PRUDENTIAL REINSURANCE COMPANY, Petitioner, v. THE SUPERIOR COURT OF LOS ANGELES COUNTY, Respondent; JOHN GARAMENDI, as Insurance Commissioner, etc., Real Party in Interest, 3 Cal. 4th 1118

Opinion LUCAS, C. J. Insurance Code

section 620 (all further statutory references are to this code unless otherwise stated) defines a reinsurance contract as “one by which an insurer procures a third person to insure him against loss or liability by reason of such original insurance.” Typically, under a reinsurance contract, the primary insurer “cedes” a portion of the premiums for its policies, and the losses on those policies, to the reinsurer.

In a reinsurance transaction, policyholders pay premiums to their original insurer, who, in turn, pays a reinsurer a percentage of the initial premiums as consideration for reinsuring a specified part of the original risk. If, after a loss, the original insurer must compensate its policyholders, the reinsurer in turn indemnifies the insurer.

The advantage of reinsurance is to secure to the original insurer adequate risk distribution by transferring a portion of the risk assumed to another insurer. (Semple & Hall, The Reinsurer’s Liability in the Event of the Insolvency of a Ceding Property and Casualty Insurer (hereafter Semple & Hall) (1986) 21 Tort & Ins.L.J. 407 [“A reinsurance agreement is one by which the reinsurer indemnifies the ceding company for losses paid”].) We granted review to determine as a matter of first impression whether reinsurance debts and credits generated between a reinsurer and the original insurer, under the terms of their reciprocal reinsurance contracts, may be set off pursuant to

section 1031, when the original insurer becomes insolvent.

Section 1031 provides in pertinent part that: “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. . . .”

Section 1031 allows the setoff of all mutual debts and credits in the course of liquidation proceedings and is patterned after the federal Bankruptcy Act of 1898 (11 U.S.C. § 108, repealed and reenacted as 11 U.S.C. § 553), and an identical New York statute that has been adopted by several states (N.Y. Ins. Law, former § 420 (Consol. 1985), recodified as § 7427). The federal and New York provisions were in turn derived from the equitable right of setoff established in 17th century England, and later adopted in early federal court cases allowing equitable setoff in the insurance context. (Downey v.

Humphreys (1951) 102 Cal.App.2d 323, 335-336 [227 P.2d 484]; see also Scammon v. Kimball (1876) 92 U.S. (2 Otto) 362 [23 L.Ed. 483] [allowing banker to setoff insolvent insurer’s deposits against unrelated insured losses].) Assuming setoff is permitted, there remain questions pertaining to the relative priorities of setoff and other claims in liquidation against the insurer. An exception to the general rule of

section 1031 is provided in

section 1031, subdivision (a) (hereafter

section 1031(a)), which does not allow setoff when the “obligation of the person in liquidation to such other person does not entitle such other person claiming such setoff to share as a claimant in the assets of such person in liquidation.” Accordingly, we must also consider whether

section 1031(

a) allows setoff claims if the estate has insufficient assets to satisfy fully all primary policyholders and claims of the California Insurance Guarantee Association (CIGA) whose claims, absent setoff, have priority (under

section 1033) over those of reinsurers and other general creditors. Because reinsurers are not considered priority claimants in an insolvency proceeding, the amount of setoff money remaining after priority claimants are paid would be less than that available before statutory preference is given to other claimants. We conclude that

section 1031 may not reasonably be construed as conditioning a reinsurer’s right to set off on the insolvent insurer’s ability to pay in full the claims of those in higher priority classes. As we explain, the majority of state and federal courts addressing the statutory right of setoff adopt this position. Thus, we hold that the reciprocal reinsurance contracts at issue here created “mutual credits and debts” under

section 1031. We also conclude that

section 1031(

a) does not preclude setoff in this case. Plaintiff reinsurer has shown a contractual and legal entitlement to the status of creditor of the insolvent insurer, and the contract between the two entities does not make setoff contingent on the ultimate financial ability of the original insurer or its estate to first pay all claimants in higher priority classes. Finally, we determine that any policy considerations favoring payment of insureds under original policies may not override the unequivocal language of

section 1031 or policies favoring setoff. To disallow setoff in this case would not only subvert clear legislative intent, but would also lead to an increased cost of insurance for the consumer, because offsetting an insurer’s debts spreads the risk incurred by the insurer and often allows smaller insurers to remain in business. (See Stamp v. Insurance Co. of North America (7th Cir. 1990) 908 F.2d 1375, 1380 [offsetting debts spreads risk and acts as mutual security for performance].) I.

Background On February 2, 1982, the Commissioner of Insurance (Commissioner) placed Mission Insurance Company (Mission) and its affiliated insurance companies into conservatorship due to insolvency. (§ 1011, subd. (d) [vesting title to assets in Commissioner when insurer’s transaction of business is hazardous to policyholders].) Several weeks later, the Commissioner obtained an order pursuant to

section 1016, authorizing liquidation of the Mission companies. The Commissioner was appointed liquidator, and thereafter demanded all reinsurers of Mission pay in full the amounts owed under their reinsurance contracts. The reinsurers refused to make any such payments, claiming that under

section 1031, they were entitled to set off the amounts owed by Mission for reinsurance proceeds and “unearned premiums” (or amounts insureds prepaid for coverage in the days and months ahead), owed to them by the insolvent insurers, against the debts they owed the insolvent insurers under reinsurance contracts executed prior to insolvency. The Commissioner commenced the underlying action against 144 reinsurers, and brought the present

summary judgment motion against petitioner Prudential Reinsurance Company (Prudential Reinsurance) to compel payment, without setoff, of moneys owed the Mission companies. The trial court granted the Commissioner’s

summary judgment motion on the ground that

section 1031 allows a setoff only when the assets of the liquidating estate are sufficient to pay in full all the claims asserted by claimants in priority classes higher than the claimant asserting the setoff right. In other words, the court concluded that

section 1031 makes the statutory right of setoff contingent on the ultimate financial ability of the liquidation estate to pay in full all claimants in

section 1033 priority classes higher than the setoff claimant. The Court of Appeal followed the rule of every state and federal court that has considered the reinsurer’s right to statutory setoff and issued a peremptory writ of mandate ordering the trial court to vacate its order granting

summary judgment and to enter a new order allowing Prudential Reinsurance the right of setoff. The Commissioner seeks our review of this judgment. As we explain, we adopt the thoughtful analysis of the Court of Appeal and conclude that a plain reading of sections 1031 and 1033 allows an insolvent insurer and a reinsurer to set off debts and credits after the appointment of a liquidator. Because we agree with the Court of Appeal that Prudential Reinsurance is entitled to set off Mission’s debts, we affirm the Court of Appeal’s judgment. II. Discussion A.

The Reinsurance Contracts Reinsurance contracts, as contracts of indemnity, operate to shift a part of the risk of loss under the insurance policy from the original insurer to the reinsurer. (1 Cal. Insurance Law & Practice, Reinsurance (1991) § 11.01, pp. 11-6, 11-7.) The insured, however, remains in privity with the original insurer, and the reinsurer owes no duties to the insured. (Ibid.) Thus, the original insured has no right to pursue contract or bad faith actions against the reinsurer. (§ 623; Ascherman v.

General Reinsurance Corp. (1986) 183 Cal.App.3d 307, 310 [228 Cal.Rptr. 1].) Reinsurance contracts are classified as either “facultative” or “treaty.” Reinsurance is facultative if it covers the reinsured’s risk on an individual policy. The majority of reinsurance contracts are placed under a treaty, which covers the reinsured’s risk for an entire class of policies. (1 Cal. Insurance Law & Practice, supra, § 11.02, at p. 11-22.) In the present case, Prudential Reinsurance is the reinsurer under 14 reinsurance treaties.

The parties refer to these treaties as “Relation A” contracts; these contracts reinsure the Mission companies. The other reinsurance contracts at issue here are called “Relation B” contracts and reinsure Prudential Reinsurance and its subsidiary, Gibraltar, as principals. Mission is the reinsurer under all but one of these latter contracts; a related company, Mission National Insurance Company, is the reinsurer under the remaining contract.

The setoff clauses of the “Relation A” contracts provide in substance that Mission, other named Mission subsidiaries (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, setoff rights are controlled by

section 1031. Similarly, the “Relation B” contracts also grant Prudential Reinsurance the express right to set off moneys due from Mission against amounts due Mission under the same or any other reinsurance contract between them. Keeping this background in mind, we now turn to the issues before us. B. Mutuality As noted above, in 1935 the Legislature granted a statutory right of set-off under

section 1031 “in all cases of mutual debts or mutual credits.” The key to setoff is the requirement of mutuality. Justice Benjamin Cardozo defined mutuality as follows: “To be mutual, [the debts] must be due to and from the same persons in the same capacity.” (Beecher v. Peter A. Vogt Mfg. Co. (1920) 227 N.Y. 468 [125 N.E. 831, 833]; see Marick et al„ Excess, Surplus Lines and Reinsurance: Recent Developments (1991) 26 Tort & Ins. LJ. 231, 244.) Later cases required that the subject debts be mutual in three respects.

First, the debts must be owed contemporaneously with, or prior to issuance of, the liquidation order. In other words, preinsolvency debts may be set off, but a preinsolvency debt may not be set off against a debt arising after appointment of a liquidator. (See, e.g., Stamp v. Insurance Co. of North America, supra, 908 F.2d at p. 1379; Downey v. Humphreys, supra, 102 Cal.App.2d at p. 336.) Next, such debts must exist between the same persons or entities in order to establish mutuality of identities. (Matter of Midland Ins.

Co. (N.Y. 1992) 79 N.Y.2d 253 [582 N.Y.S.2d. 58, 590 N.E.2d 1186, 1192] (hereafter Midland)-, Harrison v. Adams (1942) 20 Cal.2d 646, 649-650 [128 P.2d 9].) Finally, the setoff can occur only between persons or entities of equal capacity; debts owed in a fiduciary, agency, trustee, or partnership capacity are not subject to setoff. (Downey v. Humphreys, supra, 102 Cal.App.2d at p. 336; Midland, supra, 590 N.E.2d at pp. 1192-1193; see also Garrison v.

Edward Brown & Sons (1946) 28 Cal.2d 28, 30 [168 P.2d 153].) The Court of Appeal found all three requirements were met in the present case, and that the reciprocal reinsurance contracts created “mutual credits and debts” under

section 1031 as between Prudential Reinsurance and Mission. The court also concluded that

section 1031 permits setoff when the reinsurer shows legal status as a creditor of the insolvent insurer, and does not make the statutory right of setoff contingent on the ultimate financial ability of the insolvent entity to first pay all claimants (including original insureds and CIGA) in higher priority classes under

section 1033. The court concluded that favoring payment of the insureds under original policies and CIGA was contrary to the plain meaning of

section 1031. As explained below, we agree with the Court of Appeal that mutuality was established in this case. 1. Contemporaneous Mutuality The Commissioner first contends the reinsurance obligations between Prudential Reinsurance, its subsidiary, Gibraltar, and Mission did not meet the contemporaneous requirement for mutuality, because the debts owed by the reinsurers to Mission (namely, payments on insured losses) are postliquidation debts, while those owed to the reinsurers by Mission (namely, past-due premiums) are preliquidation debts.

The Commissioner reasons that the reinsurance proceeds and the return of policy premiums may not be set off because those debts are postliquidation debts that will not be due until the policyholders’ loss claims are allowed or liquidated. As the Court of Appeal herein observed, however, the Commissioner’s assertion is not supported by

section 1031 or case law. Prior to the enactment of sections 1031 and 1033 in 1935, California and federal decisions addressing the common law doctrine of equitable setoff held that debts and credits of an insolvent insurer amounted to mutual obligations for purposes of equitable setoff even if the obligations were technically not payable until closing of the insolvency estate. For example, in Carr v.

Hamilton (1889) 129 U.S. 252 [32 L.Ed. 669, 9 S.Ct. 295], the court held that once the insurer is declared insolvent, proceeds due the insured must be offset against the insured’s separate mortgage debt to the insurer. The Carr court applied the principle of offset, initially established in federal bankruptcy law, to the insurance liquidation context and held that debts due between the insolvent insurer and other persons may be set off during insolvency even if they were otherwise due at a later date.

The Carr decision was based on the premise that any contractual creditor of the insurer in liquidation should be allowed to set off mutual debts created by contract before the insolvency occurred. (See also Scammon v. Kimball, supra, 92 U.S. at p. 371 [23 L.Ed. at p. 486]; Ainsworth v. Bank of California (1897) 119 Cal. 470, 474-476 [51 P. 952] [in analogous context of estate administration, mutual debts between deceased and a bank may be set off against executor as long as debts existed prior to death].) In Downey v.

Humphreys, supra, 102 Cal.App.2d 323, the court addressed the statutory right of setoff under sections 1031 and 1033, as originally adopted in 1935. In that case, an independent insurance agent wrote an insurer’s policies for payment of policy premiums. After an insolvency receivership order was issued against the insurer pursuant to

section 1011, the agent set off all premiums due the insurer against claims due policyholders. The agent also retained funds due as earned commissions up to the date of the insolvency. Thereafter, 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 that the initial policy premiums became “unearned premiums” because the insolvency order effected a breach of those policies by the insurer.

After the trial court allowed the setoff, the Court of Appeal affirmed on the ground that the agreement between the agent and the insurer that their cross-claims should mutually compensate each other, established the necessary relationship between the parties—that of debtor and creditor—to permit the setoff. (Downey v.

Humphreys, supra, 102 Cal.App.2d at pp. 335-336.) In so holding, the Downey court reasoned that, “At the time [the insurer] was adjudicated insolvent, April 19, 1933, and at the time the liquidator was appointed, June 28, 1933, the statute providing for proceedings against delinquent insurance companies was silent as to the right of setoff. (Stats. 1919, p. 265, as amended Stats. 1933, p. 1420.) In 1935 the statute was amended to provide for setoff of mutual debts and mutual credits. (Stats. 1935, p. 544.) The statute was based on the New York law and was but the enactment of the prevailing rule. [Citations].

The Bankruptcy Act provides for a setoff of mutual debts and mutual credits. (11 U.S.C.A. § 108.)” (Downey, supra, 102 Cal.App.2d at p. 335.) “A receiver occupies no better position than that which was occupied by the party for whom he acts. . . . The right [of setoff] is to be determined by the condition of things as they existed at the moment the party was adjudged insolvent.

If the right of setoff was available to defendant at that time, the insolvency of [the insurer] did not defeat it. [Citations.] The fact that the policyholders received their unearned premiums did not create an unlawful preference.” (Downey v. Humphreys, supra, 102 Cal.App.2d 335-336; see also O’Connor v. Insurance Co. of North America (N.D.Ill. 1985) 622 F.Supp. 611, 619 [accord].) The Commissioner asserts that even under Downey v. Humphreys, supra, 102 Cal.App.2d at pages 335-336, setoff must be disallowed if the debts were not debited and credited prior to the appointment of a liquidator.

The Downey court made it clear, however, that the liquidator succeeds to the insolvent insurer’s interest in assets, subject to legislatively imposed limitations existing against the insolvent prior to the liquidation. (Ibid.) Although California courts have not addressed the statutory right of setoff since Downey in 1951, other jurisdictions have more recently discussed the issue, and we look to them for guidance. For example, in O’Connor v.

Insurance Co. of North America (O’Connor), supra, 622 F.Supp. 611, the court considered the issue whether debts owed under reciprocal reinsurance contracts between a reinsurer and an insolvent insurer are subject to a right of setoff under an Illinois statute that is substantially similar to the right granted under

section 1031.

The O’Connor court addressed the requirement of contemporaneous mutuality under the Illinois Insurance Code which provides, inter alia, that debts “between the company and another company” would be subject to setoff as long as the debts were mutual. (Ill.Rev.Stat. ch. 73, § 818 (1983).) In O’Connor, the liquidator of an insolvent insurer asserted that debts owed to it involving reinsurance proceeds, as well as unearned premiums that followed the cancellation of the policies on insolvency of the insurer, amounted to post-liquidation debts that could not be set off by the debts owed by the insolvent insurer to the reinsurers, because those debts amounted to preliquidation debts.

The O’Connor liquidator concluded that mutuality did not exist when the reinsurers’ debts were postliquidation debts, whereas the insolvent insurers’ debts were preliquidation debts. (O’Connor, supra, 622 F.Supp. at p. 618.) Like the courts in Carr v. Hamilton, supra, 129 U.S. 252, and Downey v. Humphreys, supra, 102 Cal.App.2d 323, the O’Connor court relied on bankruptcy law in rejecting the liquidator’s contention.

The court observed, “Even if the Liquidator is correct in his assertion that the debts for reinsurance proceeds and unearned premiums were not due at the time of liquidation, that fact has no bearing on whether Defendants may use these debts for set-off purposes. ‘The right of set-off may be asserted in the bankruptcy proceedings even though at the time the petition is filed one of the debts involved is absolutely owing but not presently due, or where a definite liability has accrued but is as yet unliquidated.’ ” (O’Connor, supra, 622 F.Supp. at p. 618, quoting from 4 Collier on Bankruptcy (14th ed. 1978) j[ 68.10[2].) Finally, the O’Connor court concluded that the reinsurers and the insolvent insurer “entered into a reinsurance contract which defined all of the parties’ rights and obligations.

Any liability [the insolvent insurer] may incur to pay reinsurance proceeds or return unearned premiums or ceding commissions arises as a result of provisions in the previously executed reinsurance agreement that require them to make these payments.” (O’Connor, supra, 622 F.Supp. at pp. 618-619.) The court held that because the reinsurance contracts existed prior to the insolvency, the reinsurer’s debts were “provable” under the Bankruptcy Act and became payable on the date of insolvency.

Hence, the court determined that the reinsurance debts were preliquidation debts that satisfied the Illinois Insurance Code’s contemporaneous mutuality requirement. (O’Connor, supra, 622 F.Supp. at p. 619.) The Commissioner in the present case attempts to distinguish the O’Con-nor holding. In O’Connor, all claims giving rise to the insurer’s liability were filed prior to the insolvency order. By contrast, the Commissioner observes, in the present case, the “vast majority” of the reinsurance obligations arose after the liquidation order, and therefore the debts could not be mutual.

As the Court of Appeal explained, however, the O’Connor court determined that mutuality depends on whether the debts were in existence before insolvency, not whether individual claims arose before the date of insolvency. Thus, if the reinsurance debts arose from contracts executed prior to the date of liquidation, debts arising from those contracts are considered preliquidation debts subject to setoff. (See also Ainsworth v. Bank of California, supra, 119 Cal. 470.) The O’Connor view of contemporaneous debt is shared by Stamp v.

Insurance Co. of North America, supra, 908 F.2d 1375, in which the court approved the setoff of debts owed by an insolvent insurer to a reinsurance pool. Initially, the Stamp court observed, “The Bankruptcy Code does not apply to insurance companies. 11 U.S.C. § 109(b)(2), (d). Like most other states, Illinois handles the failure of insurers in state court under the supervision of the state’s chief regulator, who takes title to the firm’s assets as trustee and liquidator.” (Id. at p. 1377.) In approving the setoff, the Stamp court found that the requirement of contemporaneous mutuality had been met.

The court noted, “A debt may exist even though it has not been valued conclusively and even though there is a bona fide dispute about the obligation to pay. [Citation.] This is the usual understanding about mutuality.” (Id. at p. 1380.) In an attempt to diminish the authority of O’Connor, Justice Kline’s dissent herein asserts "O'Connor proceeds on the unstated assumption, legally incorrect and illogical, that setoff must be allowed because it is permitted.” (Dis. opn., post, at p. 1167.) To the contrary, O’Connor’s reasoning with respect to setoff has been endorsed in subsequent decisions.

First, rather than reject O’Connor’s reasoning, the Northern District Court in Illinois denied the liquidator’s motion to reconsider O’Connor in O’Con-nor v. Insurance Co. of North America (N.D.Ill. 1987) 668 F.Supp. 1183. In so doing, the court observed that there is “also a significant policy reason for upholding [the O’Connor decision], [The reinsurer] has a right to the benefit of its reinsurance contracts, which defined the parties’ rights and liabilities with respect to the monies in dispute.

Reinsurance contracts are construed in accordance with general principles of contract law, including an implied duty [of] good faith. . . . Once the reinsured goes into liquidation, the purpose of the reinsurance agreements is vitiated. The reinsured’s liability on the policies ceases, and the reinsurer is bound to return unearned premiums and, presumably, any other form of consideration to which it is not entitled. . . .

Any other result would not be in accordance with what the parties must have intended upon entering into the reinsurance contracts.” (Id. at p. 1186 [denying motion for reconsideration].) In addition, as noted above and contrary to the dissent herein, the Stamp court followed the O’Connor holding in allowing reinsurers to exercise their statutory setoff rights. (Stamp v. Insurance Co. of North America, supra, 908 F.2d at p. 1380.) Again, Justice Kline’s dissent misreads the applicable law.

This dissent criticizes the O’Connor court’s reliance on Professor Collier’s 1978 treatise for the proposition that federal bankruptcy law recognizes that “one creditor may be getting paid more than other creditors” (O’Connor, supra, 622 F.Supp. at p. 619). The criticism is misplaced. Contrary to the dissent, Collier’s 15th edition treatise states the exact principle almost verbatim. (4 Collier on Bankruptcy (15th ed. 1992) f 553.02, p. 553-12.) In addition, Collier recognizes that “In permitting setoff . . .

Congress wisely has hedged the privilege granted under the [federal bankruptcy] Code with certain stated qualifications, [namely, recently forbidding preferences occurring 90 days before filing of insolvency] so as to prevent abuse.” (Ibid.) As Justice Kline’s dissent herein later observes, the “qualifications” noted by Collier and outlined by Bankruptcy Code

section 553 (11 U.S.C. § 553) are not applicable in this case. Based on the foregoing, we reject the Commissioner’s contention that the reinsurance obligations between Prudential Reinsurance and Mission were not contemporaneous preliquidation debts subject to setoff. 2. The Insolvency Clause

Section 922.2 requires all reinsurance contracts to contain an “insolvency clause” allowing the liquidator to collect from the reinsurer the amount that would have been due if the ceding company had not become insolvent.

The insolvency clause in this case states in pertinent part that “reinsurance provided by each and every reinsurance agreement heretofore or hereafter entered into by and between the parties hereto shall be payable by the Reinsurer directly to the Company or to its liquidator, receiver, conservator or statutory successor on the basis of the liability of the Company without diminution because of the insolvency of the Company or because the liquidator, receiver, conservator or statutory successor of the Company has failed to pay all or a portion of any claim. . . .” In a very recent case addressing statutory setoff and the requirement of mutuality, the New York Court of Appeals upheld a reinsurer’s statutory right of offset against an insolvent insurer. (Midland, supra, 590 N.E.2d 1186.) As plaintiff’s counsel observe, the Midland case is of particular significance because

section 1031 was modeled after the New York setoff statute at issue. (N.Y. Ins. Law, § 7427 (Consol. 1985); see Downey v. Humphreys, supra, 102 Cal.App.2d at pp. 335-336; see also State of California ex rel. Van de Kamp v. Texaco, Inc. (1988) 46 Cal.3d 1147, 1162 [252 Cal.Rptr. 221, 762 P.2d 385] [statute patterned after Texas statute given same construction as Texas courts].) The Midland court was faced with the issue whether a reinsurer could offset amounts it was owed by Midland under separate reinsurance contracts at the time Midland was placed into liquidation.

The liquidator objected to the setoff on the grounds that the debts were not mutual, the insolvency clause contained in one of the contracts prevented setoff, and the debts were not owed to and from the same person. The New York Court of Appeals allowed the setoff under New York Insurance Law

section 7427, subdivision (a). In addressing the liquidator’s argument that the insolvency clause contained in one reinsurance contract prevented the offset, the court observed that “[although reinsurance contracts are indemnity contracts, they commonly contain insolvency clauses which, even in the absence of a primary insurer’s payment to policyholders, permit a liquidator to collect from the reinsurer the amount of reinsurance proceeds that would have become due if the ceding company had not become insolvent.

The [offset] statutes encourage such clauses by providing that unless the reinsurance contract contains an insolvency clause the primary insurer may not consider the reinsurance as an asset or claim a deduction for the amount ceded [see

section 922.2]. The loss of those rights is substantial because if the primary insurer must maintain reserves in the full amount of reinsurance ceded, one of the primary reasons for obtaining reinsurance is defeated.” (Midland, supra, 590 N.E.2d at pp.1188-1189.) The Commissioner relies on Melco System v. Receivers of Trans-America Ins. Co. (1958) 268 Ala. 152 [105 So.2d 43], to contend that the insolvency clause destroys contemporaneous mutuality and, hence, prevents setoff because it requires payment of reinsurance recoverables “without diminution because of insolvency.” In addition, Justice Kline’s dissent herein interprets

section 922.2 as requiring any money due the insolvent insurer to be paid to the liquidator without any subtraction notwithstanding Prudential Reinsurance’s contractual right to offset Mission losses prior to insolvency. As explained below, both the Commissioner and Justice Kline’s dissent misunderstand the purpose of the insolvency clause.

The Melco court held that a reinsurer was not entitled to set off unpaid premiums due from the insolvent, because the insolvency clause in reinsurance contracts requires payment of proceeds after insolvency, when the clause becomes operative. (Melco, supra, 105 So.2d at p. 53.) Both Prudential Reinsurance and the Court of Appeal herein correctly point out that the Melco analysis is inapposite. As Midland, supra, observed, statutory provisions comparable to

section 922.2 that require an insolvency clause in reinsurance contracts were “enacted in response to the Supreme Court’s decision in Fidelity & Deposit Co. v. Pink (1937) 302 U.S. 224. . . . That case held, based on the language of the reinsurance contract and consistent with the indemnity nature of reinsurance contracts in general, that a reinsurer need only reimburse the liquidator of the insolvent ceding company for losses actually paid by the ceding company or the liquidator to the insureds on the underlying policies (see, Fidelity & Deposit Co. v.

Pink, supra). [The statutory insolvency clause] was intended to overcome that decision by altering the indemnity nature of a reinsurance contract when the ceding company becomes insolvent. . . . Pursuant to the statute, if the contract contains a statutory insolvency clause, the reinsurer is obligated to pay the liquidator his or her allocated share of any losses due under the reinsurance contract even though the insolvent ceding company has not first made payment to the insureds on the underlying policies.

Nothing in the language of [the statutory insolvency clause] or its history, however, supports the conclusion that the statute was enacted to destroy a reinsurer’s [statutory] right of offset.” (Midland, supra, 590 N.E.2d at pp. 1191-1192.) Thus, as noted above, the purpose of

section 922.2 and the insolvency clause is to provide the liquidator with the same rights and obligations of the insolvent insurer pursuant to the terms of the reinsurance contract. Certainly, the setoff in this case does not shield the reinsurers from paying reinsurance obligations directly to the liquidator or allow the reinsurer to walk away fully compensated, leaving policyholders and other more favored creditors holding the bag. Indeed, no “dimunition because of insolvency” will occur in light of this setoff. Therefore,

section 922.2 does not conflict with

section 1031; rather, it simply prevents the reinsurer from refusing to pay valid claims “on the grounds that its obligation was to indemnify the reinsured against loss, and that the reinsured only incurred loss in the amount of the diminished payments” made by the liquidator. (1 Cal. Insurance Law & Practice, supra, § 11.05(6)(

c) at p. 11-52; Semple & Hall, supra, 21 Tort & Ins. L.J. 407; American Re-Insurance Co. v. Insurance Com’n, Etc. (C.D.Cal. 1981) 527 F.Supp. 444, 452.). Melco, supra, 105 So.2d 43, did not discuss the effect of an insolvency setoff statute, and the case is contrary to California, federal and sister state law. (See Downey v.

Humphreys, supra, 102 Cal.App.2d 335-336; O’Connor, supra, 622 F.Supp. at p. 619 [rejecting Melco]; Midland, supra, 590 N.E.2d at pp. 1191-1192.) As the O’Connor court observed, the Melco court erroneously believed that “to allow the offset would give a preference to the reinsurer over other creditors because the reinsurer would be receiving full payment on its claim while other creditors would receive only fractional payment. . . . It is true that the reinsurer would be paid in full if a set-off is permitted, but, of course, that is the case anytime a set-off is permitted.

The whole point of the statutory set-off

section is to make clear that such actions are permissible, even though one creditor may be getting paid more than other creditors.” (O’Connor, supra, 622 F.Supp. at p. 619, italics in original.) In a related context, Justice Kline’s dissent herein suggests the statutory setoff scheme was not intended to be used to create a preference for reinsurers over other creditors of the insolvent insurer. (See dis. opn., post, at pp. 1157-1158.) Such reasoning begs the question when reinsurers’ rights are not statutorily subordinate because there is a setoff statute (§ 1031) that specifically allows setoff in insurer liquidation proceedings.

In refuting the liquidator’s argument that statutory setoff ignores bankruptcy priorities, Midland observed that although “permitting offsets may conflict with the statutory purpose of providing for the pro rata distribution of the insolvent’s estate to creditors, the Legislature has resolved the competing concerns and recognized offsets as a species of lawful preference.

Indeed, if an offset is otherwise valid, there would seem to be no reason why its allowance should be considered a preference: it is ‘only the balance, if any, after the set-off is deducted which can justly be held to form part of the assets of the insolvent.’ ” (Midland, supra, 590 N.E.2d at p. 1191, quoting Scott v. Armstrong (1892) 146 U.S. 499, 510 [36 L.Ed. 1059, 13 S.Ct. 148].) Finally, Justice Kline’s reliance on Corcoran v. Ardra Ins.

Co., Ltd. (2d Cir. 1988) 842 F.2d 31, for the proposition that we should “enhance the power of the Commissioner of Insurance, as liquidator, to protect [policyholders] against overreaching reinsurers” is misplaced. (Dis. opn., post, at pp. 1155-1156.) The Corcoran decision simply affirmed an order of the United States District Court for the Southern District remanding the action to state court for a determination of remedies available to the parties under their reinsurance contracts after a liquidation order had been entered.

Nowhere does the case suggest that the liquidator’s appointment affects a creditor’s substantive right of offset. (See also Midland, supra, 590 N.E.2d at p. 1192, fn. 5.) 3. Mutuality of Identity and Capacity The Commissioner next asserts that the order of liquidation destroyed the debtor-creditor relationship between the Mission companies and Prudential Reinsurance.

According to the Commissioner, as a result of the liquidation order, the reinsurance debts are owed to the Commissioner as a trustee for the benefit of the Mission companies, and are no longer owed to Mission; there is no mutuality because the trustee has no contractual obligation to Prudential Reinsurance. We agree with the Court of Appeal, and find the Commissioner’s contention without merit. As the Court of Appeal observed,

section 1031 broadly frames its mutuality criterion in terms of “all cases of mutual debts or mutual credits between the person in liquidation under

section 1016 and any other person . . . .” (Italics added.) It is well settled that once insolvency has occurred and a liquidator has been appointed to assume all the rights of the insolvent insurer, he does so subject to all legal defenses and setoffs to which the insolvent was subject at the time of insolvency and liquidation orders. (§ 1031.) In other words, the liquidator steps into the shoes of the insolvent insurer, taking the relevant claims and defenses as he finds them. The liquidator’s appointment does not disrupt the status of mutual debts at the time the liquidation order is issued. (Downey v.

Humphreys, supra, 102 Cal.App.2d at pp. 335-337.) Therefore, the Commissioner’s construction of

section 1031 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 trustee for the insolvent’s creditors. This reasoning would nullify

section 1031. In concluding that mutual credits and debts arising from mutual reinsurance contracts may permit

section 1031 setoffs in insurance liquidation proceedings, the Court of Appeal limited application of the setoff doctrine to true contractual debtor-creditor relationships between principal insurers. In doing so, it rejected Prudential Reinsurance’s assertion that its subsidiary, Gibraltar, should be permitted to set off debts owed by Prudential Reinsurance under the “Relation A” contracts even though Gibraltar is not a party to those contracts.

The Court of Appeal concluded that because Gibraltar does not owe reinsurance proceeds or premiums to the Mission companies as a principal reinsurer under the “Relation A” contracts, it has no mutual credits or debts with those companies upon which Prudential Reinsurance may claim a

section 1031 setoff against what it owes to Mission as their reinsurer. The Court of Appeal also observed that because Prudential Reinsurance was reinsured by Mission 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. We agree with the Court of Appeal. Accordingly, we refuse to expand the

section 1031 setoff of debts in the absence of an express mutual agreement that the subsidiary would be deemed a mutual debtor-creditor of the parent. (See, e.g., In re Berger Steel Company (7th Cir. 1964) 327 F.2d 401; Black & Decker Mfg. Co. v. Union Trust Co. (1936) 53 OhioApp. 356 [4 N.E.2d 929].) We conclude that such an unwarranted expansion of the setoff doctrine would permit an exponential increase in the amount subsidiaries could set off to the detriment of liquidation estates. C.

Section 1031(

a) As discussed above, under

section 1031(a), no setoff is allowed when the “obligation of the person in liquidation to such other person does not entitle such other person claiming such setoff to share as a claimant in the assets of such person in liquidation.” The Commissioner construes this subdivision as conditioning the right of setoff on the insolvent insurer’s ability to satisfy all obligations that are superior to its own in favor of the party asserting the setoff. Under the Commissioner’s

interpretation of the statute, Prudential Reinsurance is “entitled” to share in the assets of Mission only if Mission has satisfied its obligations to all claimants superior in priority to Prudential Reinsurance under

section 1033. (See fn. 2, at p. 1124, ante.) In other words, unless the estate has sufficient assets—after collection of all debts owed to it, without allowance of setoffs—to pay all priority claimants in full, no setoff claimant who is a member of the lower-priority ranks may take any estate assets by way of its

section 1031 setoff claim. According to the Commissioner, such a taking would be in effect an unauthorized preference. The Court of Appeal rejected this argument, concluding that under the Commissioner’s construction, a claimant’s right to assert a setoff cannot be determined until all the insolvent’s assets have been marshalled and the claims of all superior classes have been submitted. As the Court of Appeal observed, “entitlement” under

section 1031(

a) should be considered independently of Mission’s obligations to other claimants. If Prudential Reinsurance is owed a debt that satisfies the requirements of mutuality, it is “entitled” to share in Mission’s assets. (§ 1031(a).) The Commissioner now contends that the Court of Appeal erred in so interpreting

section 1031(

a) because a claimant asserting the right of setoff must already be a creditor of the insurer in liquidation. According to the Commissioner, if the claimant is a creditor, it is ipso facto entitled to share in the assets of the insolvent, and

section 1031(

a) is simply redundant. As the Court of Appeal observed, however, if we were to adopt the Commissioner’s proffered construction of

section 1031(a), the statutory provision would be nullified because “setoffs 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 setoff claimant in full without resort to setoff. [j[] If the Legislature had meant to gear setoff entitlement to the estate’s financial capacity, we presume it would have worded [sjection 1031 to make that intention sufficiently clear.” Finally, the Commissioner’s assertion that the Legislature, when it amended

section 1033 priorities in 1979 to create the separate priority ranks, intended to protect original policyholders from diminution of their loss recoveries due to setoffs by lower priority claimants, is contravened by legislative history. When sections 1031 and 1033 were enacted (Stats. 1935, ch. 145, pp. 544-545),

section 1033 referred to three classes of claimants only—original policyholders, CIGA, and reinsurers all shared the same priority that was classified under “all other claims.” Accordingly, if the Legislature intended to deny setoff unless there were sufficient assets to satisfy the claims of all claimants in higher priority classes, that result would have been made explicit in the statute. In sum,

section 1031(

a) is nothing more than a restatement of the mutuality requirement that is a prerequisite to the assertion of a

section 1031 setoff. D. Public Policy and Equitable Considerations The Commissioner’s final contention is that considerations of public policy and equity should preclude reinsurers’ right to set off debts they claim to be owed by the Mission companies. The Commissioner claims the allowance of a setoff permits reinsurers to obtain complete satisfaction of the debt they are owed, while Mission policyholders are relegated to partial satisfaction only. This result, he claims, subverts the recovery scheme expressly adopted by the Legislature and codified in

section 1033, which, as discussed above, generally ranks the claims of policyholders superior to the claims of other insurers. To this specific argument, he adds the more general one that it is unfair that policyholders—as opposed to reinsurers—bear the lion’s share of Mission’s insolvency, while implying even more broadly that the entire business of reinsurance was developed to permit original insurers to avoid their obligations to California policyholders. CIGA, as amicus curiae in support of the Commissioner, asserts that allowing reinsurers to exercise their setoff rights ignores specific language in

section 1033 that expressly denies them priority. CIGA relies on an exception to

section 1033 discussed below. Ranked fifth in

section 1033, subdivision (

a) priority, after expense of administration, certain unpaid charges, taxes, and claims entitled to federal preference, are “

(5) All claims of the California Insurance Guarantee Association . . . and associations or entities performing a similar function in other states, together with claims for refund of unearned premiums and all claims of policyholders of an insolvent insurer that are not covered claims. . . .” Ranked sixth and last are “All other claims.” A subparagraph of the fifth rank provides, in addition, that “Claims excluded by paragraph [ ] (3) (except claims for refund of unearned premiums) ... of subdivision (

c) of

section 1063.1 . . . shall be excluded from this priority.” Paragraph 3 of subdivision (

c) of

section 1063.1 provides, inter alia, that “‘[cjovered claims’ shall not include any obligations of the insolvent insurer arising out of any reinsurance contracts. . . .” CIGA claims that the exclusion provision of

section 1033, subdivision (a)(5) is evidence of the Legislature’s express intention that a reinsurer’s claim to the insolvent’s assets be ranked inferior to the claims of policyholders. Such a conclusion, however, is clear without reference to

section 1033, subdivision (a)(5). A reinsurer’s claim is not a claim of CIGA or of an association or an entity performing a similar function, or any otherwise uncovered claim asserted by a policyholder of the insolvent. To the extent the reinsurer submits a claim for a refund of unearned premiums, that claim is not subject to the exclusion.

Accordingly, the apparent exclusion of a reinsurer’s claim from subdivision (a)(5) effects no substantive change: that claim was already within the residual sixth rank—“All other claims.” It is true that the claims of policyholders are generally entitled to priority over the claims of reinsurers. Nonetheless, the Legislature has created an exception to the general rules of priority in situations in which the claimant and the insolvent have mutual debts; that exception is codified in

section 1031. We cannot ignore its broad mandate. In a related context, the Commissioner and Justice Kline’s dissent assert that because the doctrine of setoff is based on equitable principles, it should be denied when it would “harm the public.” As we explain, there is no evidence that the

section 1031 setoff “harms the public” and the cases on which Justice Kline and the Commissioner rely to support their arguments are distinguishable. First, in Federal Deposit Ins. Corp. v. Bank of America (9th Cir. 1983) 701 F.2d 831 (hereafter Federal Deposit), the court disapproved a setoff of a debt similar to the reinsurance debts under consideration in this case. In Federal Deposit, a Puerto Rican chartered bank issued a subordinated capital note to the Bank of America, which 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 setoff was permissible because the subscription note was expressly subordinated to general creditors of the insolvent. The setoff clause was invalid under Puerto Rican law but the transaction was nevertheless improperly approved by the Puerto Rican Secretary of the Treasury.

In deciding the case under Puerto Rican law, the Federal Deposit court observed that the portion of the subordinated capital agreement that provided there shall be no waiver of the right of setoff, violated the language of the Puerto Rican statute and regulations promulgated under it. The court stated, “ ‘capital notes shall be subject in right to the obligations with the depositors and other creditors of the issuing bank.’ ” (Federal Deposit, supra, 701 F.2d at p. 839, quoting P.R.

Laws Ann. tit. 7, § 111(o), original italics.) The court noted that the regulation clarifies this restriction, providing: “ ‘The capital notes shall be subordinate in all rights to the bank’s liabilities to its depositors, liabilities under bankers acceptances and letters of credit, and any other current obligations characteristic of banking operations.’ ” (Id. at pp. 839-840, quoting P.R.R. & Regs. tit. 4, No. 4, original italics.) The Court of Appeal herein rejected the reasoning of Federal Deposit because it concerned Puerto Rican law without any reference to the statutory right of setoff or to

section 1031, and because the setoff discussion focused on analogous stock subscription debts, which are not allowed in California. (§ 1031, subd. (c); Kaye v. Metz (1921) 186 Cal. 42, 49 [198 P. 1047].) We agree with the Court of Appeal that Federal Deposit is inapposite. The Commissioner and Justice Kline’s dissent also rely on Kruger v. Wells Fargo Bank (1974) 11 Cal.3d 352 [113 Cal.Rptr. 449, 521 P.2d 441, 65 A.L.R.3d 266], in which a bank exercised its setoff right under Code of Civil Procedure former

section 440 (cross-demands for money) against a depositor’s checking account that consisted of payments for unemployment compensation and state disability benefits, which had been deposited in the account and comprised the depositor’s only source of income. We held that the depositor’s unemployment and disability benefits were protected from setoff by the bank.

In so doing, we rejected the “assumption that a creditor’s right of setoff is absolute except when explicitly limited by statute.” (Kruger, supra, at p. 368.) We based our reasoning on the settled rule that a creditor is not allowed to set off a debt against exempt property, and that unemployment compensation and disability benefits are such property. (Ibid.) We concluded that the “legislative objective in providing unemployment compensation and disability benefits—to furnish the unemployed worker and his family with a stream of income to defray the cost of their subsistence— would obviously fail if creditors could seize that income and apply it to past debts.” (Id. at p. 370.) As the Court of Appeal observed, Kruger is materially distinguishable from the present matter. (See also Bluewater Ins.

Ltd. v. Balzano, supra, 823 P.2d 1365 [equitable setoff disallowed when proscribed by statute].) Kruger was decided on the basis of a public policy of protecting those who require welfare and disability benefits for their subsistence, and it was those benefits that were taken by setoff. (See also Jess v.

Herrmann (1979) 26 Cal.3d 131, 142 [161 Cal.Rptr. 87, 604 P.2d 208] [setoff of cross-judgments for comparative fault injuries disallowed on public policy grounds].) By contrast, in the present case, original insureds have no interest or right in a contract of reinsurance (§ 623), and no rights against the reinsurer (§ 922.2). The Commissioner and Justice Kline also assert the insolvency statutes were adopted to protect the interests of policyholders and the public in general and setoff would abrogate that protection. Such is not the case.

As Midland observed, “An important reason offset has been recognized as desirable is that it provides a form of security to insurers.” (Midland, supra, 590 N.E.2d at p. 1191.) Offsetting debts not only spreads risk but also acts as mutual security for performance. “Such security is especially important for smaller insurers; if the large firms could not count on the netting of balances to satisfy obligations, they would be more likely to exclude smaller or tottering firms—making new entry harder and precipitating failures of firms in difficulty. . . .

If . . . one member fails the other members’ exposure becomes the gross rather than the net obligation, then the mutual security of the offsetting debts is destroyed. [Reinsurance] become[s] less useful; the premium charged to bear risk will rise.” (Stamp v. Insurance Co. of North America, supra, 908 F.2d at p. 1380.) Finally, Justice Kline’s dissent charges us with favoring reinsurers over insureds in an economic contest over the limited resources in the estate of an insolvent insurance carrier. We plead not guilty.

The reinsurers prevail in this case because our Legislature has expressly and broadly recognized their right of setoff, along with the similar right of others who have dealt with insolvent carriers. Our conclusion in this respect is in accordance with those of the United States Court of Appeals for the Seventh Circuit and the New York Court of Appeals, both of which have construed statutory schemes similar to ours. In contrast, the dissent would employ what it labels equitable considerations to favor “invariably unsophisticated” policyholders over “highly sophisticated” reinsurers.

We do not perceive the issue to be one of relative levels of commercial sophistication. Nor is it one that calls for judicial favoritism of one group of claimants over another on supposed “equitable” grounds having nothing to do with the historic concerns of equity jurisprudence in this area. Instead, the issue is one calling for construction of a comprehensive broadly phrased statute permitting setoff and admitting no exception for reinsurance relationships.

The types of economic arguments made by the dissent are best addressed to the Legislature. “[W]e are unwilling to engage in complex economic regulation under the guise of judicial decisionmaking.” (Harris v. Capital Growth Investors XIV (1991) 52 Cal.3d 1142, 1168 [278 Cal.Rptr. 614, 805 P.2d 873].) III. Conclusion Once the Commissioner declared Mission insolvent, Prudential Reinsurance had a legal, statutory right to set off unearned premiums against the amount it owed Mission. The mere fact that a liquidator was appointed did not impair or affect that right.

Accordingly, we affirm the Court of Appeal’s judgment. Panelli, J., Arabian, J., and Baxter, J., concurred. Although the federal government has the power to regulate insurance as part of interstate commerce (U.S. v. Underwriters Assn. (1944) 322 U.S. 533 [88 L.Ed. 1440, 64 S.Ct. 1162]), Congress has declined to exercise that power, leaving insurance regulation to the states. (Ibid:, McCarran-Ferguson Act (1976) 15 U.S.C. §§ 1011-1015; see also 11 U.S.C. § 109 [exempting insurers from Bankruptcy Act].) As part of our state’s insurance regulatory scheme, our Legislature adopted

section 1031 in

Section 1033, subdivision (a), lists the priority of claims in liquidation in pertinent part as follows: “1. Expense of administration. “2. Unpaid charges due under the provisions of

Section 736. “3. Taxes due to the State of California. “4. Claims having preference by the laws of the United States and by laws of this state. “5. All claims of the California Insurance Guarantee Association . . . and associations or entities performing a similar function in other states, together with claims for refund of unearned premiums and all claims of policyholders of an insolvent insurer that are not covered claims. “6. All other claims. . . .” As discussed below, we conclude the statutory right of setoff is independent of

section 1033 priorities. Following oral argument, counsel for the Commissioner requested the court consider Foster v. Mutual Fire Ins. (1992)_Pa._[614 A.2d 1086] (hereafter Foster). We have read the case and conclude it is not persuasive. Contrary to

section 1031, the setoff statute at issue in Foster expressly prohibits reinsurer setoff of premium obligations. (Foster, supra, Pa. at p. _ [614 A.2d at p. 1096].) The Commissioner also cites Bluewater Ins. Ltd. v. Bolzano (Colo. 1992) 823 P.2d 1365 to support his argument that

section 922.2 defeats a reinsurer’s statutory right to offset. As the Midland court observed, however, Bluewater dealt with a common law right to offset. The Colorado Supreme Court distinguished the case from cases involving the statutory setoff rights which specifically allow offsets in insurance liquidation proceedings. (Midland, supra, 590 N.E.2d at p. 1192, fn. 4.) The Melco decision has questionable effect on the issues before us because in 1971, 13 years after Melco was decided, the Alabama Legislature enacted a statutory right of setoff substantially identical to that of

section 1031. (Ala. Ins. Code § 27-32-29 (1986).)