In buying back, what did I buy?

Over the last decade, I have participated in the drafting of dozens of settlement agreements between carriers and insureds commonly called “buybacks of insurance” or simply “buybacks.” These settlements usually take place where there are a number of claims for which coverage is either questionable or there are significant questions of allocation, future exposures or other problematic concerns. Usually, the carrier pays the insured a negotiated sum of money and the insured releases all of its rights to the policy, essentially “selling” the policy back to the carrier. The carrier obtains finality as to the account. The insured obtains immediate funds for a policy that may have limited or speculative value.

Seems like a good arrangement all around, right? In most situations it is, and all parties to the transaction benefit. But there are some limitations to this type of settlement that can create confusion or even lead to the settlement’s validity being questioned. Let’s look at these concerns.

What is a buyback?

The initial problem is one of identification. Simply, what are the aspects of a settlement that make it a “buyback” rather than a limited release or cancellation? Like many terms used by coverage lawyers (e.g., “trigger of coverage” or “collapsing coverage block”), the term “buyback” is used in a variety of contexts that, unless you are involved with these settlements frequently, may be confusing. Not all settlements with broad release language are “buybacks.” For instance, an agreement to cancel a policy as of a certain date that does not effect a release of all the insured’s rights under the policy, is not a buyback. The defining element is the completeness of the transfer of the policyholder’s rights under the policy.

“Buybacks” as I am using the term and as it is commonly used in settlement settings refers to a complete policy release or mutual rescission that extinguishes all of the settling policyholder’s rights to the policy as if it no longer exists. The term “buyback” refers to the nature of the policyholder’s act — selling back the policy — that acts as consideration for the settlement. The actual term “buyback,” though used in negotiations to describe the deal, is seldom used in the body of the settlement agreement. Usually, the “buyback” language is outlined in the release language of the settlement. A buyback does not require any magic language to be effective; the “buyback” is the effect of the release language transferring all rights under the policy.

A key aspect of a buyback, in contrast to a cancellation or more limited release, is that the release not only applies to any known claims, but also to any past or future obligations or policyholder rights under the policy. Courts reviewing these settlements usually describe and evaluate buyback agreements in terms of “mutual rescission.” Mutual rescission means that both parties to a contract agree to ending it completely with no lingering obligations. In the buyback context, that translates to the insurer and insured terminating the policy completely, with the insured relinquishing all rights and ownership it has to the policy to the carrier. This approach underscores the prospective nature of the settlement, making it clear that the release is not simply of existing claims, but is extinguishing the contract between the parties by a mutual agreement to end the contract. See Texas Gas Utilities Co. v. Barrett, 460 S.W. 2d 409 (Tex. 1970).

The complication

Buybacks have become more common because insureds have come to see them as a tool to maximize the value of a policy. In the general liability context, buybacks are often done when the actual term of the policy has expired, so that only long tail risks may remain. The carrier values the buyback based on what may happen in the future as well as on any claims currently identified.

These agreements are usually unassailable because both parties to the original policy are in agreement. An insurance policy is simply a type of contract, subject to the rules governing other types of contracts. Commonly, in buybacks the insurer and insured enter into the agreement, the policy is sold back or extinguished, and that is the end of the matter. That result is wholly consistent with the general law of contract.

However, there are exceptions that place significant limits on the availability of policy buyback arrangements. The most common limitation applies where the insured is mandated by law to retain insurance. In that case, buybacks or any settlements that extinguish the insurance are not an option.

For instance, in Texas, the business of crop-dusting requires proof of financial responsibility through liability insurance. In one case, a carrier and a crop-dusting insured entered into a buyback settlement that left the insured in violation of the statute requiring insurance. A Texas appellate court found that the buyback was inappropriate and invalidated it because it contravened the statutory requirement. Ranger Ins. Co. v. Ward, 107 S.W.2d 820 (Texarkana 2003, pet. denied). Even so, few buyback agreements are ever challenged on this basis because the areas of compulsory insurance are limited and fairly well known.

Another concern is who is affected by the settlement. If the named insured sells back its rights, does it affect any other named insured’s rights under the policy who is not a party to the settlement? Does it limit the rights of unnamed additional insureds? While most agree that it does not limit the rights of named insureds who are not parties to the settlement, many commentators argue that non-named insureds may be subject to the agreement. The safer course is to assume that non-parties to the settlement may be unaffected by it and retain any relevant, vested contractual rights.

Notably, the main concern raised regarding buyback agreements is not raised by insureds. Indeed, the insured is often the strongest proponent for a buyback since they can get actual value for a policy that may have no value to them presently or in the future. For instance, buybacks are often negotiated between insurers and insureds where there is little likelihood that there is coverage with respect to an existing claim, but the insurance company is willing to pay some amount in order to prevent any potential liability on claims in the future. The insured, who needs the money now to respond to a current claim, may “cash out” the policy by selling it back to the carrier. Both parties to the contract, the carrier that issued the policy and the insured who bought it, receive a benefit from the transaction.

Okay, so who’s complaining?

In the liability policy context, it is the underlying claimant or plaintiff who may complain. The claimant may argue that it is the intended beneficiary of the policy and that a settlement between the carrier and the insured is an attempt to strip them of contingent rights.

In Texas, this should not be much of an issue. Texas law does not recognize any right or interest of a third party in a liability insurance policy until it has obtained a judgment against the insured. Allstate Ins. Co. v. Watson, 876 S.W.2d 145 (Tex. 1994). Thus, nothing should prevent the two parties to the insurance contract, barring some statutory requirement, from mutually rescinding their contract. Indeed, barring a judgment, courts have uniformly rejected the third party beneficiary argument. Cowley v. Texas Snubbing Control Inc., 812 F. Supp. 1437 (S.D. Miss. 1992) (applying Texas law).

As noted by the learned and ubiquitous Michael Quinn, the argument that a policy is created intending to benefit third parties is not definite enough to create rights for any specific claimant barring a judgment. The policy is created intending a potential benefit to some member of a class without intending benefit to any particular person. So, until that interest is fully vested, such as with a judgment, there is no intended benefit to any specific claimant or plaintiff.

Look before buying

Buybacks are a valuable settlement option for insureds and insurers. But before exercising that option, carefully analyze your factual situation so that you limit any confusion with your agreement by other potential insureds or claimants. Done correctly, buybacks will be effective and bullet proof.