Insurance Premium Financing in Bankruptcy Cases
Notwithstanding the utility of insurance premium financing, many insolvency professionals do not completely appreciate insurance premium financing and, more importantly, its secured structure. As a consequence, insurance premium finance companies often face challenges to their security interest by bankruptcy trustees and creditors alike. This article discusses insurance premium financing in its terms and also in terms of how the transaction can be used in bankruptcy cases.
Premium Financing, Generally
Insurance premium financing is used to purchase insurance coverage by borrowing a portion of the insurance premium. In a typical insurance premium financing transaction, the insured makes a down payment which, together with a secured loan funded by a premium finance company, is used to pay the premium due under an insurance policy. To memorialize the transaction, the insured executes an insurance premium financing agreement pursuant to which it becomes obligated to, among other things, repay the loan and finance charges in amortized monthly installments to the finance company.
As collateral security for the secured loan, the insured assigns all right, title and interest it has in the financed policy including, among other things, all "unearned" or "return" premium of the insurance policy (collectively, the "unearned premium") to the finance company.2 Despite paying all insurance premium(s) at inception of coverage, however, the premium is actually "earned" by the insurer over the policy term. State insurance law and the provisions of the relevant insurance policy generally govern how a premium is earned over the term of the policy.
Typically, during the policy term there is a balance of unearned premium that the insurer is obligated to return to the insured in the event the policy is cancelled. This balance declines daily during the policy term. Thus, on the first day of coverage in most property and casualty insurance policies, 100 percent of the premium is "unearned."3 The last portion of premium is eventually "earned" on the final day of coverage. It is this balance of unearned premium to which the finance company security interest attaches.
Most insurance premium finance agreements generally appoint the finance company as attorney-in-fact with the right to (1) cancel the financed policy after notice, (2) collect all return or unearned premium from the carrier and (3) apply all unearned premiums to the debt if the insured/borrower fails to make the required payments to the finance company. To cancel coverage, the finance company sends a notice of a default and its intent to cancel the policy to the insured and the insurance broker. After the expiration of a notice period, the length of which is generally determined by state statute, the finance company may cancel the insurance policy by sending a notice of cancellation to the insurer. Coverage is then cancelled as though the insured had requested such cancellation. If the default is cured after cancellation, the finance company may request reinstatement of coverage. However, there is no obligation on the part of the finance company to do so. There is also no guarantee or requirement that the insurer reinstate the policy upon request of the finance company. Once the policy is cancelled, the finance company contacts the insurer to arrange for the return of the unearned premium.
Security Interest in Unearned Premium: No UCC Filing Needed
The cornerstone of the insurance premium finance business is the finance company's security interest in unearned premium. To protect this security interest, an overwhelming majority of states4 have codified a finance company's security interest in unearned premium by enacting a premium financing statute, which generally provides that:
[N]o filing of the assignment or notice thereof to the insured shall be necessary to the validity of the written assignment of a premium finance agreement as against creditors or subsequent purchasers, pledgees or encumbrances of the assignor.5
There is also overwhelming case law to support the validity and enforceability of a finance company's security interest in unearned premiums. The courts have stated that the primary purpose of these premium financing statutes is to protect a finance company's "ability to recover funds it advances to purchase insurance." In re Braniff International Airlines Inc., 101 F.3d 686 (2nd Cir. 1996). Provided that the finance company complies with the respective state statute, courts have consistently held that a finance company's security interest in unearned premiums is automatically perfected upon entering into financing agreements.6
A finance company's security interest in unearned premium is further strengthened by case law holding that Article 9 of the Uniform Commercial Code (UCC) is inapplicable to a security interest in unearned premium. Thus, no UCC or other type of filing is necessary to protect a finance company's collateral.7
Accordingly, provided that the finance company complies with applicable premium finance law and based on the inapplicability of the UCC to the transaction, the senior perfected lien of a finance company in unearned premium should be beyond reproach.
Section 552(a): New Approach, Same Result
Notwithstanding statutory and case law support, a finance company's security interest on unearned premiums still come under attack in bankruptcy cases. While such attacks usually focus on the underlying validity of the security interest, recent challenges have relied on §552(a) of the Bankruptcy Code.8 It is argued that because unearned premium is not "returned" until after a bankruptcy filing, the finance company's security interest does not "spring" to life or become "secured" until after the bankruptcy filing and that §552(a) of the Code trumps the finance company's lien because unearned or return premium is not returned until after the bankruptcy filing. Notwithstanding the "creativity" of this argument, it ultimately fails.
The reason it fails is because the vesting of a finance company's right to unearned or return premium arises at the time the respective insurance policies are financed. See In re U.S. Repeating Arms. Co., 678 B.R. 990, 996 (Bankr. D. Conn. 1986). A finance company's right to receive and apply unearned premium is not dependent upon subsequent cancellation of the respective insurance policy. Cancellation of the insurance policy merely triggers the obligation to return the unearned or return premium to the finance company. See Id. A finance company has an extant pre-petition property right and perfected security interest in unearned or return premiums. See Id. Moreover, §552(a) does not apply because the unearned premium(s) are not "proceeds" or "after-acquired property," but constitute property that in fact existed as of the effective date of the subject insurance policy.
As the bankruptcy court stated in In re U.S. Repeating Arms. Co., 678 B.R. at 996:
Implicit in [the relationship] is an assumption that the insured party is vested with the right to cancel the policies and receive the unearned premiums at the time the policies are funded by the financer. Thus, the unearned premiums come into existence when the policy is funded, not when the policies are cancelled. At the first moment the policy takes effect, the entire premium is unearned. On each date thereafter, the unearned portion of the premium is reduced and the earned portion is proportionately increased, so that on any given date the unearned premium may be computed (citing RBS Industries at 951).
As this court concluded in In re RBS Industries Inc., unearned premiums are not after-acquired property. Cancellation is merely a procedural device through which the parties intend to provide the finance company with recourse to the collateral securing its loan; it does not operate to create the collateral.9
As such, all that is required to vest a finance company with a security interest in unearned premium is an effective assignment of the insured's right to the unearned premium—nothing more. Section 552(a), standing alone, does not affect the validity of a finance company's security interest in unearned premium.
By utilizing insurance premium financing, a DIP is able to preserve cash flow and purchase desired limits of coverage without cutting corners for dollar considerations. Clearly, the benefits of increased liquidity without pledging additional collateral remain an attractive financing option for a DIP. In addition, and perhaps more importantly, the benefits of insurance premium financing are buttressed by state statutes and case law that protect finance companies from trustees and creditors looking to derail this financing method by attacking the senior perfected lien held by a finance company.
2 Typically, a finance company will also take a security interest in (a) all money that is or may be due the insured because of a loss under the respective policy that reduces the unearned premium (subject to the interest of any applicable mortgage or loss payee) and (b) dividends that may become due the insured in connection with the policy. The term "unearned premium" used throughout this article refers to this collective security interest. Return to article
3 While most property and casualty policies earn premiums throughout the policy period, some policies may earn a minimum amount of premium at policy inception. In addition, certain policies may be subject to audit or retrospective rating by an insurer. As such, the actual amount of premium that is owed may be much larger or smaller than originally funded at the beginning of the policy. Thus, if the insured cancels the policy, the insurer may apply any unearned premium to be returned to the finance company to any "additional premium," thereby potentially reducing the value of the unearned premium. Return to article
4 Currently, 47 states plus the U.S. Virgin Islands have enacted statutes governing premium financing transactions. While the statutes vary, they commonly regulate (1) the contents of the premium finance agreements, (2) notification procedures to be followed by the premium financing companies in canceling coverage pursuant to the power of attorney and (3) procedural requirements for returning unearned premiums upon default. Return to article
6 See In re Braniff International Airlines Inc., 164 B.R. at 831 (applying New York law); In re Universal Motor Express Inc., 72 B.R. 208, 210 (Bankr. W.D.N.C. 1987) (applying North Carolina law); In re RBS Industries, 67 B.R. 946, 949 (Bankr. D. Conn. 1986) (applying New York law); In re U.S. Repeating Arms. Co., 678 B.R. 990, 996 (Bankr. D. Conn. 1986) (applying Maryland law); In re Air Vermont Inc., 40 B.R. 335, 337 (Bankr. D. Vt. 1984) (applying Massachusetts law); Premium Financing Specialists Inc. v. Lindsey, 11 B.R. 135, 138 (Bankr. E.D. Ark. 1981) (applying Arkansas law); In re Mapleweed Poultry Co., 2 B.R. 550, 554-55 (Bankr. D. Me. 1980) (applying New Jersey law); In re Krimble Trucking Co. Inc., 3 B.R. 4, 6 (Bankr. W.D. Wash. 1979) (applying Washington law); In re Redfeather Fast Freight Inc., 1 B.R. 446, 450 (Bankr. D. Neb. 1979) (applying New York and Nevada law). As the Redfeather court observed, a security interest in unearned or return premiums is created when the premium finance company makes payment of the premium(s) due, and in return, through an assignment effective under state law, receives the right to any unearned premiums following the default of the insured. See Matter of Redfeather Fast Freight Inc., 1 B.R. at 450. Return to article
7 See In re Remcor Inc., 186 B.R. 629 (Bankr. W.D. Pa. 1995) (holding that Article 9 of the UCC does not apply to the transfer of an interest in any policy of insurance—including unearned premium); In re Duke Roofing Co. Inc., 47 B.R. 990 (E.D. Mich. 1985) (finding that Article 9 of the UCC does not apply to claims "in or under any policy of insurance"); In re Megamarket of Lexington Inc., 207 B.R. 527 (Bankr. E.D. Ky. 1997) (stating that excluding unearned premiums from Article 9 of the UCC makes sense because filing a financing statement to put interested parties on notice of the premium finance lender's security interest would not be as effective as notifying the insurer, which is what the premium finance lender forwards to the carrier upon execution by the debtor of the premium finance agreement and accompanying power of attorney); Premium Financing Specialists Inc. v. Lindsey, 11 B.R. 135 (E.D. Ark. 1981) (finding that "the breadth of the exclusion in §9-104(g) itself and the comments of its draftsmen convince the court that Article 9 of the UCC does not apply to a secured transaction in which the collateral consists of unearned insurance premiums"). Return to article
8 Section 552 of the Code provides, in pertinent part:
(a) Except as provided in subsection (b) of this section, property acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.
(b) (1) Except as provided in §§363, 506(c), 522, 544, 545, 547 and 548 of this title, if the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, product, offspring or profits of such property, then such security interest extends to such proceeds, product, offspring or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable non-bankruptcy law, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise. Return to article