PRUDENTIAL REINSURANCE COMPANY v. Roxani V. Gillespie, as Insurance Commissioner, etc, Real Party in Interest. (1989)

This petition for writ of mandate seeks review of an order granting a summary adjudication motion of the Insurance Commissioner in an action, brought in her capacity as liquidator of a group of insolvent insurance companies, to compel reinsurers to pay into the liquidation estate all reinsurance debts due to the insolvents without any set-off credits.

The subject order determines that reinsurers of the insolvents in liquidation have no entitlement under Insurance Code section 1031 ¹ to set off reinsurance debts, owed to them by the insurers in liquidation, against the debts they owe to the insolvent insurers under “cross-reinsurance” contracts executed prior to insolvency.

Two issues, each of first impression in this state, must be resolved to determine the reinsurers' entitlement to set-offs.   First, whether the reinsurance debts and credits generated between petitioner reinsurers and the insolvent insurers, under their reciprocal reinsurance contracts, are “mutual” as required by section 1031 of the Insurance Code.   Second, whether the section 1031, subdivision (a) exception to set-off entitlement requires that set-off claimants merely have a provable claim giving them a legally recoverable claim or, rather, allows set-off claims only if the estate has sufficient assets to satisfy fully all claimants in higher priority classes than the claimant.

We conclude that the reciprocal reinsurance contracts involved created “mutual credits and debts” under section 1031 as between petitioner Prudential Reinsurance Company and Mission Insurance Company and Mission National Insurance Company only.   We also conclude that subdivision (a) of section 1031 permits set-offs when the claimant shows legal entitlement to status as a creditor of the insolvent insurer and does not make set-offs contingent upon the ultimate financial ability of the estate to first pay all claimants in higher priority classes.   Finally, we conclude that the strong public policy considerations favoring payment of insureds under primary policies may not override the unequivocal language of the controlling statute or cause that language to be unreasonably construed to achieve that policy goal.

The facts giving rise to the underlying motion are relatively simple.

On February 2, 1987, the Commissioner obtained an order pursuant to section 1011 placing Mission Insurance Company and its affiliated insurance companies in conservatorship due to insolvency.   These companies (e.g., Mission Insurance Company, Mission National Insurance Company, Enterprise Insurance Company, Mission Reinsurance Corporation, and Holland America Insurance Company) are subsidiaries of the Mission Insurance Group, Inc.   For convenience, hereafter these various insolvent insurers will be referred to in the aggregate as “the Mission companies.”

On February 24, 1987, a section 1016 liquidation order issued, appointing the Commissioner as liquidator of the Mission companies.

In the liquidation proceedings the Commissioner demanded that companies thathad issued reinsurance to the Mission companies pay to her the full amount of reinsurance proceeds due.   The reinsurers refused to do so, claiming set-offs pursuant to section 1031 for reinsurance debts owed under policies issued to them by the Mission companies.   The Commissioner commenced the underlying action to compel payment without set-offs.

Petitioner, Prudential Reinsurance Company, is one of approximately 144 reinsurer defendants in the underlying action who claim section 1031 off-set rights against the liquidation estate.

The subject reinsurance contracts (“treaties”) and facultative contracts, as well as the parties' statements of undisputed facts submitted below, show that Prudential Reinsurance is the reinsurer under 14 reinsurance treaties issued to member companies of the Mission Insurance Group, Inc.  (These treaties are referred to by the parties as the “Relation ‘A’ Contracts.”)   The respective “Relation ‘A’ Contracts” reinsure either all or some of the Mission companies.   Two of the “Relation ‘A’ Contracts” do not reinsure Mission Insurance Company.

The “Relation ‘B’ Contracts” all reinsure both Prudential Reinsurance and its subsidiary, Gibraltar, as principals.   Mission Insurance Company is the reinsurer under all but one of these contracts;  Mission National Insurance Company is the reinsurer under the remaining contract.

The set-off clauses in the “Relation ‘A’ Contracts” provide in substance that Mission Insurance Company and other named Mission companies (as reinsureds) and Prudential Reinsurance (as reinsurer) agree that the parties thereto may offset any and all reinsurance debts owed by or to them “under the same or any other reinsurance agreement between them.”   Some of the clauses acknowledge that in the event of insolvency of a party thereto, set-off rights are controlled by Insurance Code section 1031.

Some of the “Relation ‘B’ Contracts” contain this same broad set-off clause while others do not.

It appears that most of petitioner's set-off claims are based on losses it paid under its primary policies that were reinsured by the Mission companies under the “Relation B” contracts and upon unpaid reinsurance premiums due from the Mission companies as ceding insurers under the “Relation A” contracts.

Respondent's denial of set-off rights was founded upon two primary grounds.   First, that the language of subdivision (a) of section 1031 makes set-offs contingent upon the ultimate financial ability of the liquidation estate to pay in full all claimants in higher section 1033 priority classes than the set-off claimant.²  Second, that the section 1031 mutual-debt criterion is geared to the priority classes in section 1033.   Thus, a set-off is not permitted if it would result in diminution of payment to claimants against the estate who are in a higher-priority section 1033 class than the set-off claimant.

We issued the alternative writ because of the importance of the issues presented and because we disagree with the stated grounds for the underlying ruling.

I. MUTUALITY OF REINSURANCE DEBTS

The two primary issues to be resolved here arise from a dispute as to the proper construction of the language of the controlling statute, Insurance Code section 1031.   The statute provides, in pertinent part, as follows:

“In all cases of mutual debts or mutual credits between the person in liquidation under Section 1016 and any other person, such credits and debts shall be set off and the balance only shall be allowed or paid, but no set-off shall be allowed in favor of such other person where any of the following facts exist:

“(a) The obligation of the person in liquidation to such other person does not entitle such other person claiming such set-off to share as a claimant in the assets of such person in liquidation.”

The section 1031 criterion that debts and credits be “mutual” is derived from and coterminous with the equitable doctrine of set-off.

The right of set-off requires that the subject debts and credits be mutual in three respects.   First, mutuality of identities requires that debts must be owed between the same persons or entities.   Second, these persons must owe and be owed the debts in the same legal capacities;  debts owed to a person in his individual capacity may offset only debts owed by him in that capacity and not by debts owed by him in a fiduciary, agency, trustee or partnership capacity.   Third, the debts must be owed contemporaneously.  (Harrison v. Adams (1942) 20 Cal.2d 646, 650, 128 P.2d 9;  Garrison v. Edward Brown & Sons (1944) 25 Cal.2d 473, 477, 154 P.2d 377;  Garrison v. Edward Brown & Sons (1946) 28 Cal.2d 28, 31, 36, 168 P.2d 153;  Carnation Co. v. Olivet Egg Ranch (1986) 189 Cal.App.3d 809, 819–821, 229 Cal.Rptr. 261.)

In the underlying action all three aspects of mutuality are disputed.   We will first address the issue of temporal mutuality.

A. Temporal Mutuality of Debts

 No California decision has been found which determines on its facts whether reciprocal reinsurance debts between an insolvent insurer and cross-reinsuring insurers are owed contemporaneously, i.e., prior to issuance of the liquidation order.

The Commissioner contends that the respective reinsurance debts were not owed at the same time because the debts owed by the claimant reinsurers to the insolvents are post-liquidation debts while those owed to them by the insolvents are preliquidation debts.   Her reasoning is that the reinsuring claimants' debts to the liquidation estate for reinsurance proceeds do not accrue until after the liquidator approves the underlying primary policyholders' loss claims against the insolvent.   She also reasons that return of unearned premiums on those reinsurance contracts did not become due until the liquidation order issued.

Prudential Reinsurance contends that all debts for reinsurance proceeds and unpaid premiums exist prior to liquidation because they arise from the provisions of the reciprocal reinsurance contracts existing before liquidation.

(i). California and Federal Case Law

Early federal and California decisions establish that debts and credits of an insolvent insurer are deemed mutual debts subject to set-off even if the obligations would otherwise mature or be payable only after closing of the insolvency estate.

Carr v. Hamilton (1889) 129 U.S. 252, 9 S.Ct. 295, 32 L.Ed. 669, holds that, upon the insolvency of the insurer, proceeds due an insured under an insurance endowment policy must be offset against the insured's independent mortgage debt to the insurer.  Carr explicitly applies to the insurance liquidation context the principle established in federal bankruptcy law that, upon insolvency, debts between persons and the insolvent may be set off irrespective of whether they were otherwise due at a later date.   The rationale is that liquidation orders terminate all business of the insolvent insurer and require that all its accounts be wound up.   Any contractual creditor of the insurer in liquidation should be permitted an equitable set-off based on mutual debts created by contract before insolvency occurred.  (Id., at p. 256, 9 S.Ct. at p. 296.)

In Scammon v. Kimball, Assignee (1876) 92 U.S. 362, 23 L.Ed. 483, it was held that a bank was entitled to set off funds its insurer had on deposit against the insurer's debt to the bank under an insurance policy for property damage, although the insurance proceeds were not otherwise payable at the time of the insolvency.

In Scott v. Armstrong (1892) 146 U.S. 499, 508–509, 13 S.Ct. 148, 150–151, 36 L.Ed. 1059, it was held that one bank indebted to another upon a note was entitled, upon the insolvency of the other, to set off its deposit account in the insolvent bank against the note, although the debt on the note would not mature until a future date.

In Ainsworth v. Bank of California (1897) 119 Cal. 470, 474–476, 51 P. 952, it was held, in the analogous context of a decedent's estate, that otherwise mutual debts between a deceased and a bank may be set-off against the executor irrespective of the fact that one is due before death and the other was due after that date.   The Supreme Court determined that such debts are mutual as to time for purposes of set-off, as long as they are capable of assertion as a debt during administration of the estate.   Such debts become postmortum debts due to the personal representative only in the sense that the representative succeeds to ownership of the debt as an asset, subject to all rights and set-offs to which the deceased was subject before death.

In Downey v. Humphreys (1951) 102 Cal.App.2d 323, 227 P.2d 484, an independent insurance agent wrote an insurer's policies under an express contract that the agent was responsible in his individual capacity for paying the policy premiums, irrespective of whether he collected the premiums from the insureds.   An insolvency receivership order was issued against the insurer (Ins.Code, § 1011), whereupon the agent ceased payments of premiums to the insurer on new policies and used those funds to place those insureds with other insurers.   The agent also retained funds due him as earned commissions up to the date of the insured's insolvency.   Two months after the insolvency order, a liquidation order (Ins.Code, § 1016) issued.   The liquidator demanded that the agent pay to him all premium amounts for the newly written policies, less earned commissions which were routinely set off.   The agent claimed the right to set off his entire debt under section 1031 on the basis that the initial policy premiums otherwise due the insurer became unearned when the insolvency order effected a breach of those policies by the insurer.   The liquidator contended that any debt owed to the insurer for unearned premiums was a post-liquidation debt not subject to offset against the agent's pre-liquidation debt for premiums.   The liquidator filed an action to compel full payment without offset.

Downey first determined that the debts were mutually owed to and by the agent in his individual capacity.   As to the issue of temporal mutuality of the debts, the Downey court reasoned that as of the date of insolvency the premiums due became unearned because the insurer's insolvency breached the insurance contracts.   Thus, “[o]n April 19, 1933, defendant had a legal right to set off unearned premiums against the amount he owed [to the insurer].  The fact that a receiver of [the insurer] had been appointed did not affect that right․  Neither the receiver nor the liquidator had any better right than [the insurer], upon its adjudication as insolvent, to the unearned premiums, and [the insurer] had none.”  (Id., at p. 337, 227 P.2d 484.)

These cases establish a rule that mutual debts created by contract between an insolvent and another are subject to set-off upon insolvency even if they mature by virtue of the event of insolvency.   No California decision has heretofore applied this principle to reinsurance set-off claims similar to those in the underlying action.

(ii). Decisions in Other States

Absent a squarely controlling California decision, decisions from other states may be examined for persuasive analysis of the issue.

In Illinois the precise issue raised in this mandate proceeding has been determined in favor of set-off under a statute identical in substance to section 1031.  (O'Connor v. Insurance Co. of North America (D.C.Ill.1985) 622 F.Supp. 611, 618–619, reconsideration denied (N.D.Ill.1987) 668 F.Supp. 1183.)   However, an earlier Alabama decision holds that reinsurance debts are not contemporaneous debts owed prior to insolvency and denied set-off claims.  (Melco System v. Receivers of Trans–America Ins. Co. (1958) 268 Ala. 152, 105 So.2d 43, 52–53.)

Decisions in other states have upheld set-offs for similar debts under insurance-liquidation statutes identical in substance to section 1031.   (Barnett Bank v. State Dept. of Ins. (Fla.App.1987, 1st Dist.) 507 So.2d 142;  Sunset Commercial Bank v. Florida Dept. of Ins. (Fla.App.1987, 1st Dist.) 509 So.2d 366.)

For the reasons explained below, we believe that O'Connor v. Insurance Co. of North America, supra, 622 F.Supp. 611, is correctly analyzed.   We adopt its reasoning in determining that the respective reinsurance debts are contemporaneous, preliquidation debts under section 1031.

O'Connor v. Insurance Co. of North America, supra, 622 F.Supp. at pages 618–619, holds that debts owed under reciprocal reinsurance contracts between the insurer in liquidation and other insurers are subject to set off.   The set-off claimants need pay only the balance to the liquidator.

O'Connor arose in the same procedural posture as the underlying action and was determined under an Illinois Insurance Code section having the same “mutual debts” criterion as section 1031.

O'Connor directly addresses the issue of whether such debts are contemporaneous, preliquidation debts.   That court drew upon the principle, established in the analogous area of bankruptcy law, that mutual debts arising from contracts in existence before insolvency are entitled to set-off if they are either fixed in amount or capable of liquidation.  O'Connor concludes that, for purposes of entitlement to offsets, reinsurance debts arise from contracts executed and performed prior to the date of liquidation and are thus preliquidation debts subject to set-off.   All claims against the insolvent for reinsurance proceeds are based upon losses and claims accruing before liquidation (because the insurer's insolvency cancels the underlying primary policies).   For the same reason, all claims by and against the insolvent for unearned premiums became due upon the adjudication of insolvency and prior to liquidation.

O'Connor is particularly helpful because the parties therein raised the identical arguments raised in the underlying action concerning temporal mutuality of “cross-reinsurance” debts upon insolvency.

Barnett Bank v. State Department of Ins., supra, 507 So.2d 142, holds that a bank is entitled to set off an indemnification deposit on a credit account against the liquidation estate of an insurer for checks drawn on the insured's account with another bank and dishonored by that other bank, after the claimant bank cashed the checks.   The deposit debt and the debt on the dishonored checks were held to be mutual, preliquidation debts subject to set-off (under a Florida statute virtually identical to section 1031) irrespective of the fact that the insurer's debt, to the claimant bank on the dishonored checks, was not payable until the checks were dishonored by the drawee bank after commencement of the insurer's liquidation.

Barnett reasoned that under state commercial law the claimant bank became a holder of the insurer's debt with the right to enforce immediately upon its payment of the presented checks.   The fact that enforcement against the drawer was suspended, until the drawee bank dishonored the instruments, did not render the insurer's debt under the checks a post-liquidation debt.

Sunset Commercial Bank v. Florida Dept. of Insurance (Fla.App.1987) 509 So.2d 366, follows Barnett Bank in analogous circumstances.

A view contrary to the above cases is taken in Melco System v. Receivers of Trans–America Ins. Co., supra, 105 So.2d 43, 52–53, which is cited by the Commissioner as controlling the issue.

In Melco, supra, the Alabama Supreme Court holds that a reciprocal reinsurer of the insurer in liquidation is not entitled to set off unpaid reinsurance premiums, due from the insolvent, against the reinsurance proceeds it owes to the insolvent.   The Melco court reasons that the premiums were due to the claimant prior to insolvency while the proceeds became due to the insolvent only after it was adjudged insolvent.  Melco pointed out that the reinsurance contract did not generally require payment of proceeds until the reinsured actually paid the loss on the primary policy;  and that the controlling insolvency clause in the reinsurance contract called for payment of proceeds only after insolvency, which clause did not become operative until insolvency occurred.   Thus the debts to and from the insolvency estate were not mutual because they were not owed contemporaneously prior to insolvency.   (105 So.2d at p. 53.)

We disagree with the Melco analysis for the same reasons that analysis was explicitly rejected in O'Connor v. Insurance Co. of North America, supra, 622 F.Supp. at pp. 618–619.  Melco relies upon no citation of authority for its holding and is contrary to well established principles of set-off in the analogous area of bankruptcy law.   To the extent that the Melco holding concerning lack of contemporaneous debts might be influenced by the expressed concern for avoiding an unlawful preference, we point out that Melco does not consider any set-off statute analogous to section 1031 or the Illinois statute considered in O'Connor, supra, or the Florida statute considered in Barnett Bank, supra, and Sunset Commercial Bank, supra.

Melco also appears squarely contrary to the principles set forth in the California and United States Supreme Court decisions discussed above.

The Commissioner also relies upon Federal Deposit Ins. Corp. v. Bank of America (9th Cir.1983) 701 F.2d 831, as disapproving a set off of a debt analogous to the reinsurance debts under consideration here.   In that case a Puerto Rico chartered bank issued a subordinated capital note to the Bank of America and the Bank of America sought to set off the insolvent's deposits with the Bank of America against the balance due on that note.   It was held that the law of Puerto Rico controlled and that no set-off was permissible because the subscription note was expressly subordinated to general creditors of the insolvent.   The set-off clause was invalid under Puerto Rican law but the transaction was nevertheless improperly approved by the Puerto Rican Secretary of the Treasury.

The Federal Deposit Ins. analysis has no application to the present dispute.   It concerns Puerto Rican law, without any reference to a set-off statute similar to section 1031.   The decision analyzes the subordinated capital note as analogous to a stock subscription debt.   California law does not permit set offs of deposited funds against a stock subscription debt.   (Ins.Code, § 1031, subd. (c);  Kaye v. Metz (1921) 186 Cal. 42, 49, 198 P. 1047.)   The Commissioner does not directly contend that reinsurance is analogous to a stock subscription capital contribution.

B. Mutuality of Identity and Capacity of Debtors

 The commissioner advances several arguments why the requisite mutuality of identity or capacity may not exist under the reciprocal reinsurance contracts involved here.   None of these arguments is persuasive.

It is first contended that reinsurance debts are not mutual because a reinsured acts in the capacity of a “ceding insurer” while a reinsurer acts in the capacity of an “assuming insurer.”   This distinction is a technical one having no impact upon the mutuality issue.   The significant relationship in reciprocal reinsurance is that both insurers act as debtor-creditor principals, rather than as trustees or agents for third parties.   Stripped of the technical insurance jargon proffered by the Commissioner, reinsurance is essentially a buyer-seller or a reciprocal creditor-debtor relationship between principals.

The Commissioner's primary argument against mutuality of identity and capacity is that upon the appointment of the liquidator there occurs a novation of the reinsurance contracts that alters both the identity of the parties thereto and the capacity of the parties.   The reasoning of this argument is vaguely presented.   As best we can understand this theory, mutuality of identity is destroyed because, upon issuance of the liquidation order (§ 1016), the liquidator takes the place of the insolvent with respect to all debts and credits.   Because claims against the estate are not payable debts until allowed by the liquidator, these are owed by the liquidator to claimants;  but debts owed to the estate are preliquidation debts owed to the insolvent but payable to the liquidator.

The Commissioner contends that mutuality of capacity is also destroyed upon issuance of the liquidation order because the reinsurance debts owed to the Mission companies in their individual capacities as creditors prior to the liquidation order become debts owed to the liquidator in her capacity as trustee for the claimants (beneficiaries) of the liquidation estate;  but debts owed by the estate are owed by the liquidator in the same debtor capacity as they were owed by the Mission companies prior to the liquidation order.   Conversely, reinsurance proceeds owed by the reinsurers claiming set offs were owed by them in the capacity of indemnitors directly to the Mission companies before the liquidation order;  but as of the liquidation order, those reinsurance proceeds are owed by the reinsurers in the capacity of sureties for the benefit of the creditors of the liquidation estate.

This is a sophistic theory.

First, section 1031 itself explicitly frames its mutuality criterion in terms of “․ mutual debts or mutual credits between the person in liquidation under Section 1016 and any other person, ․” (Emphasis added.)   Thus, the replacement of the insolvent by the liquidator is irrelevant to determination of the mutuality of debts under section 1031 at the time of liquidation.   It is well settled in California that the nature of debts does not alter upon appointment of an insurance insolvency receiver or liquidator.   The liquidator assumes all the rights of the insolvent insurer subject to all legal defenses and set-offs to which the insolvent was subject at the time of insolvency and liquidation orders.   The liquidator does not disrupt the status of mutual debts nor do debts alter in nature upon issuance of a liquidation order.   (Scott v. Armstrong, supra, 146 U.S. 499, 13 S.Ct. 148;  Ainsworth v. Bank of California, supra, 119 Cal. at pp. 475–476, 51 P. 952;  Downey v. Humphreys, supra, 102 Cal.App.2d 323, 336–337, 227 P.2d 484.)

Second, the Commissioner's proffered construction would never permit an offset because appointment of the liquidator would always effect a change in the parties and always transform debts owed to the insolvent insurer, as a principal creditor, into debts owed the liquidator, as trustee for the creditors of the insolvent.   This theory produces an absurd result and would render section 1031 nonfunctional.

In this regard the Commissioner contends that Downey v. Humphreys, supra, 102 Cal.App.2d 323, 227 P.2d 484, actually compels the determination that the debts owed under the reciprocal reinsurance contacts and faculative treaties involved here were not contemporaneously owed at the time liquidation was ordered. Specifically, it is argued that in Downey the agent withheld and diverted the disputed “unearned” premium funds after the insolvency order but before the liquidation order issued two months later.   Since section 1019 provides that the rights between an insolvent insurer and claimants are fixed as of the date of a section 1016 liquidation order, the set-off in Downey had been fully executed, a fait accompli, prior to the liquidation order and thus the mutual debts were clearly preliquidation.

The Commissioner argues that because no actual set-off of the reciprocal reinsurance debts between petitioner and the Mission companies had been physically “effected” before the issuance of the liquidation order, the reinsurance debts owed by and to the Mission companies are not mutualdebts as in Downey.   Rather, these reinsurance debts are controlled by her novation theory.

We find the suggested distinction unpersuasive.   The record and the Commissioner's briefs herein show that on February 2, 1987, the Commissioner obtained an order pursuant to section 1011, subdivision (d), placing the Mission companies in conservatorship due to insolvency.   On February 24, 1987, the Commissioner obtained a section 1016 order placing the Mission companies into liquidation.   Nothing in Downey is reasonably susceptible to the interpretation that an insurance liquidator may reach back and negate the set-off of contemporaneous, mutual debts if those debts had not actually been debited and credited, and the balance physically disbursed to other purposes before the liquidation order issued. If anything, Downey stands for the principle that the liquidator succeeds to the insolvent's interest in assets subject to all lawful defenses and limitations existing against the insolvent before the liquidation.   The circumstance that the agent in Downey had physically redirected the disputed funds, to purchase other policies for his clients before the liquidation order issued, does not negate the fact that as of the date of the liquidation order the liquidator claimed that all of the disputed funds were owed to it from the agent and the agent claimed a set-off debt was owed to him.

Similarly, in the matter before us the reinsurers have refused to pay to the liquidator the total reinsurance debt they owe and they have asserted set-offs existing as of the issuance of the liquidation order.   The Downey situation differs from this only in the respect that here the specific purpose to which petitioner has diverted the disputed and unpaid set-off funds has not been specified.

The Commissioner's argument ignores the point that irrespective of the Downey agent's alternate use of the disputed funds, the set-off which the Commissioner characterizes as having been fully executed prior to the liquidation order occurred within the two months immediately preceding issuance of the liquidation order.   If the agent's claimed credit for unearned premiums and the insurer's claim for unpaid premiums were not based upon debts owed contemporaneously, then the agent had no lawful section 1031 set-off and his retention and diversion of those funds would have been an unlawful section 1034 preference collectable by the liquidator.

Even if Downey, supra, is distinguishable, the Commissioner's position that debts created or rendered payable upon the event of insolvency are not mutual debts capable of set off is refuted by Carr v. Hamilton, supra, 129 U.S. 252, 9 S.Ct. 295;  Forsythe v. Kimball (1876) 91 U.S. 291, 23 L.Ed. 352;  Scott v. Armstrong, supra, 146 U.S. 499, 508, 13 S.Ct. 148, 150;  Ainsworth v. Bank of California, supra, 119 Cal. 470, 474–476, 51 P. 952, and Garrison v. Edward Brown & Sons, supra, 25 Cal.2d 473, 483, 154 P.2d 377.

Finally, we find unpersuasive the Commissioner's criticism of O'Connor and other decisions, as improperly applying federal bankruptcy law set-off principles to the insurance liquidation context.   It is argued that entitlement to set-offs in the context of state-regulated liquidations of insurers differs critically from set-off rights in bankruptcy proceedings because unsecured creditors in bankruptcy (after payment of administration costs and federal and state taxes and special priority creditors) are all in the same priority class.   So permitting a set-off by an unsecured creditor in bankruptcy effects what the Commissioner terms a “preference” over only general unsecured creditors having the same priority as the set-off claimant.   In contrast, insurance-liquidation proceedings in California have two classes of lower-priority claimants:  “Class 5” claimants (primary policyholders and certain CIGA claims) and “Class 6” claimants, defined as “all others” and including reinsurers.   From this distinction the Commissioner concludes that permitting a section 1031 set-off to reinsurers would effect not just a “preference” over other claimants in the same priority class, but would effect what she terms a “double preference” that also favors set-off reinsurers over the higher-priority “Class 5” policyholders and CIGA claimants.   She argues that this “double preference” is so egregious as to compel acceptance of her proffered construction of section 1031 to preclude such a result.

The proffered distinction and rationale are negated by two considerations.

First, in 1935 when sections 1031 and 1033 were enacted, section 1033, which then controlled claim priorities as it does today, provided for only one class of general claimants (“Class 3.   All other claims”) subordinate to the first two classes, which are, for purposes of this analysis, identical to the first four section 1033 priority classes existing today.   Thus, when section 1031 was enacted primary policyholders, CIGA claims, and reinsurers all shared the same Class 3 priority (“All other claims”).   This lump classification of claimants in 1935 was identical to the single class of general unsecured creditors claimed by the Commissioner to exist under bankruptcy law.  (But see 11 U.S.C. § 507.)  Section 1033 was not amended to create its present Class 5 and Class 6 until 1979, long after the legislature had formulated its scheme for section 1031 set-offs.   It is thus impossible for the section 1031 mutuality criterion have been keyed to section 1033's present distinction between Class 5 and Class 6 claimants.

Second, to the extent that the Commissioner uses the term “double preference” to imply that a section 1031 set-off is an unlawful, improper or voidable transaction working contrary to the preferences established in section 1033, her usage is inconsistent with the Insurance Code. Insurance Code section 1031 expressly authorizes set-offs section 1033. It follows that the term “double preference” has no relevance to section 1031 set-offs because set-offs are seperate from and independent of the distribution of the estate pursuant to the section 1033 class priorities. Moreover, section 1034 defines a “voidable preference” as a transaction effecting an unauthorized advantage by one creditor over “any other creditor of the same class”; it is irrelevant that the transaction also effects an advantage over members of higher classes.

C. Application of the Mutuality Rules to the Facts

Having determined that mutual credits and debts arising from mutual reinsurance contracts may permit section 1031 set-offs in insurance liquidation proceedings, we now consider such potential entitlement under the facts in this case.

 As explained, Prudential Reinsurance is the sole reinsurer of the Mission Insurance Group, Inc. companies under the “Relation ‘A’ Contracts.”   Gibraltar is not a named party to those contracts.   On the other hand, Mission Insurance Company is the only reinsurer of Prudential Reinsurance and Gibraltar under the “Relation ‘B’ Contracts,” with the exception of one contract whereunder Mission National is the reinsurer.

Thus Prudential Reinsurance did not demonstrate below that both it and its subsidiary, Gibraltar, contracted as both reinsurers and reinsureds with the Mission companies.   Since Gibraltar does not owe any reinsurance proceeds or premiums to the Mission companies as a principal reinsurer, it has no mutual credits or debts with those companies upon which Prudential Reinsurance may claim a section 1031 off-set against what it owes to the Mission companies as their reinsurer.

Conversely, because Prudential Reinsurance was reinsured by Mission Insurance Company and by Mission National Insurance Company, but not other Mission companies, the remaining Mission companies are not principal reinsurers having mutual reinsurance debts and credits with Prudential Reinsurance under the cases discussed above.

Prudential Reinsurance contends that absent a de facto and direct mutuality of debts between its subsidiary and the Mission companies, and absent a direct mutuality of debts between it and the Mission companies that did not reinsure it, a case-law expansion of the mutuality doctrine should apply to effect the missing mutuality.   In this regard, Prudential Reinsurance relies upon a few out-of-state decisions that adopt the rule that when a parent corporation deals with another entity and both agree to treat credits or debts between the subsidiary and the other entity as existing between the parent and that entity, a triangular mutuality may exist permitting equitable set off of the “mutual debts.”  (In re Berger Steel Company (7th Cir.1964) 327 F.2d 401;  Black & Decker Mfg. Co. v. Union Trust Co. (1936) 53 Ohio App. 356, 4 N.E.2d 929;  Piedmont Print Works v. Receivers of People's S. Bank (4th Cir.1934) 68 F.2d 110.)

It is to be noted that these cases adopt the expanded doctrine of mutuality in circumstances where the parties have made an express mutual agreement that the subsidiary or affiliate corporation will be deemed a mutual debtor-creditor of the parent, and where equitable considerations favor the result achieved by such fiction.

For example, In re Berger Steel Company, supra, 327 F.2d 401, a manufacturing company purchased certain raw materials from a parent corporation and sold certain manufactured items to the parent's subsidiary.   The manufacturer was in poor financial condition and needed materials from the parent corporation to sustain production.   The manufacturer was delinquent in its account with the parent, but the subsidiary owed the manufacturer for goods.   The manufacturer and parent entered into a disputed oral agreement whereby the debt owed by the subsidiary would be applied to satisfy the manufacturer's debt to the parent.   After the parent supplied the manufacturer with additional materials, the manufacturer became insolvent.   In the insolvency proceedings the parent sought to offset the subsidiary's debt to the manufacturer with the manufacturer's debt to the parent, thereby obtaining proportionately more than other creditors in its class.   The Berger Steel court considered permitting the set-off under the theory that a three-way mutuality of debt was created by contract, but that court ultimately determined that the parent seeking the set-off had not proven the existence of such a contract.

Research has revealed no California decision adopting this expanded doctrine of set offs based upon tripartite debts in any context.   We believe that it is particularly inappropriate to adopt that doctrine in the context of set-off claims by reciprocal reinsurers in insurance liquidation proceedings.   As the present case illustrates, such an expansion of mutuality under section 1031, as construed by California decisions, would permit an exponential increase in the amounts affiliated insurance groups could offset to the detriment of liquidation estates and, pragmatically, primary policyholders.

It is one thing to permit reinsurance set-offs meeting the traditional test of mutuality under California law, given that section 1031, which was formulated under the doctrine of equitable set-off as then recognized in this state, expressly commences “In all cases of mutual debts or mutual credits between the person in liquidation ․ and any other person, ․”  (Emphasis added.)   But it is another matter to permit such setoffs under a far broader test of mutuality never adopted in this state and certainly never contemplated by the legislature when it added section 1031 to the insurance liquidation chapter in 1935.

Moreover, the evidence adduced below does not show any prior agreement between the set off claimant to the effect that Gibraltar would be considered as a principal reinsurer of the Misson companies or that the Mission companies other than the two named as reinsuring parties would be deemed to also be principal reinsurers under all the subject reinsurance treaties and facultative certificates.

Neither does it appear that equity or the interests of justice would be served by adopting the doctrine.   We point out that the circumstance in Berger Steel, supra, 327 F.2d 401, exhibits a close similarity to an assignment of debt for set off collection purposes.   Such set-offs are not permitted in California on the ground that the assignee of the debt acts as a trustee rather than a principal and thus mutuality of capacity is lacking.  (Harrison v. Adams, supra, 20 Cal.2d at p. 650, 128 P.2d 9.)

II. THE SECTION 1031, SUBDIVISION (a) EXCEPTION

 Respondent adopted the Commissioner's construction of subdivision (a) of section 1031 as meaning that legal entitlement to creditor status against the liquidation estate is insufficient unless the estate is capable of first paying in full all claimants who are members of higher priority classes under the section 1033 priority scheme.   This construction is founded upon the view that the phrase “entitle ․ to share as a claimant in the assets of such person in liquidation” requires an actual financial ability of the estate to pay the set-off claimant in the order of priorities under section 1033.   That is, unless the estate has sufficient assets—after collection of all debts owed to it, without allowance of set-offs—to pay all Class 5 claimants in full, no set-off claimant who is a member of the lower-priority Class 6 may take any estate assets by way of his section 1031 set-off claim.

We find this construction to be contrary to the plain language of the statute and to create an irreconcilable internal inconsistency.   We also reject the view that section 1031, subdivision (a), was intended to be keyed to the present section 1033 priority scheme placing policyholders and CIGA in a higher priority class than the reinsurer claimants.

The Commissioner's construction of the section 1031, subdivision (a) exception creates an irreconcilable conflict with the main text of that statute.  Section 1031 provides:  “In all cases of mutual debts or mutual credits between the person in liquidation under Section 1016 and any other person, such credits and debts shall be set off and the balance only shall be allowed or paid, ․”  (Emphasis added.)   This is a classic statement of the doctrine of equitable set off, universally recognized to require payment of only the set-off balance into an insolvency estate.  (Scott v. Armstrong, supra, 146 U.S. 499, 13 S.Ct. 148;  Ainsworth v. Bank of California, supra, 119 Cal. at pp. 475–476, 51 P. 952;  Kaye v. Metz, supra, 186 Cal. at p. 49, 198 P. 1047;  Scammon v. Kimball, Assignee, supra, 92 U.S. 362;  Carr v. Hamilton, supra, 129 U.S. 252, 9 S.Ct. 295.)

To adopt the Commissioner's proffered construction would have section 1031 first direct that set-off be calculated at the outset and only the net balance due to be paid;  but then direct that the entire debt due the estate first be paid and that set-off claimants await reinbursement if the estate assets, as so collected, prove insufficient to fully pay all higher-priority creditors.

The settled rule is that upon the insolvency of an insurer, policy premiums which are unearned at that time may be offset against a personal debt owed by the insured to the insurer.  (Scott v. Armstrong, supra, 146 U.S. 499, 13 S.Ct. 148;  Ainsworth v. Bank of California, supra, 119 Cal. at pp. 475–476, 51 P. 952.)

The construction urged by the Commissioner would also render section 1031 without meaningful function because set-offs would essentially be permitted only in cases where the estate is sufficient to pay higher priority classes in full and most likely be sufficient to also pay the set-off claimant in full without resort to set-off.

If the Legislature had meant to gear set-off entitlement to the estate's financial capacity, we presume it would have worded section 1031 to make that intention sufficiently clear.

Another reason the Commissioner's construction must be rejected is that it rests heavily upon the argument that the legislature intended to effect the overriding public policy of protecting primary policyholders under Class 5 from diminution of their loss recoveries due to set-offs by Class 6 (“all others”) claimants such as reinsurers.

As with one of the Commissioner's previous arguments, this argument fails upon recognition that when sections 1031 and 1033 were enacted in 1935 (Stats.1935, ch. 291, p. 1008) section 1033 set forth only three classes of claimants.   Primary policyholders, CIGA, and reinsurers shared the same Class 3 (“All other claims”) priority.   No construction of section 1031 may be valid if based upon the premise that the legislative intent of section 1031, subdivision (a) in 1935 was keyed to the post–1979 distinction between Class 5 and Class 6 priorities under section 1033.

For the same reason we find no merit in the Commissioner's related contention that it is inappropriate to construe section 1031, subdivision (a) as analogous to the bankruptcy criterion of “provable claim.”   The argument is that claimants in insurer-liquidation proceedings are intended to have greater protection than unsecured general creditors in bankruptcy due to the specialstate interest in reimbursing losses to primary policyholders, which interest is reflected in conferring Class 5 priority upon primary policyholders over Class 6 (“all others claims”) claimants.

Finally, the Commissioner argues that permitting section 1031 setoffs here would offend public policy by effecting a “double preference” over remaining Class 6 claimants and over Class 5 claimants otherwise enjoying higher priority.   This is inaccurate.   Set-offs in insurer-liquidation proceedings are not unlawful preferences.  (Ins.Code, § 1034;  Scott v. Armstrong, supra, 146 U.S. 499, 13 S.Ct. 148;  Downey v. Humphreys, supra, 102 Cal.App.2d at p. 336, 227 P.2d 484.)

Accordingly, we reject the commissioner's and respondent's construction and construe the section 1031, subdivision (a) phrase “[entitled] to share as a claimant in the assets of such person in liquidation” as a descriptive counterpart of the “provable claim” language of the federal bankruptcy statute controlling set-offs.   As such, a set-off claim need only be demonstrated to be enforceable against the estate under the other liquidation statutes.

Neither do we accept the Commissioner's argument that the language of section 1031, subdivision (a) could not impose only a “provable claim” criterion because to qualify for set-off a claimant must have a valid claim;  thus subdivision (a) exception must mean something more.   We view the subdivision (a) exception to be directed at screening out unenforceable or unlawful claims, such as those failing to meet the standard of section 1025.  (See former § 1035 [Stats.1919, ch. 178, § 8, p. 265;  Stats.1933, ch. 534, § 4, p. 1421] the predecessor of § 1025, which disallowed contingent claims.)   Subdivisions (b) and (c) of section 1031 exclude otherwise lawful claims that are also denied set-off entitlement under general case law because of lack of mutuality of capacity or interest.  (See Kaye v. Metz, supra, 186 Cal. at p. 49, 198 P. 1047 [rejecting for lack of mutuality of capacity, a set-off by a stocksubscriber of his unpaid subscription debt, against a debt of the corporation owed to the subscriber in his individual capacity];  Harrison v. Adams, supra, 20 Cal.2d at p. 650, 128 P.2d 9 [rejecting a set-off debt obtained by assignment for lack of mutuality of interest].)  Even if subdivision (a) imposes a qualification upon debts that might have been placed in the main text of section 1031, we view this as merely a stylistic matter not affecting the substance of the statute.

III. THE PUBLIC POLICY ARGUMENT

 The Commissioner's final argument is that even if this court does not construe section 1031 as she urges, the overriding state interest in the overall insurance law—effectuating payment of primary policyholders' losses—requires this court to refuse to apply section 1031 if it contravenes that goal.

In her argument before respondent the Commissioner founded this position solely upon general considerations of public policy and state interest.   It is contended that because reinsurance permits insurers to write additional policies, due to its credit effect on their capital reserves, it is improper to negate that reserve by permitting set-offs of reinsurance debts in liquidation.   Now, for the first time, Kruger v. Wells Fargo Bank (1974) 11 Cal.3d 352, 367, 113 Cal.Rptr. 449, 521 P.2d 441, is relied upon by analogy.   Although the petitioner has not commented upon the application of Kruger, we find Kruger distinguishable.

In Kruger v. Wells Fargo Bank, supra, 11 Cal.3d 352, 113 Cal.Rptr. 449, 521 P.2d 441, a bank customer maintained an account wherein she deposited her state disability and welfare benefit funds, which funds are protected against judicial process by the state exemption statutes.   The bank set off those funds against the customer's delinquent credit-card debt to it.   Kruger holds that although the state exemption statutes protect only against the use of state judicial process to seize such assets, the creditor's right under the general doctrine of equitable set off is not absolute and may be restricted by judicial decision if necessary to uphold the state policy of protecting essential rights of the debtor.  Kruger reasoned that exempt assets do not lose their protected status when deposited in a bank account and that permitting set off would frustrate the state interest in providing such persons with funds determined by the state to be essential for subsistence.   Moreover, if the nonjudicial execution were permitted, the state would have to provide the depositor with additional funds for their daily necessities.   Upon these considerations Kruger holds that the bank may not accomplish by a “banker's set-off” what it is prohibited from doing through legal process.

Kruger is materially distinguishable in several respects.

First, the banker's set-off invalidated there was based upon only the general common law doctrine of equitable set-off and squarely conflicted with the intent of specific statutes proscribing such a result under judicial process.   In contrast, in our case the set-off claimed by petitioner is explicitly authorized by section 1031 in insurer-liquidation proceedings.

Second, Kruger is founded upon the public policy of protecting persons who require welfare and disability benefits for their subsistence, and the very benefits held by such a person were taken by set-off.   In our case, primary insureds have no interest in a contract of reinsurance (Ins.Code, § 623) and no rights against reinsurers (unless otherwise expressly provided by contract), even upon liquidation of their insurer.  (Ins.Code, § 922.2.)   Moreover, here losses under the primary policy will, subject to certain limitations, be covered by CIGA as part of the statutory scheme for protecting primary insureds upon liquidation of their insurer.  (Ins.Code, §§ 1063–1063.12.)   This expense will be shared among all the insurers doing business in this state;  the state itself will not have to expend additional funds to the policyholders by reason of petitioner's assertion of its set-off rights under section 1031.

IV

Let a peremptory writ of mandate issue directing respondent to vacate its order of May 3, 1989, and to make a new and different order in conformity with the views expressed in this decision.   It is further ordered that this court's temporary stay of respondent's May 3 order shall remain in effect until this decision becomes final as to this court.

FOOTNOTES

1.   All further statutory references are to the Insurance Code unless otherwise specified.

2.   Under the construction of section 1031, subdivision (a) urged by the Commissioner and adopted by respondent, the insufficiency of the assets of the liquidation estate to pay all Class 5 claimants fully if any section 1031 set-offs were allowed was a material fact issue.   However, under our contrary construction of section 1031, that issue is immaterial to the issue of set-off entitlement.   Accordingly, solely for purposes of resolving the issues in this mandate proceeding we shall assume that the liquidation estate would not be able to pay all higher-priority claimants in full if set-offs were permitted to Class 6 claimants such as petitioner.

ARLEIGH M. WOODS, Presiding Justice.

McCLOSKY and GEORGE, JJ., concur.