, thus norepayment or set-off is allowed. The practice of prefunding has be-come a subject of some concern, as it can effectively mask a com-pany's financial troubles from regulators and other companies.

One court has addressed intermediary prefunding in the reinsur-

214. See, e.g., Vitkowsky, Status and Obligations of Reinsurance Brokers and In-termediaries In the United States, in 1988 A.B.A. SEC. TORT & INS. PRACTICE, LAW ANDPRACTICE OF INTERNATIONAL REINSURANCE COLLECTIONS AND INSOLVENCY 264; Sheffrey,Reinsurance Intermediaries: Their Relationship to Reinsured and Reinsurer, 16 FORUM 922(1981); Wollan, Caught in the Middle, Reinsurance Intermediaries, BEST'S REVIEW, April1986; In re Pritchard v. Baird, 8 Bankr. 265 (D.N.J. 1980).

215. See Bent v. Alexander, 15 Mo. App. 181 (1884) (intermediary held $100,000 givenfrom one insurer to promote the transfer of assets to it of another insurer in return for reinsur-ance. Both insurers were placed in liquidation and both claimed the $100,000).

216. See Vitkowsky, supra note 214 (discussing how In re Pritchard v. Baird, 8 Bankr.265 (D.N.J. 1980), resulted in the inclusion of a standard intermediary clause in reinsuranceagreements).


ance context. In Ideal Mutual Insurance Co. v. Korean ReinsuranceCorp.,217 a reinsured in liquidation ("Ideal") sued its reinsurer, Ko-rean Reinsurance Corp. ("KRIC"), for amounts due under a rein-surance contract. Ideal sued for damages that included sums ad-vanced by Ideal's intermediary, Hogg Robinson & GardnerMountain International, Ltd. ("Hogg"), to Ideal when KRIC re-fused to pay the amount it allegedly owed under the reinsurancecontract.21 8

KRIC contended that Hogg's payments to Ideal were gratui-tous, 21 9 and thus irrecoverable; Ideal contended that it is commonindustry practice for brokers to pay their clients amounts that areleft unpaid under reinsurance contracts. The court rejected KRIC'sargument, finding that there was no evidence that the relationshipbetween Ideal and Hogg was anything but strictly commercial.220

The evidence also indicated that Hogg's payments to Ideal were notgifts, but more akin to advances, which would have to be repaid assoon as Ideal received payment from KRIC. The court reasoned that"a rule of law that would allow KRIC to escape payment in this casesolely because the brokers' payments would provide incentive forother reinsurance companies to renege on similar contracts in. thehope that brokers would likewise, in effect, pay the reinsurance com-panies' debts for them. 221

(b) Premium set-offs by insureds.-The prohibition against set-offs by agents of premiums should not apply to insureds becausethere usually is no mutuality of capacity problem. In those statesand territories whose statutes do not expressly prohibit premium set-offs by an insured, 222 or have no set-off provision applicable to insur-ance insolvency proceedings, 223 the common law has provided con-flicting answers to this question. Some courts addressing the issue

217. 657 F. Supp. 1174 (S.D.N.Y. 1987).218. Id. at 1174-75.219. The same argument was made by a liquidator in response to a set-off asserted by

an agent with respect to unearned premiums in Insurance Premium Serv., Inc. v. Wood, 57Tenn. App. 514, 420 S.W.2d 595 (1967), but the court never decided the point. See also Eng.v. Wheeler, 302 S.W.2d 263 (Texas Civ. App. 1957) (agent who returned unearned premiumsto policyholders acted as volunteer and could not set off claims thus assigned to him).

220. Ideal Mutual, 657 F. Supp. at 1176.221. Id. at 1177.222. Alabama, Alaska, Arizona, Arkansas, Delaware, Florida, Georgia, Illinois, Kansas,

Louisiana, Maine, Maryland, Nevada, New Jersey, New York, North Carolina, North Da-kota, Ohio, Oklahoma, Tennessee, (Texas), Utah, Vermont, Virginia, Washington, West Vir-ginia, Wyoming, Puerto Rico and Virgin Islands. See Appendix infra.

223. Colorado, District of Columbia, Massachusetts, Michigan, Mississippi, Missouri,Nebraska, Rhode Island and South Dakota. See Appendix, infra.


have allowed insureds to set off premium obligations against losses orclaims; 224 others have not.22 5 Insureds no longer in privity, or havingattenuated relationships with insurers that become insolvent, alsohave been denied set-offs. Thus, in Ewing v. Coffman,2 6 a husbandwho purchased a policy on his life for his wife was denied a set-offagainst a mortgage debt incurred on a loan from the life insurer be-cause the life insurer assigned its assets to a new company and thehusband received a new policy from the assignee. Similarly, inManchester Insurance & Indemnity Co. v. Manchester PremiumBudget Corp.,12' a company that financed premiums on policies writ-ten by an insurer was denied a set-off of unearned premiums againstan obligation on a note that it executed in favor of the insurer.

(c) Set-offs between affiliated companies.-As a general rule,set-offs are permitted only between the parties (or their successors ininterest) specifically included in the contracts between the parties.Thus, a debtor cannot set off an amount it owes to an insolvent com-pany against an amount owed by the insolvent to the debtor's affili-ate or subsidiary company.228 Similarly, an insolvent will not be per-mitted to claim the benefit of a set-off accruing to one of its affiliatesor subsidiaries.

In the recent case of Prudential Reinsurance Co. v. SuperiorCourt,229 Prudential asserted set-offs between its subsidiary and theinsolvent by relying on cases in which set-offs were allowed becausethe parties agreed to treat the debt of the subsidiary company as thedebt of the parent. The California appellate court rejected the at-

224. See, e.g., Pink v. Isle Theatrical Corp., 246 App. Div. 24, 284 N.Y.S. 447 (1935)(insured employer may set off workers compensation payments); Van Schaick v. Astor, 154Misc. 543, 277 N.Y.S. 394 (1935) (same); Newman v. Hatfield Wire & Cable Co., 113N.J.L. 484, 174 A. 491 (1934) (same).

225. See, e.g., In re Wisconsin Mutual Ins. Co., 247 Wis. 485, 19 N.W.2d 889 (1945)and cases cited therein; Pink v. Georgia Stages, Inc., 35 F. Supp. 437 (M.D. Ga. 1940); VanSchaick v. Lincoln Dye Works, Inc., 146 Misc. 342, 263 N.Y.S. 114 (1933) (insured's pre-mium obligation is an absolute debt and cannot be set off) (citing Sawyer v. Hoag, 84 U.S.610 (1873); Stoddard v. Guy, 209 A.D. 39, 204 N.Y.S. 371 (1924)).

226. 80 Tenn. (12 Lea) 79 (1883).227. 469 F. Supp. 126 (E.D. Mo. 1979).228. See generally 4 COLLIER ON BANKRUPTCY, supra note 165, at 1 553.04(2).Similarly, set-offs would not be allowed when a cedent to two different companies, both of

which are involved in separate insolvency proceedings under the direction of the same receiver,seeks to set off debts due to one insolvent against claims made against the other. See, e.g.,Mead Reinsurance Corp. v. Town of Oyster Bay, 138 A.D. 2d 578, 526 N.Y.S.2d 159 (1988).

As a general rule, individual credits may not be set off against joint and several debts.See, e.g., Forsythe v. Kimball, 91 U.S. 291 (1875).

229. Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.App. 3d 293, 265 Cal. Rptr. 386 (1989), review granted, 268 Cal. Rptr. 542, 789 P.2d 342(1990) (Opinion in 216 Cal. App. 3d 1321 omitted. Reprinted without change in 227 Cal.App. 3d 293, to permit tracking pending review by the supreme court.).


tempted set-off, noting that in the cases cited by Prudential, an ex-press mutual agreement was made to treat the subsidiary companyas a mutual debtor-creditor, whereas no such agreement existed be-tween Prudential and the insolvent. The court also hinted that evenif an express agreement existed between Prudential and the insol-vent, such an agreement might not ensure allowance of a set-off.Analogizing a case allowing a subsidiary set-off by agreement to thesituation in which an assignment of debt is made for set-off collec-tion purposes, the court noted that such set-offs are impermissible.The court rejected Prudential's arguments in favor of expanding thedoctrine of set-off to include subsidiaries, holding that:

We believe that it is particularly inappropriate to adopt thatdoctrine in the context of set-off claims by reciprocal reinsurersin insurance liquidation proceedings. As the present case illus-trates, such an expansion of mutuality under [the set-off stat-ute], as construed by California decisions, would permit an ex-ponential increase in the amounts affiliated insurance groupscould offset to the detriment of liquidation estates and, pragmat-ically, primary policyholders. 30

Set-offs between merged companies, however, should be allowedby receivers under appropriate circumstances. If, after the making ofa contract, a company merges with another company into a singleentity, the new company may assert set-offs in its own name and onbehalf of the two merged companies as the separate companies nolonger exist and the set-offs would otherwise be lost. Of course, if themerger preceded the insolvency so shortly that a question ariseswhether the merger was simply a device for securing a favorable set-off, the set-off would be denied under current law.2"' Conversely, iftwo companies are technically separate, but over the course of thecontract have acted as one entity, some receivers reject attempts toset off, because a course of dealing is not considered sufficient toovercome the prohibition against affiliate set-offs.232

(d) Set-offs of assessments and capital contributions.-In sev-eral reported cases, mutual company policyholders who are liable byassessment for company losses have asserted set-offs for losses andunearned premiums against their obligations to pay assessments. The

230. 227 Cal. App. 3d at 312, 265 Cal. Rptr. at 397.231. See MODEL ACT, supra note 3, at § 29.B(2).232. For example, in Prudential, set-off was denied even though reinsurance accounts of

several entities were treated as a single entity during the performance of the contract.


courts usually reject such set-offs, holding that the assessments arein essence a trust fund created for the benefit of all creditors.233

Likewise, courts have denied the assertion of set-offs by policyhold-ers against capital contributions owed to the insolvent insurer. 34

Section 29 of the Model Act prohibits such set-offs,23 5 and moststates have specific statutory prohibitions against setting-off assess-ments, stock subscriptions, and capital contributions. For example,the Illinois Insurance Code provides that:

[N]o setoff or counterclaim shall be allowed in favor of any per-son where . . . the obligation of such person is to pay an assess-ment levied against members or subscribers of any companywhich issued assessable policies, or to pay a balance upon a sub-scription to the shares of a stock company.2 36

(e) Set-offs of salvage and subrogation recoveries.-Little at-tention has been devoted to the issue of whether salvage and subro-gation recoveries in the hands of a reinsured may be set off againstclaims owed in an insurance insolvency. Like all set-off determina-tions, resolution of this issue turns on the question of mutuality.

Historically, subrogation 237 developed as an equitable doctrineto avoid unjust enrichment by substituting one person or entity in

233.. See, e.g., Tuttle v. State Mutual Liability Ins. Co., 2 N.J. Misc. 973, 127 A. 682(1925) (no set-offs allowed of returned unearned premiums against assessments levied by thereceiver); Lloyd v. Cincinnati Checker Cab Co., 67 Ohio App. 89, 36 N.E.2d 67 (1941) (set-off denied to policyholders of a mutual company because set-off cannot be allowed betweencontractual and statutory obligations, and because assessments were deemed a trust fund forpurpose of paying the company's debts); Taggart v. Graham, 108 Pa: Super. 320, 165 A. 68(1933), aff'd, 315 Pa. 438, 173 A. 423 (1934) (no set-off of assessments against losses forholder of mutual insurance company certificates); In re Banks, 85 S.C. 37, 67 S.E. 19 (1910)(policyholder of insolvent mutual insurer could not offset loss claims against receivers' claimsfor assessments). Compare Traer v. Consolidated Coal Co., 221 II1. App. 576 (1921) (no set-off of assessments because policyholders voluntarily agreed to pay them in order to raisemoney to pay losses). But see Ely v. Oakland Circuit Judge, 162 Mich. 466, 125 N.W. 375,378 (1910) (policyholders who are liable for assessment "should be allowed to offset theunearned premium").

234. See, e.g., Scammon v. Kimball, 92 U.S. 362 (1875); Sawyer v. Hoag, 84 U.S. 610(1873).

235. MODEL ACT, supra note 3, § 29.B.(5).236. Illinois Insurance Code § 206(a), ILL. REV. STAT. ch. 73, para. 818(a) (1989).237. There are two types of subrogation: conventional subrogation, which is an interest

established by a convention of the parties, such as an understanding, agreement, contract orstatute; and legal subrogation, a right of subrogation which exists as a consequence of a judi-cial determination. R. KEETON & A. WIDISS, INSURANCE LAW: A GUIDE TO FUNDAMENTALPRINCIPLES, LEGAL DOCTRINES. AND COMMERCIAL PRACTICES (Practitioner's Edition) 219(1988). In most instances, the distinction has no significance because the facts that entitle aperson to claim subrogation by operation of law are ordinarily the same facts that entitle aperson to claim the benefit of a contract for subrogation. COUCH ON INSURANCE 2d § 61:2(Rev. ed. 1983).


place of another with respect to some claim or right the second per-son has against a third. In the insurance context, when an insurerindemnifies an insured who is entitled to recover for his loss fromanother person, the insurer may be subrogated to the insured's rightsto recover from the other person.238 Subrogation is designed to placeultimate responsibility for loss upon the one on whom, in good con-science, it ought to fall. It is also designed to reimburse an innocentparty who was compelled to pay.238

Salvage is distinct from subrogation.240 Initially developed inthe context of marine insurance, salvage was the insured propertyabandoned by the insured after a loss. Now, "salvage" simply refersto that portion of property that is taken over by the insurer afterpayment of a claim for the loss:"4" "The payment of a total loss bythe insurers, or their liability to pay such a loss in consequence of anabandonment, gives them an equitable right to the property, or whatremains of it, so far as it was covered by the policy, including thespec recuperandi .... "I'll

Only the New York Court of Appeals has squarely addressedthe precise issue of whether salvage and subrogation recoveries maybe set off in insurance insolvencies, 43 resolving the issue on the basisof mutuality of capacity. The seminal decision, Pink v. American

238. R. KEETON & A. WIDISS, supra note 237, at 219; Central Nat'l Bank & Trust Co.v. Central Illinois Light Co., 65 Ill. App. 2d 287, 212 N.E.2d 489 (1965).

239. Geneva Const. Co. v. Martin Transfer & Storage Co., 4 II. 2d 273, 122 N.E.2d540 (1954).

240. Aetna Ins. Co. v. United Fruit Co., 304 U.S. 430, 437-38 (1938) ("there is noanalogy between the insurer's right to be subrogated to the fruits of the insured's recoveryfrom a wrongdoer and the insurer's rights to a wreck which is his by abandonment").

241. K. GERATHEWOHL. REINSURANCE PRINCIPLES AND PRACTICE, vol. I, ch. 10, § 3.1.2at 703 (1980); BLACK'S LAW DICTIONARY 1202 (5th ed. 1979).

242. Republic of China v. National Union Fire Ins. Co., 163 F. Supp. 812, 815-16 (D.Md. 1958) (quoting PHILLIPS ON INSURANCE, sec. 1707).

243. Some courts and commentators, however, have addressed the same issue in relatedcontexts. Thus, on the issue of whether an action may be maintained in the name of a subro-gee, "the great majority of courts hold the insurer to be the real party in interest (because) ifthe insurer satisfies his liability to the insured, but the insured sues and recovers his entireoriginal loss, the recovery is impressed with a trust for the insurer up to the amount to whichhe was entitled by principles of subrogation." 3A MOORE'S FEDERAL PRACTICE 17.09[2.-l],at 17-17 to -18 (2d ed. 1948) (citing VANCE, INSURANCE (3d ed. 1951) 786, et seq.). See, e.g.,Glacier Gen. Assurance Co. v. G. Gordon Symons Co., 631 F.2d 131 (9th Cir. 1980); BraniffAirways, Inc. v. Falkingham, 20 F.R.D. 141 (D). Minn. 1957); National Garment Co. v. NewYork, Chicago & St. Louis RR Co., 173 F.2d 32 (8th Cir. 1949). Courts have reached thesame conclusion whether the subrogee is the primary insurer or a reinsurer. Glacier, supra;Universal Ins. Co. v. Old Time Molasses Co., 46 F.2d 925 (5th Cir. 1931); Maryland CasualtyCo. v. City of Cincinnati, 291 F. 825 (S.D. Ohio 1923). Accord COUCH, supra note 237 at §61:5 ("Where the insurer effects reinsurance, the same right of subrogation which arises withrespect to an insurer also arises with respect to the reinsurer") (citing Maryland Casualty Co.v. City of Cincinnati, 291 F. 825 (S.D. Ohio 1923)). See also Semple and Hall, supra note 70,at 422 n.59.


Surety Co.,2" involved the liquidation of an insurance company thatentered into a reciprocal reinsurance agreement with another in-surer. The insolvent, Guardian Casualty Company ("Guardian"), re-insured risks ceded to it by the American Surety Company of NewYork ("American Surety"). American Surety, in turn, reinsuredrisks ceded to it by Guardian.24 5 Pursuant to the terms of two gen-eral agreements for reinsurance, the reinsurer was entitled to sharewith the reinsured any salvage or recovery in the proportion that theamount of reinsurance bore to the amount of the bond.246

After Guardian was declared insolvent and placed into liquida-tion, Guardian's liquidator sued American Surety to recover certainsums that American Surety had recovered in salvage proceedings. 14 7

American Surety, in turn, claimed that it was entitled to set off thesalvage recovery against amounts owed to American Surety fromGuardian. The trial court denied the set-offs and American Suretyappealed. 48

The New York Court of Appeals affirmed. The court held thatthe salvage proceeds could not be set off because they were held intrust: "In relation to any salvage collected to recoup losses on spe-cific risks under the reinsurance contracts the reinsured was a trusteefor the reinsurer as to moneys in its hands belonging to the latter orto be applied to a specific purpose. 24

19 The court declared that "it is

clear . . . that the claims of the parties to this action were not heldin the same right . . . and there were consequently no mutual debtswithin the meaning of the [statute].1 250 In other words, set-off wasdenied because the parties were not acting in mutual capacities, 251

despite the fact that the obligation to share salvage recoveries be-tween the two parties was contractual.252

244. 283 N.Y. 290, 28 N.E.2d 842 (1940).245. Id. at 293, 28 N.E.2d 843.246. Id. at 296, 28 N.E.2d at 844.247. Id. at 294, 28 N.E.2d at 843.248. Id.249. Pink v. American Surety Co., 283 N.Y. 290, 296, 28 N.E.2d 842, 844 (1940).250. Id. at 298, 28 N.E.2d at 845.251. See also In re Consolidated Indemn. & Ins. Co., 287 N.Y. 34, 38 N.E.2d 119, 169

N.Y.S.2d 907 (1941) (set-off of salvage denied); In re Preferred Accident Ins. Co., 3 N.Y.2d990, 147 N.E.2d 476 (1957) (abstract only) (set-off of salvage denied).

252. The Pink decision remains good law. See, e.g., Superintendent of Ins. v. Baker &Hostetler, 668 F. Supp. 1057 (N.D. Ohio 1986), aft'd, 826 F.2d 1065 (1987) (applying NewYork law and citing Consolidated for the holding that legal counsel's claim for attorney feescould not be set-off against funds held in client's trust fund account).

The unresolved question remains, however, whether under the doctrine of recoupment areinsurer should be entitled to reduce reinsurance proceeds it owes to an insolvent reinsurer bysalvage proceeds held by the insurer and owed to the reinsurer even if the salvage proceeds areheld as trust funds. See Wolke, supra note 205, at 367. But see O'Conner v. Insurance Co. of


G. Mutuality of Time

One of the first steps in any insurance insolvency is the estab-lishment of an exact date upon which all rights, obligations, and lia-bilities of the insolvent company and its creditors can be fixed. TheModel Act provides for the fixing of rights and liabilities:

Upon issuance of the order [of liquidation or rehabilitation], therights and liabilities of any such insurer and of its creditors, pol-icyholders, shareholders, members and all other persons inter-ested in its estate shall become fixed as of the date of entry ofthe order.

253

Consistent with the Model Act, the insurance statutes of moststates provide that the rights and liabilities of the company and itscreditors are fixed as of the date of the entry of an order of liquida-tion or rehabilitation.2 5 The effect of this "fixing date" is significant;it provides a date at which coverage is terminated, such that a credi-tor who suffers a loss prior to the fixing date will share in the ulti-mate distribution of assets, but not for any loss occurring after thefixing date. The fixing date also determines what debts and creditsmay be set off. Finality and efficiency are the reasons for the fixingdate: "[p]ublic policy requires that a fixed date be had to the endthat the liquidation proceedings should not be interminably carriedon.", 55

In order for debts to be set off in an insurance insolvency, thedebts must be mutual as to time as well as capacity. This require-ment has often been stated in terms of a restriction that hinges uponthe fixing date.256 That is, preliquidation debts may be set off onlyagainst other preliquidation debts, and postliquidation debts onlyagainst other postliquidation debts. In other words, a preliquidationdebt cannot be set off against a postliquidation debt.2 57 Put another

North Am., 622 F. Supp. 611, 615 n.2 (N.D. II1. 1985).253. MODEL ACT, supra note 3, at § 18.B.254. See, e.g., Illinois Insurance Code § 194, ILL. REV. STAT. ch. 73, para. 806 (1989).255. Van Schaick v. Pennsylvania Exchange Bank, 236 A.D. 453, 260 N.Y.S. 37, 40

(1932).256. Manchester Premium v. Manchester Ins. & Indem., 612 F.2d 389, 391 (8th Cir.

1980) ("the determination of the propriety of a set-off must be based on the right of theparties at the time of insolvency").

257. O'Connor v. Insurance Co. of North Am., 622 F. Supp. 611, 618 (N.D. Ill. 1985),Manchester Ins. & Indem. Co. v. Manchester Premium Budget Corp., 469 F. Supp. 126, 129(E.D. Mo. 1979), afftd, 612 F.2d 389 (8th Cir. 1980); Gambrell v. Cox, 250 S.C. 228, 157S.E.2d 233, 236 (1967); Wisconsin Mutual Ins. Co. v. Manson, 24 Wis. 2d 673, 130 N.W.2d182 (1964); In re New York Title & Mortgage Co., 260 A.D. 729, 23 N.Y.S. 2d 303, 306(1940); O'Hern v. DeLong, 298 III. App. 375, 19 N.E.2d 214, 215-16 (1939); New York Title& Mortgage Co. v. Friedman, 153 Misc. 697, 276 N.Y.S. 72 (1934); Van Schaick v. Pennsyl-


way, the debts and credits to be set off must be owedcontemporaneously.258

The reason for the pre- versus post-liquidation rule lies in equi-table considerations underlying all insolvency proceedings. Becauseas a general rule an insolvent's assets are to be distributed pro ratato creditors,'5 9 all parties must stand or fall by the condition of thecompany at the time the receiver is appointed or insolvency is de-creed. A person indebted to an insolvent corporation cannot, afterappointment of the receiver, purchase or acquire from other creditorstheir claims against the corporation, and then by set-off evade thefull payment of his own indebtedness. °0

1. The Pre- versus Post-Liquidation Controversy.-Definingwhen a debt arises for purposes of fixing it as a pre- or post-liquida-tion debt is a subject of great controversy. The only state to haveresolved this problem by statute appears to be Florida, whose statuteprovides that:

No offset shall be allowed in favor of any such person where:(a) The obligation of the insurer to such person

would not at the date of the entry of any liquidationorder or otherwise, . . . entitle him to share as a claim-ant in the assets of the insurer. Any such obligationmust be fully vested and mature as of the date of theorder of liquidation and in no way contingent upon anyfuture event or condition precedent to allow an offset.261

vania Exchange Bank, 236 A.D. 453, 260 N.Y.S. 37 (1932).In addition, at least one court has held that to be a valid preliquidation debt, the obliga-

tion must have become absolute: a party is entitled to set offif on the date of the commencement of the action for dissolution or liquidationthe debt is absolute. It cannot rest upon any contingency. If on that date thedebt has absolutely matured, such type of debt enables the creditor to share inthe assets of the defunct corporation, for the status of such creditors fixed as ofthe date of the commencement of such action for dissolution or liquidation.

New York Title & Mortgage Co. v. Friedman, 153 Misc. 697, 276 N.Y.S. 72, 78 (1934).258. Stamp v. Insurance Co. of North Am., 908 F.2d 1375, 1379 (7th Cir. 1990)

(" 'Mutual' in bankruptcy law means contemporaneous and in the same capacity"); PrudentialReinsurance Co. v. Superior Ct., 216 Cal. App. 3d 1321, 1325, 265 Cal. Rptr. 386, 390(1990).

259. See, e.g., Sawyer v. Hoag, 84 U.S. 610 (1873). See also the statutory prioritydistribution schemes enacted in most states, discussed in subsection H.2., infra.

260. See, e.g., Gambrell v. Cox, 250 S.C. 228, 157 S.E.2d 233 (1967); Commonwealthv. Guardian Fire Ins. Co., 65 Pa. Super. 203 (1916); accord Wheeler v. Clark, 306 S.W.2d158 (Tex. Civ. App. 1957).

261. FLA. STAT.*ANN. § 631.281(2) (West Supp. 1991). This provision reflects Sec-tion 631.192, which provides that: "No claim based upon a contract of insurance ... may beallowed or paid . . . unless the event causing the loss to, or creating the liability of, the obligeeof the contract occurred prior to the order of liquidation . ... "


Case law reflects the controversy in deciding when a debt ac-crues in the insurance insolvency context. In Melco System v. Re-ceivers of Trans-America Insurance Co., 62 the Alabama SupremeCourt denied a set-off between an insolvent insurer and its reinsurer,based on differences in timing of the two debts. The insolvent, Trans-America Insurance Co. ("Trans-America"), had a reinsurance treatywith Employers Reinsurance Corporation of Kansas ("Employ-ers").263 In addition to the reinsurance treaty, Trans-America andEmployers had executed an "insolvency agreement," in which thereinsurance under the treaty would be payable by Employers on thebasis of Trans-America's liability, without diminution on account ofthe insolvency of Trans-America.2 64 After Trans-America wasplaced into receivership, Employers agreed to pay its debts to Trans-America's receiver, but also sought a set-off for unpaid premiumsowed by Trans-America to Employers.265

In deciding whether the set-off was appropriate, the Melcocourt focused on "when Employers became indebted to the receiversof Trans-America. ' 266 The court held that Employers did not be-come liable as a reinsurer under the treaty until Trans-America ac-tually had paid the loss. 267 Although the insolvency agreement im-posed responsibility for payment in the event Trans-America becameinsolvent, the court found that this agreement did not become opera-tive until after the insolvency of Trans-America. 26 8 The court con-cluded that Employers was not indebted to Trans-America prior tothe insolvency, but that Trans-America owed premiums to Employ-ers prior to its becoming insolvent. '269 Therefore, the court foundthat there was no mutuality of time and denied the set-off.2 70

In sharp contrast to the Melco decision is the decision inO'Connor v. Insurance Co. of North America.2 7' In O'Connor, Re-

262. 268 Ala. 152, 105 So. 2d 43 (1958).263. Id. at 156, 105 So. 2d at 44.264. Id. at 156-57, 105 So. 2d at 45.265. Id. at 156, 105 So. 2d at 44.266. Id. at 164, 105 So. 2d at 53 (emphasis in original).267. Melco Sys. v. Receivers of Trans-Am. Ins. Co., 268 Ala. 152, 164, 105 So. 2d 43,

53 (1958).268. Id.269. Id.270. See also Pink v. Title Guar. & Trust Co., 274 N.Y. 167, 8 N.E.2d 321 (1937) (set-

off denied because "[a]t the time of insolvency there was no debt - no mutuality of debts andcredits"); Pink v. American Surety Co., 283 N.Y. 290, 28 N.E.2d 842 (1940) (set-off deniedbecause "at the time of the insolvency there was no debt insofar as the offsets claimed by thedefendant were concerned"); In Re Manson, 24 Wis. 2d 673, 130 N.W.2d 182 (1964) (set-offdenied because "an unmatured debt could not be set-off against a matured one").

271. 622 F. Supp. 611 (N.D. 111. 1985), motion to reconsider denied, 668 F. Supp. 1183


serve Insurance Company ("Reserve") had been found insolvent andplaced in liquidation. Reserve had ceded risks to various reinsurers,and the liquidator sought recovery on certain losses from those rein-surers under the reinsurance treaties. 27 12 The reinsurers, in turn,sought to set off debts that Reserve owed to them.

The liquidator contended that the debts owed to Reserve, rein-surance proceeds and unearned premiums, were created as a resultof the court-ordered cancellation of the policies, while the debtsowed by Reserve to the reinsurers were preliquidation debts.278 Theliquidator argued that, because the reinsurance proceeds would notbe due until the policyholders' loss claims were allowed or liquidatedby the liquidation court, the reinsurers' claims were postliquidationclaims.274 Similarly, as unearned premiums would not become dueuntil the cancellation of the policies, the liquidator contended thatthere was no obligation to refund those amounts before Reserve'sinsolvency, since they too were postliquidation debts.275 Therefore,the liquidator contended that mutuality of time did not exist betweenthe reinsurer's postliquidation debts and Reserve's preliquidationdebts, and thus no set-off could be permitted.276 In response, thereinsurers argued that their debts arose under provisions in the rein-surance contracts which were executed and performed prior to thetime of the insolvency, and, therefore, the debts in question were allpre-liquidation debts. 7

The court agreed with the reinsurers and allowed the set-offs,finding that the reinsurers and Reserve had

entered into a reinsurance contract which defined all of the par-ties' rights and obligations. Any liability [the reinsurers] mayincur to pay reinsurance proceeds or return unearned premiumsor ceding commissions arises as the result of provisions in thepreviously executed reinsurance agreement that require them tomake these payments.27

The court also concluded that although the claims were not paidprior to Reserve's insolvency, they were susceptible of liquidation.279

Reasoning that the unearned premiums on policies still in existence

(N.D. 111, 1987), affd sub nom., 908 F.2d 1375 (7th Cir. 1990).272. Id. at 614.273. Id. at 618.274. Id.275. Id.276. O'Conner v. Insurance Co. of North Am., 622 F. Supp. 611, 618 (N.D. III. 1985).277. Id.278. Id. at 618-19 (emphasis added).279. Id. at 619.


on the date of insolvency became payable on that date, and that theamounts were fixed, the court held that the reinsurers' debts werepreliquidation debts. Thus, mutuality of obligation existed and a set-off would be permitted against the liquidator. 80 In essence, theO'Connor court held that if a debt could be construed as arising outof a preliquidation contract, it must be classified as a preliquidationdebt. 81

The liquidator appealed but the Seventh Circuit Court of Ap-peals affirmed the trial court's decision.282 Focusing upon the mutu-ality of time requirement, the court interpreted Illinois' statutory set-off provision as requiring mutuality of obligation rather than identityof time of payment.28 As the court explained, "[a] debt may existeven though it has not been valued conclusively and even thoughthere is a bona fide dispute about the obligation to pay." '284 Thus, thecourt based its decision on the fact that the obligations to be set offarose preliquidation; the fact that the obligations were not liquidatedin amount or did not mature until postliquidation was deemed to beirrelevant. The court found further support for its decision in thevery nature of reinsurance pools as set-off devices that serve as se-curity for the protection of policyholders.2 85

Taken together, Melco and the O'Connor decisions raise morequestions than they answer. For example, would the Melco analysisapply to a situation in which there was an insolvency clause appear-ing in the reinsurance treaty as opposed to a separate insolvencyagreement? And what would happen in a rehabilitation, as opposedto liquidation, proceeding? Does the mutuality of time requirement

280. The court declined to resolve the case under the doctrine of recoupment, reasoningthat the Illinois Insurance Code did not provide for recoupment. Id. at 615 n.2.

281. The California appellate court adopted the O'Connor trial court's mutuality of timerationale in Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.App. 3d 293, 265 Cal. Rptr. 386 (1989), review granted, 268 Cal. Rptr. 542, 789 P.2d 342(1990) (Opinion in 216 Cal. App. 3d 1321 omitted. Reprinted without change in 227 Cal.App. 3d 293, to permit tracking pending review by the supreme court.). The Prudential courtallowed set-offs between cross-reinsurers, rejecting the liquidator's contention that some of thedebts did not mature until the liquidation order issued and thus were postliquidation debts. Asin O'Connor, the Prudential court reasoned that debts arising out of preliquidation contractswere preliquidation debts. The court cited the rule that "mutual debts created by contractbetween an insolvent and another are subject to set-off upon insolvency even if they mature byvirtue of the event of insolvency." Prudential, 227 Cal. App. 3d at 303, 265 Cal. Rptr. at 391.

282. Stamp v. Insurance Co. North Am., 908 F.2d 1375 (7th Cir. 1990).283. Id. at 1380.284. Id.285. Id. Again, the court declined to decide whether the Illinois statutory set-off provi-

sion displaced principles of common law recoupment and whether recoupment would havebeen available in this case. Id. at 1381.


make any sense in a rehabilitation? 286 If so, should there be one fix-ing date or a series of bar dates?28 7

2. Set Off of Contingent, Unliquidated, and ImmatureClaims.-The Melco and O'Connor decisions reveal that satisfactionof the mutuality of time requirement often depends upon the relativedevelopment of the claims and debts to be set off. The general rule isthat only claims that are certain in terms of liability may be set off;contingent claims may not.2 88 In essence, a claim is contingent if it isuncertain that the party asserting the claim will ever become liableto pay. 89 A noncontingent claim is one of certain liability; althoughthere may be a question as to the ultimate amount of the liability orwhen it is due, there is no doubt that some debt will be due at sometime. Thus, the development of noncontingent claims is measured bytheir liquidity and maturity. An unliquidated claim is uncertain as toamount.2 90 An immature claim is a liquidated claim that is not yetowing. A mature claim - also known as an absolute claim - isready to be paid.291

286. It is important to note that the Prudential and O'Connor decisions were renderedin liquidation, not rehabilitation cases. Courts considering the issue, however, have held thatset-offs may be applied differently in reorganization as opposed to liquidation bankruptcy pro-ceedings. See, e.g., Lowden v. Northwestern Nat'l Bank & Trust Co., 298 U.S. 160 (1936);Susquehanna Chemical Corp. v. Producers Bank & Trust Co., 174 F.2d 783 (3d Cir. 1949);Penn. Central Transp. Co. v. March Warehouse Corp., 356 F. Supp. 567 (S.D. Ind. 1972).See also MODEL ACT, supra note 3, § 29.A.(6) (disallowing reinsurance set-offs in liquida-tions, but allowing them in rehabilitations).

287. See, e.g., MODEL ACT, supra note 3, § 29.C (obligating liquidators to provide rein-surers with accounting statements identifying due and payable debts, and providing that suchdebts may be set off only against mutual credits due and payable for the same accountingperiod), and § 29.D (allowing cedents to set off only obligations which the cedent has paid).

288. Pink v. Title Guar. & Trust Co., 274 N.Y. 167, 8 N.E.2d 321 (1937) (contingentclaims may not be set-off); New York Title Co. v. Friedman, 153 Misc. 697, 276 N.Y.S. 72(1934) (same). In bankruptcy, however, contingent claims may be set off. See I I U.S.C.A. §§502, 553; 4 COLLIER ON BANKRUPTCY, supra note 165, at 1111 502.03, 553.08, 553.11; Note,Set-off of Contingent Claims in Bankruptcy, 49 YALE L.J. 119 (1939).

289. In re Lexington Surety & Indem. Co., 272 N.Y. 210, 5 N.E.2d 204 (1936).290. Hilgeman v. State ex rel. Payne, 374 So. 2d 1327, 1329 (Ala. 1979) (citing In re

Munsie, 32 F.2d 304 (D. Conn,), rev'd on other grounds, 33 F.2d 79 (1929); Ellis v. Burnham,263 Mass. 57, 160 N.E. 437 (1928)).

291. Accord Pate v. Security Union Ins. Co., 54 S.W.2d 355 (Tex. Ct. App. 1932). Thisdifference between absolute claims and immature claims has been adopted by at least 14 statesin provisions relating to the filing and allowance of contingent or special claims. See, e.g.,CONN. GEN. STAT. § 38-457 (1987); HAW. REV. STAT. § 431: 15-327 (1988); IDAHO CODE §41-3337 (1977 & Supp. 1990); IND. CODE ANN. § 27-9-3-35 (Burns 1986); IowA CODE ANN.§ 507C.37 (West 1988); Ky. REV. STAT. ANN. § 304.33-390 (Baldwin 1987); MINN. STAT.ANN. § 60B.39 (West 1986); MONT. CODE ANN. § 33-2-1366 (1989); N.H. REV. STAT. ANN. §402-C: 39 (1983); OHIO REV. CODE ANN. § 3903.37 (Baldwin 1989); 40 PA. CONS. STAT.ANN. § 221.39 (Purdon's Supp. 1990); S.C. CODE ANN. § 38-27-560 (Law. Co-op. 1989);UTAH CODE ANN. § 31A-27-330 (1991); WIS. STAT. ANN. § 645.63 (West 1980 & Supp.1990).


An example may be helpful. Assume that A negligently driveshis automobile into the rear end of B's car. As a result of A's negli-gence, B has a contingent claim against A. If B sues A and A failsto appear in court, B may be awarded a default judgment of liabilityagainst A. B now has a noncontingent claim, but it remains unliqui-dated until he proves its value, and immature until the court entersjudgment on the amount. In other words, the claim remains contin-gent until liability is certain, unliquidated until it is assigned a value,and immature until it is due. Viewed another way, contingency is afunction of liability, liquidation is a function of valuation, and ma-turity is a function of time.29 These distinctions between contingentand noncontingent claims are matters of substance, not form. Unliq-uidated and immature claims may be set off, but contingent claimsmay not.2 93 Unfortunately, the distinctions often are employedmistakenly.29

292. See Wolke, supra note 205, at 364:To determine whether a claim existed at the time of the order, it is important tounderstand certain concepts: (1) contingent v. absolute claims; (2) immature v.mature claims; and (3) unliquidated v. liquidated claims. A contingent claim isone which is not absolutely owing at the time the insolvency occurs and thereceiver or liquidator is appointed, but may ripen into an absolute claim later on.An insured, for example, would have a contingent claim under a fire policybefore the fire occurs. An immature claim is one which may be an absolute debtat the time of the insolvency but may not then be due and payable. A cedinginsurer, for example, may be liable to a reinsurer for written premium, but theliability may not mature until the end of the quarterly accounting period whenpayment is due. An unliquidated claim is one where the holder of the claim hasa right to recover against the estate, but the amount has not yet been deter-mined. Unfortunately, liquidation statutes and courts have sometimes confusedthese entirely different concepts. (footnote omitted).

Accord Ky. REV. STAT. ANN. § 304.33-380(4) (Baldwin 1987) (providing that "ImmatureClaims" are "Claims that are due except for the passage of time which shall be treated asabsolute claims . . .")

293. Scott v. Armstrong, 146 U.S. 499 (1892) (absolute but unmatured claims may beset off); Van Schaick v. Astor, 154 Misc. 543, 277 N.Y.S. 394 (1935) (same); see also Pink v.Isle Theatrical Corp., 246 A.D. 24, 284 N.Y.S. 447 (1935) (unliquidated debts may be setoff); Van Schaick v. Bank of Yorktown, 154 Misc. 400, 277 N.Y.S. 311 (1934) (immatureclaims may be set off); In re Empire State Surety Co., 214 N.Y. 553, 108 N.E. 825 (1915)(absolute but unliquidated claims may be set off). But see Harnett v. National MotorcyclePlan, Inc., 59 A.D. 2d 870, 399 N.Y.S. 2d 242 (1977) (holding that agent could not set off, asagainst claims for premiums and commissions he collected, claims for damages for breaches ofcontract, and observing that such claims had not "matured" at the time of insolvency); In reManson, 24 Wis. 2d 673, 130 N.W.2d 182 (1964) (unmatured surplus note may not be setoff); Newman v. Hatfield Wire & Cable Co., 113 N.J.L. 484, 174 A. 491 (1934) (unliquidatedclaims, i.e., those "incapable of being ascertained definitely by arithmetical calculation," maynot be set off); Van Schaick v. Pennsylvania Exchange Bank, 236 A.D. 453, 260 N.Y.S. 37, 38(1932) (",It is well established that unmatured claims . . . may not be set off against a ma-tured claim . . .").

294. Compare WIs. STAT. ANN. §§ 645.63(1), (2), (3) (West 1980); In re Liquidation ofWisconsin Surety Corp., 112 Wis. 2d 396, 332 N.W.2d 860 (1983) (distinguishing between"technically" contingent claims, "truly" contingent claims, and "other" contingent claims, in-cluding "technically" contingent claims of those not third parties); CAL. INS. CODE § 1025


The rationale for the general rule allowing set-offs of noncontin-gent claims was illustrated in the Prudential case. In Prudential, theliquidator contended that mutuality of time was absent in that therespective reinsurance debts were not due at the same time.295 Sheargued that the claimant reinsurers' debts owed to the insolvents didnot accrue until after the liquidator approved the underlying primarypolicyholders' loss claims against the insolvent, and that theunearned premiums on these reinsurance contracts did not becomedue until the liquidation order issued.2" 6 The trial court agreed, butthe appellate court rejected the liquidator's position. 7 Observingthat early federal and California decisions established that debts andcredits of an insolvent insurer are deemed mutual and subject to set-off even if the obligations would otherwise mature or be payable onlyafter closing of the estate, the court adopted the reasoning of theO'Connor trial court and rejected Melco.298 The Prudential courtagreed with the O'Connor trial court that the reinsurers' obligationsto reimburse their insolvent reinsureds accrued (became noncontin-gent) prior to liquidation. 99 Even though the obligations wereneither liquidated nor mature until the liquidator approved the poli-cyholders' claims, the trial court's adjudication of insolvency effecteda cancellation of all outstanding primary policies and reinsurancetreaties. It thus made no sense to consider an obligation arisingunder those policies and treaties as being either contingent or post-liquidation after the order of insolvency was entered.

Whether the contingent-noncontingent claim distinction remainsa viable rationale for prohibiting set-offs has yet to be tested by thecourts. Forty-two states and two territories have enacted statutoryguarantees of the right to assert set-offs in insurance insolvency pro-

(1972); TEXAS INS. CODE ANN. § 21.28(d) (1981) (referring to "unliquidated" and "undeter-mined" claims). See also Commissioner of Ins. v. Massachusetts Accident Co., 314 Mass.558, 50 N.E.2d 801 (1943) (claims of policyholders who have not yet suffered loss are notcontingent within the meaning of insurance insolvency statute because they have lost cover-age); In re Empire State Surety Co., 214 N.Y. 553, 108 N.E. 825 (1915) (policyholder'sclaims against insolvent insurer were not contingent because liability became certain and fixedupon insurer's breach of policies); Ratchford v. United States Cent. Underwriters Agency,Inc., 492 F. Supp. 137 (E.D. Mo. 1980) (holding that claim for damages allegedly sustainedby reason of pre-insolvency termination of contracts could not be set off because it was"unliquidated").

295. Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.App. 3d 293, 301, 265 Cal. Rptr. 386, 390 (1989) (Opinion in 216 Cal. App. 3d 1321 omitted.Reprinted without change in 227 Cal. App. 3d 293, to permit tracking pending review by thesupreme court).

296. 227 Cal. App. 3d at 301, 265 Cal. Rptr. at 390.297. Id.298. Id. at 1328, 265 Cal. Rptr. at 392-93.299. Id. at 304, 265 Cal. Rptr. at 392.


ceedings. °° None of those states has any provision prohibiting theset-off of contingent claims. In fact, thirty-nine states and both terri-tories30 ' have enacted provisions for the filing and allowance of con-tingent claims in insurance insolvencies. The insurer insolvency set-off provisions of thirty-two of those thirty-nine states limit set-offs toobligations of the insolvent insurer that as of the fixing date wouldentitle the set-off claimant to share in the insurer's assets.3"2 More-over, as Section 36 of the Model Act provides, a claim "which iscontingent only on [a third party] first obtaining a judgment againstthe insured shall be considered and allowed as if there were no suchcontingency."30 3 In light of such provisions, a reasonable argumentmight be made in favor of allowing set-off of contingent claims, as-suming such claims could be valued.

The NAIC, however, has manifested its belief that contingentclaims may not be set off - at least not by parties to reinsurancecontracts with the insolvent. Section 29 of the Model Act now pro-vides that the liquidator must provide reinsurers with accountingstatements identifying debts that are currently due and payable.3°0

The reinsurer's right of set-off is then limited to the period covered

300. See Appendix, infra.301. ALA. CODE. § 27-32-30 (1986); ALASKA STAT. § 21.78.280 (1990); ARIZ. REV.

STAT. ANN. § 20-639 (1990); ARK. STAT. ANN. § 23-68-102 (1987); CAL. INS. CODE §§ 1025,1027 (Deering 1976); CONN. GEN. STAT. § 38-457 (1987); DEL. CODE ANN. tit. 18, § 2928(1989); FLA. STAT. ANN. § 631.192 (West 1984); GA. CODE ANN. § 33-37-22 (Harrison1990); HAW. REV. STAT. § 431: 15-327 (1988); IDAHO CODE § 41-3337 (1977 & Supp.1990); ILL. ANN. STAT. ch. 73, para. 818 (Smith-Hurd Supp. 1991); IND. CODE ANN. § 27-9-3-35 (Burns 1986); IOWA CODE ANN. § 507C.37 (West 1988); Ky. REV. STAT. ANN. § 304.33-390 (Baldwin 1987); LA. REV. STAT. ANN. § 22: 749 (West 1978); ME. REV. STAT. ANN.tit. 24A, § 4378 (1990); MD. INS. CODE. ANN. § 160 (1990); MASS. GEN. L. ANN. ch. C.175,§§ 180G, H (West 1987); MINN. STAT. ANN. § 60B.39 (West 1986); MONT. CODE ANN. § 33-2-1366 (1989); NEB. REV. STAT. § 44-127.05 (1988); NEV. REV. STAT. § 696B.450 (1987);N.H. REV. STAT. ANN. § 402-C: 39 (1983); N.Y. INS. LAW § 7433 (McKinney 1985 & Supp.1991); N.C. GEN. STAT. § 58-155.29 (1990); OHIO REV. CODE ANN. § 3903.37 (Baldwin1989); OKLA. STAT. ANN. tit. 36, § 1929 (West 1990); OR. REV. STAT. § 734.380 (1989); 40PA. CONS. STAT. ANN. § 221.39 (Purdon's Supp. 1990); S.C. CODE ANN. § 38-27-560 (Law.Co-op. 1989); TENN. CODE ANN. § 56-9-129 (1989); TEX. INS. CODE ANN. § 21.28 (Vernon1981 & Supp. 1991); UTAH CODE ANN. § 31A-27-330 (1991); WASH. REV. CODE ANN. §48.31.300 (1984); W. VA. CODE § 33-10-29 (1988); WIS. STAT. ANN. § 645.63 (West 1980 &Supp. 1990); WYO. STAT. § 26-28-127 (1983); P.R. LAWS ANN. tit. 26, § 4018 (1977); VI.CODE ANN. tit. 22, § 1278 (1970).

302. See note 301, supra. The seven states listed in note 301 whose statutes do notcontain such a limitation are Florida, Illinois, Louisiana, Maine, Massachusetts, Nebraska andOregon. Oregon, however, prohibits all set-offs "except for cases of policy loans or reinsur-ance." OR. REV. STAT. ANN. § 734.370 (1989).

303. MODEL ACT, supra note 3, § 36. Cf Illinois Insurance Code §§ 209(3), (4), ILL.REV. STAT. ch. 73, paras. 821(3), (4) (1989). Eighteen other states have virtually the samestatutory language as Illinois; two others have a slightly modified version, the main differencebeing omission of any reference to "liability insurance policy." ME. REV. STAT. ANN. tit. 24A,§ 4378 (1990); N.J. STAT. ANN. § 17:30C-28 (West 1985).

304. MODEL ACT, supra note 3, § 29.C.


by the accounting statement."0 5 Moreover, reinsureds may set offagainst debts due to the insolvent only those mutual credits that thereinsured has paid or that the liquidator has allowed for payment.30 6

These provisions make good sense when applied in a rehabilitationproceeding because the purpose of the proceeding is to keep the com-pany operating on a going-forward basis. In such circumstances,there may be no fixing date or single bar date for the submission ofclaims, and claims should be paid or set off when they are absolute,liquidated, and mature. For whatever reason, the NAIC did notmake the accounting statement provision applicable to rehabilitationproceedings. Moreover, when viewed in the context of liquidationproceedings, the new Section 29 provisions stand in sharp contrast tothe Prudential and O'Connor decisions, and are certain to intensifythe national debate over set-offs.

3. The Prohibition Against After-Acquired Set-Offs.-Another issue involving timing of set-offs arises when a partyacquires a debt by assignment subsequent to the insolvency and thenattempts to use that assigned debt as a set-off.3"7 Many states' stat-utes prohibit such set-offs,30 8 and the courts have been unanimous indisallowing them. In Hammond Screw Machinery Co. v. Sullivan,30 9

the defendant acquired receivables from an English corporation afteran English receiver had been appointed for the corporation. The de-fendant then attempted to assert a claim by way of set-off.3 "0 Thecourt denied the claim under English law, noting that there was a"sound common sense justification" for the English prohibition ofsuch set-offs: "[i]f a debtor were allowed to set off against a claim ofa receiver debts against the company in receivership that the debtoracquired by assignment and after the appointment of the receiver,the priority supposedly conferred upon the debenture holder couldeasily be circumvented."311 The court also rejected the attempted

305. Id.306. Id. § 29.D.307. A related issue is whether set-off may be used prospectively, that is, whether a

creditor may ignore its current obligation to pay a debtor in anticipation of setting it offagainst some later claim. The answer is no. See, e.g., In re Buckley & Assoc. Ins., Inc. v.Transamerica Ins. Group, 78 Bankr. 155 (E.D. Tenn. 1987).

308. See, e.g., Illinois Insurance Code § 206, ILL. ANN. STAT. ch. 73, para. 818 (Smith-Hurd Supp. 1991) ("no setoff or counterclaim shall be allowed in favor of any person wherethe obligation of the company to such person was purchased by or transferred to such personwith a view of its being used as a setoff or counterclaim"); MODEL ACT, supra note 3, §30.B.(2).

309. 580 F. Supp. 24 (N.D. Ill. 1984).310. Id. at 24, 25.311. Id. at 26.


set-off under the long-standing American majority rule limiting thecircumstances in which a debtor may assert a set-off claim:

The courts of most jurisdictions recognize and allow a debtor ofan insolvent to set off a claim against the insolvent acquiredprior to the insolvency proceeding upon the theory that wherethe right to set off exists at such time, the insolvent's debtorequitably owes only the balance, if any, over and above theamount which the insolvent owes him, and that such balance isthe only debt that passes to the receiver on his appointment. . . . Conversely it is well settled that after an assignment forthe benefit of creditors has taken place and a receiver properlyappointed, a debtor of the insolvent cannot take an assignmentof a claim against the insolvent and set it off against his indebt-edness to the assignee for the benefit of creditors. 312

Some states, however, have created an exception for thepurchase or assignment of unearned premium claims, even if after-acquired. In particular, Florida, Kansas, and North Carolina protectthe set-off rights of an agent who voluntarily pays the unearned por-tion of a premium to a policyholder (and receives an assignment ofthe policyholder's unearned premium claim),31 while Louisiana pro-tects the set-off rights of any person who does so.""

H. Recent Set-Off Developments in the U.S.

The application of set-offs in insurance insolvencies in the U.S.has long been a controversial issue among both regulators and theinsurance industry."' 3 In particular, regulators and the industry havewaged a long, on-going battle over the proper application of set-offsinvolving reinsurance.

1. The Battle Over Reinsurance Set-Offs.-Until the secondhalf of this century, it was assumed that reinsurers of insolvent in-

312. Id. at 26 (emphasis in original), quoting Chaitman v. ENM Co., 14 II1. App. 3d990, 304 N.E.2d 107, 109 (1973). See also Gambrell v. Cox, 250 S.C. 228, 157 S.E.2d 233,236 (1967) ("[l]t is well settled in this jurisdiction that a debtor will not be permitted to set-off against his debt a claim or claims assigned to him after the insolvency or receivership of hiscreditor. The right, if any, to set-off against an insolvent concern or individual has to be gov-erned by the state of facts existing at the time of the insolvency rather than rights created orobtained thereafter."); Wheeler v. Clark, 306 S.W.2d 158 (Tex. Civ. App. 1957) (agent whotook assignments from policyholders of a company in liquidation for unearned premium claimscould not set-off those amounts against unearned commissions owed by the agent to thereceiver).

313. FLA. STAT. ANN. § 631.281 (West 1984); KAN. STAT. ANN. §40-3602 (1986); N.C.GEN. STAT. § 58-155.28(c) (1990).

314. LA. REV. STAT. ANN. § 22:747 (West 1978).315. See, e.g., McCullough, The Upset Over Offsets, 6/89 REACTIONS 34 (1989).


surers could set off their reinsurance obligations against claims theymight have against the insolvent for losses under primary policies orreinsurance treaties underwritten by the insolvent. In fact, it appearsthat no court addressed the precise issue until 1958.10 Since thattime, the assertion of set-offs by reinsurers has been a controversialissue, much debated in the legislatures and - as evinced above -

litigated in the courts.The first major legislative battle over reinsurance set-offs in in-

surance insolvency proceedings was waged in 1965, when the Wis-consin legislature created an Insurance Laws Revision Committeecharged with rewriting the state's insurance code. 317 The first chap-ter of the insurance code reviewed by the Committee related to therehabilitation and liquidation of insurers."' 8 The Committee createda provision that would have denied reinsurers any set-off of an insol-vent cedent's premium obligations. The purpose of the provision wasto maximize the assets available for liquidation, encourage reinsurersto be more concerned with the financial condition of cedents, makereinsurance better perform its stabilizing function, and frustratefraudulent reinsurance transactions. However, the Committee's sug-gestion was rejected, and the restrictive provision was never enactedinto law.31 1

The dissent over reinsurer set-off rights continued. In July 1970,the California Assembly considered a bill requiring that all pay-ments due from a reinsurer be made without any set-off for premi-ums due from the insolvent insurer. By the time the bill passed inAugust of that year, however, the anti-set-off provision had been de-leted.320 In December 1970, a committee of the NAIC revisited thedebate, creating a subcommittee to consider elimination of reinsur-ance set-offs.3 2 The prevailing perception that surplus aid reinsur-ance was being abused and had become a serious problem providedimpetus for the reconsideration.322 After intense debate, both public

316. Melco System v. Receivers of Trans-Am. Ins. Co., 268 Ala. 152, 105 So. 2d 43(1958). The Melco decision is discussed in detail in Subsection G., supra.

317. Kimball, supra note 50, at 14.318. Id. at 15-16.319. Id. at 28-29.320. Assembly Bill 2194, as amended in Senate July 27, Briggs, Ca. Leg. Reg. Sess.,

1970 Assembly Final History; Assembly Bill 2194, as amended in Assembly August 14,Briggs, 1970 Ca. Leg. Reg. Sess., 1970 Assembly Final History. The issue was renewed inlegislation in 1972, but the particular bill was never put to a vote. Assembly Bill 1390, asintroduced March 15, 1972, Briggs, Ca. Leg. Reg. Sess., 1970 Assembly Final History; 5 J.ASSEMBLY OF CAL. 8695 (1972).

321. NAIC PROCEEDINGS 1971, 1:134; see also NAIC PROCEEDINGS 1971, 11:38, surpanote 53.

322. Kimball, supra note 50, at 28; NAIC PROCEEDINGS 1971, 11:377-403, supra note


and private, the matter was temporarily resolved in December 1972by the addition of a "ceded insurance report" to Schedule S of theannual report form that insurers are required to file with the variousstate departments of insurance.32 3 The issue was revived briefly in1983 when revision of the Utah insurance code was undertaken, 324

but this time the right of reinsurers to set-off was expresslypreserved.

3 25

In 1986, the NAIC again found itself hosting heated debatesover proposals to eliminate, or at least modify, the right to assert set-offs against reinsurance obligations owed to insolvent insurers andreinsurers. In September 1986, the Law/Legislation Study Group ofthe NAIC's Rehabilitators and Liquidators (Ex 4) Task Force("Task Force") reported that it was considering "the question of off-set for reinsurers. ' 326 In June 1987, an Offset Issues Working Group("Working Group") was established to review the applicability ofSection 30 (the predecessor of Section 29) of the Model Act (theset-off provision) "as it affects reinsurers. '

"327 In 1988, this chargewas delegated to a Reinsurance Setoff Study Group ("StudyGroup") 28 composed of industry representatives. A regulatory coun-terpart to the Study Group was created called the Regulatory Sub-group of the Offset Issues Working Group ("Regulatory Sub-group"), comprised of representatives from the insurancedepartments of various states. 29

The Working Group, the Study Group, and the RegulatorySubgroup met on numerous occasions. They drafted or considered atleast six separate proposed revisions of former Section 30. They alsocreated, distributed, collected, and tabulated the results of a ques-tionnaire designed to elicit the views of the various state insurancedepartments and industry segments on certain set-off issues. Addi-tionally, they produced written majority and minority reports, re-sponses to those reports, and replies to the responses. They also con-

53.323. Kimball, supra note 50, at 30 (citing NAIC PROCEEDINGS 1973, 11:265-70, supra

note 53).324. See REPORT OF THE STUDY GROUP ON REINSURANCE OFFSET, NAIC PROCEED-

INGS 1989, 1:476, 481 (citing FIRST DRAFT, section 96-45-56 (20(e))).325. Kimball, supra note 50, at 31 (citing Laws of 1985, ch. 242, § 32, enacting Utah

Ins. Code, UTAH CODE ANN. § 31A-27-323(2) (1986)).326. NAIC PROCEEDINGS 1987, 1: 474, supra note 53.327. REPORT OF THE WORKING GROUP ON REINSURANCE SETOFF, in NAIC PROCEED-

INGS 1989, I: 476, supra note 53.328. Id.329. California, Delaware, Illinois, Indiana, Iowa; Kentucky, Missouri, New Jersey,

New York, Ohio, Pennsylvania and Texas. NAIC PROCEEDINGS 1989, I1: 384, supra note 53.


ducted a workshop on the issue for regulators and their staff,3 30 atwhich a majority of the regulators in attendance agreed on proposedchanges to Section 30.1a1

In August 1988, the Study Group concluded its deliberations onreinsurance set-offs, and reported its findings in September of thatyear to the Task Force.382 The Study Group concluded that reinsur-ance set-offs were consistent with both English and American law, aswell as equitable and business principles. Nevertheless, the StudyGroup recommended certain clarifications of former Section 30, thatis, deleting all reference to counterclaims, adding language denyingset-offs when the obligation "was not in existence upon entry of anorder of liquidation," and adding language denying set-offs when theobligation sought to be set-off is "that of an insured to pay earnedpremium to the insurer" or that of a person to pay "to an insurersums held in a fiduciary capacity".3 3

A dissent to the Study Group Report was submitted, rejectingthe proposed clarifications, and arguing that Section 30 was not inaccordance with legal and equitable principles, thus leaving the lawon set-offs unsettled.3 3 4 One of the authors of the dissent, Henry Jer-nigan, also proffered changes to Section 30 that would limit set-offsto mutual debits and credits "arising from a single contract," pro-vide that no contractual provision that increases the debts to be set-off will be enforceable, and prohibit set-off of joint and severalobligations.11

5

In April 1989, the Regulatory Subgroup proposed its ownamendments to former Section 30.338 The Subgroup's amendmentswere the most comprehensive to date, including deletion of refer-ences to counterclaims, allowance of set-offs arising out of differentcontracts, and denial of set-offs between affiliates. The Subgroup alsoproposed that the receivers provide reinsurers with accountings ofoutstanding debts, and that only claims which a cedent had paid

330. See NAIC PROCEEDINGS 1989, I: 337-54; NAIC PROCEEDINGS 1989 1: 378-446,461-538; NAIC PROCEEDINGS 1988, 1I: 351-59, supra note 53.

331. NAIC PROCEEDINGS 1989, l1: 384, supra note 53. Numerous arguments have beenmade as to the business, financial, and economic consequences of restricting set-offs beyond thelimitations imposed by Section 29 (and its predecessor, Section 30) of the Model Act. A dis-cussion of those arguments is beyond the purview of this article. For a detailed discussion ofsuch arguments, see Semple & Hall, supra note 70, at 172; NAIC PROCEEDINGS 1989, 1:487-90, 495-512, 521-22, supra note 53.

332. NAIC PROCEEDINGS 1989, 1: 475, supra note 53.333. Id. at I: 384.334. Id. at 1: 513.335. Id. at I: 414.336. Id. at I: 345-46.


could be set off. 337 This proposal sparked intense debate andspawned numerous counterproposals, both from regulators and fromthe insurance industry. 338

For example, the Illinois Department of Insurance proffered aproposal that would have amended Section 30.A. to expressly allowset-offs between different contracts, amend Section 30.B.(1) to clar-ify the pre- and post-insolvency prohibitions, add a prohibitionagainst set-offs by affiliates, and limit set-offs to mutual debts andcredits "which are currently due and payable. 33 9 Under this propo-sal, if the party asserting the set-off determined that after set-off itowed the insolvent, then that party either could pay the net amountor delay payment of a portion of the net amount for future assertionas a set-off, provided it deposited that portion into an interest-bear-ing trust account for the insolvent's benefit.34 °

2. Priority Distribution Statutes and Public Policy.-ThePrudential and Midland decisions have intensified the debate overreinsurance set-offs. In both cases, industry representatives advo-cated a broad interpretation of statutory set-off provisions. Receiverscontended that permitting any broad rights of set-off is fundamen-tally inconsistent with the statutory schemes of priority distributionestablished in the Model Act34 and adopted in one form or anotherin the vast majority of states.34 2 Both appellate courts reached thesame results based on priority distribution statutes.3 43

Priority distribution statutes create and rank different classes ofcreditors in an insurance insolvency. Under these statutes, creditorsin a particular class may be paid only after the insolvent's assetshave been distributed pro rata to all other classes of creditors of ahigher priority and those creditors have been paid in full. One of the

337. Proposed deletions are in brackets; proposed additions are underlined.338. See, e.g., NAIC PROCEEDINGS 1989, I1: 346 (proposal of National Reinsurance

Corporation), 347 (proposal of Illinois), 351 (proposal of Henry Jernigan and his co-author ofthe "minority report," Christopher Maisel), and 357 (proposal of The Alliance of AmericanInsurers, The American Council of Life Insurance, The American Insurance Association, TheNational Association of Independent Insurers, and The Reinsurance Association of America("Joint Industry Proposal")), supra note 53.

339. NAIC PROCEEDINGS 1990, I1: 530, 533 supra note 53.340. Id.341. MODEL ACT, supra note 3, § 42.342. See, e.g., Illinois Insurance Code § 205, ILL. ANN. STAT. ch. 73, para. 817 (Smith-

Hurd Supp. 1991).343. Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.

App. 3d 293, 265 Cal. Rptr. 386 (1989), review granted, 268 Cal. Rptr. 542, 789 P.2d 342(1990) (Opinion in 216 Cal. App. 3d 1321 omitted. Reprinted without change in 227 Cal.App. 3d 293, to permit tracking pending review by the supreme court.); In re Liquidation ofMidland Ins. Co., Index No. 42550, slip op. (N.Y. App. Div. May 14, 1991).


central purposes of such priority distribution statutes is to favorclaims of primary policyholders over those of general creditors, in-cluding reinsureds. Some receivers take the position that allowanceof set-offs in an insurance insolvency strips policyholders of their fa-vored position under the priority statutes because set-offs enable theparty setting off, that is, reinsurers with lower priority than policy-holders, to recover 100% of their claims before the higher prioritypolicyholders can recover any portion of their unsecured claims.

The California Court of Appeals recently rejected the notionthat reinsurance set-offs may be permitted only after all parties withhigher priority under a statutory distribution scheme have been fullypaid. In Prudential Reinsurance Co. v. Superior Court,44 Pruden-tial sought to set off amounts owed by it to the insolvent MissionInsurance Group, Inc. ("Mission"), against amounts owed by Mis-sion to Prudential under reciprocal reinsurance contracts. 345 That is,Prudential sought to set off amounts owed by Prudential as a rein-surer of Mission against amounts owed by Mission as a reinsurer ofPrudential.

The California liquidator denied the asserted set-offs for tworeasons. First, the liquidator claimed that the language of Califor-nia's insurance insolvency statute made payment of set-offs contin-gent upon the financial ability of the insolvent company to pay in fullall claimants with a higher statutory priority than Prudential. 3"' Sec-ond, the liquidator contended that strong public policy considerationsfavoring payment of policyholders rendered set-offs improper underthe statute if such set-offs would result in diminution of payment toclaimants with a higher statutory priority than Prudential. 47

The trial court agreed with the liquidator's views on set-offs anddenied Prudential's set-off claims. 348 Prudential appealed and theCalifornia appellate court reversed. 49 The appellate court deter-mined that the priority distribution scheme of the California Insur-ance Code did not control the interpretation of the set-off provision

344. 216 Cal. App. 3d 1321, 277 Cal. App. 3d 293, 265 Cal. Rptr. 386 (1989), reviewgranted, 268 Cal. Rptr. 542, 789 P.2d 342 (1990) (Opinion in 216 Cal. App. 3d 1321 omitted.Reprinted without chnage in 227 Cal. App. 3d 293, to permit tracking pending review by thesupreme court.).

345. 227 Cal. App. 3d at 299-300, 265 Cal. Rptr. at 388.346. Id. at 312-13, 265 Cal. Rptr. at 397-98.347. Id. at 315, 265 Cal. Rptr. at 399.348. Id.349. Prudential Reinsurance Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.

App. 3d 293, 316, 265 Cal. Rptr. 386, 400 (1989), review granted, 268 Cal. Rptr. 542, 789P.2d 342 (1990) (Opinion in 216 Cal. App. 3d 1321 omitted. Reprinted in 227 Cal. App. 3d293, to permit tracking pending review by the supreme court.).


therein.350 Rejecting the liquidator's contention that set-off was im-permissible until all higher-priority claimants had been paid, thecourt reasoned that such a construction of the set-off provision wouldcreate an irreconcilable conflict in the Code.35 The court found theset-off provision to be "a classic statement of the doctrine of equita-ble set-off, universally recognized to require payment of only the set-off balance into an insolvency estate. '352

The court also rejected the liquidator's contention because sucha construction would render the set-off statute meaningless. As thecourt noted, "If the legislature had meant to gear set-off entitlementto the estate's financial capacity, we presume it would have worded[the set-off statute] to make that intention sufficiently clear. '3 3 Fur-thermore, the court found that when the set-off and priority provi-sions were adopted in 1935, the priority provision set forth only threeclasses of claimants, with primary policyholders and reinsurers shar-ing the same priority. The provision did not assign a higher class topolicyholders until 1979. 31' Thus, the legislature could not have in-tended the 1979 amendment to the priority provision to control inter-pretation of the 1935 enactment of the set-off provisions. Also, ob-serving that set-offs are not unlawful preferences, the court rejectedthe liquidator's contention that the set-off provision effected a"double preference" in favor of reinsurers over both policyholders ofa higher class and general creditors of the same class.3 55

In tandem with Prudential stands the Midland decision. InMidland,a56 the trial court relied on the dominant purpose of thestatutory liquidation scheme-pro rata distribution of the insolvent'sassets-to deny reinsurance set-offs. The court found that by with-holding payment of its reinsurance obligation, Kemper sought to ob-

350. 227 Cal. App. 3d at 313, 265 Cal. Rptr. at 398.351. Id.352. Id.353. Id.354. Prudential Reinsurance-Co. v. Superior Court, 216 Cal. App. 3d 1321, 227 Cal.

App. 3d 293, 314, 265 Cal. Rptr. 386, 398 (1989) (Opinion in 216 Cal. App. 3d 1321 omitted.Reprinted in 227 Cal. App. 3d 293, to permit tracking pending review by the supreme court.).

355. Id. The appellate court also found that permitting set-offs under cross reinsuranceagreements between Prudential and the insolvent did not offend public policy. The court didnot deem the interests of primary policyholders to be an overriding state policy interest suffi-cient to negate the application of set-offs. In reaching this result, the court noted that primaryinsureds have no interest in a contract of reinsurance, that the losses of primary insuredswould be covered under the statute by a guaranty association, and that the state itself wouldnot have to expend any funds for the policyholders'benefit as a result of the application of set-off rights. Id.



tain a greater share of reinsurance proceeds that should have beencontributed to Midland's assets for pro rata distribution to all ofMidland's claimants.857 This, the court said, "is in fundamental op-position to the express policy behind the liquidation statute and willnot be countenanced. '" 58 The court held that set-off effects a prefer-ence that cannot be tolerated under the New York statutory schemefor liquidating the estates of insolvent insurers. 5 9

Once again, the trial court's decision was reversed. 360 In fact,the appellate court quoted from the Seventh Circuit's decision inStamp v. Insurance Company of North America,36 1 agreeing thatreinsurer set-offs are in the interests of policyholders and the generalpublic.36

(a) Set-off of federal government claims.-Federal claims areanother type of claim in which the applicability of set-offs may de-pend upon a statutory priority of distribution scheme. In 1797, a fed-eral statute was enacted to govern the priority of the federal govern-ment's claims in insolvencies.6 3 Essentially unchanged today, thisstatute, known as the "Superpriority Statute," provides that:

(a)(1) A claim of the United States Government shall bepaid first when-

(A) a person indebted to the Government is insol-vent; and-

(i) the debtor without enough property to pay alldebts makes a voluntary assignment of property;

(ii) property of the debtor, if absent, is attached; or(iii) an act of bankruptcy is committed; or(B) the estate of a deceased debtor, in the custody

of the executor or administrator, is not enough to pay

357. In re Liquidation of Midland Ins. Co., Index No. 41294/86, slip op. 5-6 (N.Y. Sup.Ct. Jan. 31, 1990).

358. Id., slip op. at 5. Accord Corcoran v. Universal Reins. Corp., Index No. 40924/86,slip op. (N.Y. Sup. Ct. Dec. 1990). In view of the fact that the trial court's decision in Mid-land was reversed, it is doubtful that Corcoran has any validity.

359. Id., slip op. at 5-6. Some courts that have considered the issue have held that set-off does not effect a preference because only the balance owed the estate after assertion of theset-off is an asset of the estate. See, e.g., Korlann v. E-Z Pay Plan, Inc., 247 Or. 170, 428P.2d 172 (1967). Others have held simply that the equity of equality among creditors is eitherfound inapplicable to set-off or yields to their superior equity. See, e.g., Scott v. Armstrong,146 U.S. 499 (1892).


361. 908 F.2d 1375, 1380 (7th Cir. 1990).362. In re Midland Ins., slip op. at 10-11.363. 31 U.S.C. § 3713 (1988).


all debts of the debtor.364

This statute enables the federal government to be paid on its claimsbefore any other claimants or creditors; thus the federal governmenthas a "superpriority" claim in an insolvency proceeding. The penaltyfor ignoring the statute is high: "A representative of a person or anestate . . . paying any part of a debt of the person or estate beforepaying a claim of the Government is [personally] liable to the extentof the payment for unpaid claims of the Government. ' ' a6 5

Currently, there is great controversy as to whether the Superpri-ority Statute applies to insurance insolvencies. Some commentatorsargue that the exclusion of the business of insurance from federalregulation 66 precludes application of the Superpriority Statute instate insurance insolvency proceedings. Others argue that the statuteis applicable, as insolvency proceedings do not fall within the "busi-ness of insurance" excluded from federal regulation.3 67

This debate gives rise to an interesting question: are federalclaims asserted in state insurance insolvency proceedings pursuant tothe Superpriority Statute subject to rights of set-off? The Superpri-ority Statute is silent on the issue. As previously discussed, the exis-tence of a prioritized distribution statute does not automatically ne-gate the application of statutory set-off provisions before payment ofpriority claims. Thus, it would appear (at least under Prudential)that statutory set-offs could be applied before payment of govern-ment claims. In fact, at least one court has taken such a position.3 68

Another question arises regarding federal claims: can an insol-

364. 31 U.S.C. §§ 3713(a)(l)(A)(i), (iii), (B).365. 31 U.S.C. § 3713(b).366. Under the McCarran-Ferguson Act, 15 U.S.C. §§ 1011-15 (1988), the regulation

of the "business of insurance" is made exclusively a matter of the state, not federal law: "NoAct of Congress shall be construed to invalidate, impair or supersede any law enacted by anystate for the purpose of regulating the business of insurance . . ." 15 U.S.C. § 1-12(b).

367. Two courts have held that state insurance liquidation proceedings are not the "bus-iness of insurance" and thus are not exempt under the McCarran-Ferguson Act. See Gordon v.United States Dept. of Treasury, 846 F.2d 272 (4th Cir. 1988); State of Idaho ex. rel. Sowardv. United States, 858 F.2d 445 (9th Cir. 1988). At least one court has suggested, however,that the Superpriority Statute has no application in state insolvency proceedings. Grode v.Mutual Fire, Marine & Inland Co., 1990 WL 12253 at 9 (Pa: Commw. Ct. Jan. 23, 1990)("McCarran Ferguson would appear to preclude the application of the Federal Priority Act"to state insurance insolvency proceedings). For a general discussion of the issue, see Howard,Uncle Sam Versus the Insurance Commissioners: A Multi-Level Approach to Defining the"Business of Insurance" Under the McCarran-Ferguson Act, 25 WILI.AMETTE L. REV. I(1989); Kennedy, The McCarran Act: A Limited "Business of Insurance" Exemption MadeEven Narrower - Three Decisions, 18 FORUM 528 (1983).

368. See United States v. Winnett, 165 F.2d 149 (9th Cir. 1947) (federal governmententitled to enforce tax lien against insolvent only as to the unpaid balance on a note after theapplication of set-offs under state law).


vent company take a set-off against government claims? The ques-tion would appear to be controlled by application of the two-partrequirement for setoffs: mutuality of capacity and mutuality of time.Thus, set-offs might be denied on mutuality of capacity grounds ifthe state receiver is deemed to be holding insolvency funds in trustfor the federal government.3 69 Complicating the analysis is the exis-tence of the federal supremacy clause, dictating that the laws of thefederal government are supreme to those of state government regu-lating the same subject. It could be argued that the SuperpriorityStatute overrides state set-off statutes to the extent they are deemedto conflict. Unfortunately, it does not appear that this issue will beresolved short of litigation.

III. Conclusion

The first legislature in the United States to enact a set-off guar-antee was motivated, at least in part, by a desire to curtail the multi-plicity of actions. Little has changed in the last 350 years. If any-thing, the desire to decrease the amount of litigation in the UnitedStates has grown substantially. In response, the law has adopted pro-cedures designed to curtail the circuity of actions, namely, recoup-ment, set-off, and counterclaim. The distinctions between these con-cepts have blurred over the years in the eyes of courts, legislatures,and receivers of insolvent insurance companies struggling to achievea fair and equitable distribution of benefits and burdens through anincreasingly complicated and inconsistent morass of common law,legislative, and administrative procedures and remedies.

Established rules of set-off are now teetering on the brink ofchange. Regulators, receivers, and legislative committees are chal-lenging the policies underlying set-offs heretofore regarded as funda-mental. In this time of rapidly increasing numbers of insolvencies,the notion that insolvency alone is a sufficient justification for set-offis being re-evaluated in light of another basic rule of insolvency law:pro rata distribution of an insolvent's assets. It is time to resolve thisand other set-off issues on a uniform basis, at least in the context ofinsurance insolvency.

Section 29 of the Model Act mirrors the ongoing debates overset-offs. Thanks to recent amendments, it now expresses the majorityview that reinsurer set-offs between separate contracts are permissi-ble, but then temporally limits such set-offs to paid claims by rein-

369. See, e.g., Lewis v. United States, 92 U.S. 618 (1875); United States v. Duncan, 25F. Cas. 927 (7th Cir. 1850) (No. 15,003).


sureds and mature, liquidated claims of reinsurers. Whether the va-rious state legislatures will adopt such amendments remains to beseen. The combatants in the battle over set-offs have not been con-tent to wage war within the confines of their respective legislativeand trade organizations, but have carried their causes to the courts,as evidenced by the recent O'Connor, Prudential, and Midland deci-sions. The next field of battle undoubtedly will be the state legisla-tures. Whatever the end result of the current controversy, two thingsare clear: the doctrine of set-off in U.S. insurance insolvencies is farfrom settled, and further changes in the current law governing theapplication of set-offs will not be the result of compromise.

The business of insurance is a global enterprise whose problemsdemand global solutions. The many conflicting and inconsistent com-mon law, statutory, and regulatory provisions applicable to set-offs inthe context of insurance insolvencies evince the need for reform. Un-less receivers and industry work together to achieve needed change,these problems will only be exacerbated, hindering the growth andeconomic efficiency of the world's insurance markets.


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Documents

Onset of An Offset Revolution: The Application of Set-Offs