The Taylor Wessing Insurance And Reinsurance Review Of 2009 (PART 1)

PROPERTY INSURANCE

When can an Insured's dishonesty vitiate a claim?

Direct Line Insurance Plc v. Fox [2009]¹?

Queen's Bench Division, 10 March 2009

Where an insured commits fraud in the pursuit of a policy claim he puts himself in breach of his duty of utmost good faith. The result generally is that he cannot recover for any of the claim in question, including any part of it unaffected by the fraud (Britton v. Royal Insurance Co (1866)²). The policy may also be avoided prospectively but (unlike fraud or misrepresentation at and before inception) such avoidance does not operate ab initio (Axa v. Gottleib [2005]³).

In the present case, a fire occurred at the insured's property, for which he pursued a claim. In addition to the duties that exist at common law, the policy contained an express provision that it would become void in the event of a fraudulent claim.

The insurer, Direct Line, accepted the claim and entered into a settlement agreement with the insured by which it would make an interim payment followed by a final VAT payment. The final VAT payment was subject to a condition precedent that the insured would supply supporting invoices from a contracting company (B). The interim payment was duly made, and subsequently the insured produced VAT invoices purportedly from B, even though B had not in fact carried out the work. When the authenticity of the invoices was queried, the insured simply retracted the VAT element of the claim.

The court held that the insured had acted dishonestly in sending the invoice to the insurer, as he knew that B had not done any work and therefore no VAT had been paid. However, it also found that the dishonesty had not been committed in furtherance of a claim under a policy so much as to satisfy a condition precedent appearing in the settlement agreement. The settlement agreement, though it related to an insurance claim, was not of itself a contract of insurance and thus not a contract of utmost good faith. Accordingly, the insured's dishonesty would not result in him having to repay to the insurer sums already paid. Furthermore, this position was unaffected by the express provision in the policy by which it would become void in the event of a fraudulent claim. Again, this could have only prospective effect, in line with the common law principle, and as such would not entail repayment of claims already settled.

Result: Judgment for the insured.

Meaning of the Insured's

"Wilful Act" Porter v. Zurich Insurance Co [2009]⁴

Queen's Bench Division, 5 March 2009

Whether in direct insurance policies or contracts of reinsurance, compliance with a claims notification and/or claims co-operation clause will often be expressed as a "condition precedent" to liability. Even where those precise words are not used, the same result will be achieved if the intention of the parties is clear (as in the recent case of Aspen & Ors v. Pectel [2008]⁵). Where a clause is found to operate as a condition precedent, breach of the clause will be fatal to the claim, whether or not the re/insurer has actually suffered loss as a result.

By contrast, where the clause is found not to operate on a condition precedent basis, mere breach will not be enough. That was the position in Thomas v. Zurich Insurance Co [2009], a case decided on 5 March 2009, in the Liverpool District Registry of the High Court.

The claim arose under a household property insurance. The policy excluded "any wilful or malicious act by a member of the family or by a person lawfully at or in the home", and it also contained a clause specifying the requirement to give notification of a claim "as soon as reasonably practicable" and thereafter variously to co-operate with insurers and to provide all information and evidence as may reasonably be required.

The insured suffered from a delusional disorder and alcoholism, and attempted to kill himself by setting fire to the house. Having set the fire, however, the insured then changed his mind and escaped unharmed, but the house was severely damaged and was rendered uninhabitable. It was boarded up, but was subsequently burgled on three occasions. Following presentation of a claim, adjusters were appointed to deal with the theft claims. Due to lack of co-operation from the insured, however, no meetings or inspections of the property took place, and no statements were taken.

With respect to the fire claim, the court noted the general rule of insurance law that an insured cannot normally recover the policy monies when he has intentionally brought about the event upon which the policy specifies the monies to be payable (Britton v. Royal Insurance Co (supra)). As a matter of construction of the policy, it is presumed that the insurers have not agreed to pay in those circumstances, although this presumption can be overturned by the particular terms of the policy. In this case, the policy expressly excluded a wilful act by the lawful occupant of the property, and for these purposes an act would be wilful unless it could be shown that the perpetrator was legally insane (i.e. so impaired that he did not know the nature and quality of the act he was doing or did not know that it was wrong). Having considered the medical evidence, the court concluded that this was not so in the insured's case. Accordingly, the fire claim failed.

As to the theft claims, the court agreed with insurers that the insured was in breach of the obligation to co-operate in relation to the loss. However, breach of itself would not be enough to defeat the claim, the relevant requirement falling short of a condition precedent. To reject the theft claims entirely, the insurer would have to show that, had it been able to investigate the claims, it would have been entitled to decline coverage for them, or that it was now impossible to investigate. Failing that, the policy claim could only be reduced by such actual loss proved to flow from the insured's breach, the precise amount of which would need to be proved at a separate quantum hearing.

Result: Judgment for the insurers on the fire claim. Theft Claims deferred to quantum hearing.

Fire protection and the "Material Change" clause

Ansari v. New India Assurance Ltd [2009]⁶

Court of Appeal, 18 February 2009

The Porter v. Zurich decision came shortly after Judgment on another property insurance policy claim, in Qayyum Ansari v. New India Assurance Ltd [2009], handed down by the Court of Appeal on 18 February 2009.

This case was an appeal by the insured against an earlier High Court decision dismissing his claim for fire damage to the insured property. The insured had stated on the proposal form that the property was protected by an automatic sprinkler system. Furthermore, the policy contained a standard "Change of Facts" clause providing that the insurance would cease to be in force upon any "material change in the facts" stated in the proposal form, unless the Insurer agreed in writing to continue the insurance.

A fire broke out in the property, causing considerable damage for which the insured claimed under the policy. It transpired that, at the time of the fire, the sprinkler system had not been working, and following investigation the court found that the system had in fact been turned off by the tenant, by closing the isolation valve at the junction with the main water supply and placing a filing cabinet against the control handle so as to prevent it being opened. The water supply to the system had been disconnected following the tenant's failure to pay water charges.

The court held that a statement in the proposal form that the premises were protected by a sprinkler system meant a properly functioning sprinkler system that was ready to operate in the event of a fire, and not merely that the system was capable of functioning. The insurers must be taken to understand that there might be occasions on which the sprinkler system would be turned off temporarily, for example, for maintenance or repairs. There was also the possibility that the system might be turned off for other reasons, but again only temporarily. What the insurers could not contemplate was that the system would be turned off indefinitely. The sprinkler was intended to provide constant protection against fire, and where a protection system of that kind was turned off for an indefinite period the result was to alter the nature of the subject matter of the insurance. The court held that this was precisely the sort of situation to which the Change of Facts provision was intended to apply.

The only remaining question, therefore, was whether the insured was actually aware of the actions of its tenant in isolating the system. The court found that the insured had visited the property regularly, and there was also evidence that he had advised the fire investigation officer that the sprinkler system had not been operational for some time. In the circumstances, it was clear that the insured had been aware of the notifiable change of facts. Accordingly, the claim failed.

Result: Judgment for the insurers.

BREACH OF WARRANTY

Construction of warranties and the Insured's knowledge

A C Ward & Sons Ltd v. Catlin (Five) Ltd & Ors [2009]⁷

Commercial Court, 3 December 2009

This case was the latest in a number of recent decisions concerning breach of warranty in insurance contracts.⁸ The claimant was a member of the Booker Group of companies, operating (amongst other things) a warehouse in West Thurrock, Essex. During the weekend of 17 and 18 March 2007, a quantity of cigarettes and alcohol was stolen from the warehouse by burglars who had cut through the first floor level of the building, leading them to a mezzanine level where the stock was stored.

The Claimant was insured by the Defendants under a "Multiline Commercial Combined Policy" of insurance ("the Policy") containing both a Protection and Maintenance Warranty ("the P&M Warranty") and a Burglar Alarm Maintenance Warranty ("the Alarm Warranty"). The P&M Warranty stipulated that:

The Alarm Warranty read as follows:

"It is warranted that:

(a) the premises containing the Insured property are fitted with the burglar alarm system stated in the Schedule, which has been approved by the Insurers and that no withdrawal, alteration or variation of the system, or any structural alteration which might affect the system shall be made without the consent of the Insurers,

(b) the burglar alarm system shall have been put into full and effective operation at all times when the insured's premises are closed for business, and at all other appropriate times, including when the said premises are left unattended,

(c) the burglar alarm system shall have been maintained in good order throughout the currency of this Insurance under a maintenance contract with a competent specialist alarm company who are approved by the Insurers...

All defects occurring in any protections must be promptly remedied."

Initially, the insurers sought summary judgment against the insured on the grounds of breach of the above warranties. The alarm system in place at the time of the theft was not fully operational, which insurers contended was enough on its own to defeat the claim. Although no specific burglar alarm had been stated in the schedule to the Policy, they argued that any burglar alarm or other manner of security protection installed at the warehouse, whether present at the time of inception or subsequently, was required to be in full and effective operation at all times when the warehouse was unattended, failing which the entire policy would be automatically discharged. This would also be true, argued insurers, even if the defective operation of the system was unknown to the insured and could not reasonably have been known to them. The requirement for compliance, on insurers' case, was strict.

In a judgment issued by the Commercial Court in December 2008, insurers' application for summary judgment was rejected, a decision affirmed by the Court of Appeal in September 2009. In giving its reasoning, the Court of Appeal described insurers' argument as "draconian"; it said that the insured had a real prospect of arguing successfully for what it described as "a more reasonable commercial meaning" of the warranties, in other words, that the "protections provided for the safety of the insured property" as referred to in the warranty were to be limited to those protections actually identified in the original proposal form, and similarly that the burglar alarm system referred to in the Alarm Warranty meant the system as specified in the Schedule (of which here there were none). The Court of Appeal was also attracted to the argument that breach of the warranties could only arise by reason of defects within the knowledge, or reasonably capable of being within the knowledge, of the insured and its agents.

Accordingly, these and other matters were referred back to the Commercial Court for trial on the merits, upon which the Commercial Court gave its judgment on 3 December 2009. Having heard all the evidence, the Commercial Court concluded that the P&M Warranty was not limited to the particular "protections" specified in the proposal form, nor was the Alarm Warranty confined to such alarm system as might have been identified in the Schedule. As a matter of commercial common sense, the warranties referred to whatever protections or alarms actually existed, whether identified in the policy documentation or not. However, the court added that the warranties could only relate to such facilities as existed at the time of inception. New or improved systems installed after inception would not be subject to the warranty.

As to knowledge, the Commercial Court adopted the view heralded by the Court of Appeal. It said that a breach of warranty will occur only in the event of a defect in the particular protection or burglar alarm system of which the insured was, or should reasonably have been, aware, and which it had then failed to remedy promptly. On the evidence, the Court rejected insurers' argument that the insured was aware of the defects. It also rejected the insurers' case that one of the insured's employees had in fact colluded in the theft.

On breach of warranty, therefore, insurers' case failed. Ultimately, however, the dispute was determined in favour of insurers on an entirely different ground, namely non-disclosure or misrepresentation. The decisive point, in the end, related to an endorsement that had initially been imposed as part of the policy terms, by which it was:

On the terms of the endorsement, the claim would not have been recoverable, since at the time of the theft the stolen goods were stored within a wire mesh cage located on the mezzanine floor. Prior to the theft, the underwriters had agreed to remove the endorsement and to allow cigarettes and alcohol to be stored in the cage upon an assurance that additional movement detectors had been installed in the mezzanine area, along with "vibration inertia detectors" (i.e. guardwire) on the walls and ceiling of the mezzanine. In fact, so the court found, there were no movement detectors additional to those already installed, and the guardwire had been installed in only two of the four walls of the cage. The statements were therefore incorrect and they amounted to misrepresentations which the court found to be material to insurers' decision to relax the endorsement.

Accordingly, the court held that insurers we entitled to avoid the agreement to waive the endorsement, with the effect that it became reinstated to the policy terms. The effect of this was to take the loss outside the terms of coverage.

Result: Judgment for the insurers.

PROPOSAL FORMS

Construction and status of proposal form questions

R&R Developments Ltd v. Axa Insurance UK Plc [2009]⁹

Chancery Division, 28 September 2009

This case was an appeal from a High Court Deputy Master. It concerned a claim under a "Commercial Combined and Contract Works" insurance policy taken out by the Claimant to protect itself against theft and damage at a small property development.

General Condition 1 stipulated that the policy would be voidable in the event of any misrepresentation, mis-description or non-disclosure in any material particular. The insured had been asked the following question in the proposal form: "Have you or any... directors either personally or in connection with any business in which they have been involved ... ever been declared bankrupt or are they the subject of any bankruptcy proceedings or any voluntary or mandatory insolvency". To this question, the answer "no" was given.

In fact, it transpired that one of the company's directors had been a director of company that was in administrative receivership, and was previously a director of a number of companies that had gone into liquidation. However, none of the directors had themselves been declared bankrupt or been subject to any personal bankruptcy proceedings.

Nevertheless, the insurer contended that it was entitled to avoid the policy, since the question was designed to elicit information not just as to the personal bankruptcy status of the directors but also that of any other companies of which any of them were or had been directors. At issue, therefore, was the proper construction of the question in the proposal form, and in particular how the court should resolve any ambiguity in the words used.

Upon review of the relevant authorities, the court concluded that the proposal form question was confined to the status of the insured company and that of the directors, each in their personal capacity. This was the literal construction of the words used and it also happened to make "good commercial sense". It was perfectly reasonable to ask the insured about the directors' personal position, whether arising from their personal affairs or from any businesses which they have been involved, without going further and asking about the position of the companies as well. While it might also have made good commercial sense for the insurer to ask questions about the claims and insurance history of other companies with which the directors had been involved, the fact is that they failed to do so by the words actually employed in the proposal form.

Furthermore, even if the Judge had taken the view that the question was ambiguous, he said he would still have held that the meaning contended for by the insured was a fair and reasonable meaning to be attributed to the question. Accordingly, applying the contra proferentem principle, he would still have found in the insureds' favour.

Result: Judgment for the insured.

MARINE INSURANCE

Inevitability and Inherent Vice: Loss of jack-up rig under tow

Global Process Systems Inc v. Syarikat Takaful Malaysia Berhad [2009]

Commercial Court, 31 March 2009

Court of Appeal, 17 December 2009

As Lord Birkenhead LC noted in the famous case of British & Foreign Marine Insurance v. Gaunt [1921], a policy on "all risks" terms cannot be held simply to cover all damage howsoever caused "for such damage as is inevitable from ordinary wear and tear ... is not within the policies". The principle is simply this: insurance covers risks, that is to say something that might or might not happen, and not certainties.

The point was developed further in Soya GmbH v. White [1982], concerning a claim for heat damage to a consignment of soya beans on a voyage from Indonesia to Antwerp. The court in that case drew a distinction between cargo shipped with greater than 15% moisture content, which on the expert evidence it said was bound to suffer heat damage during the intended voyage, and cargo shipped with between 13% and 15% moisture content, which it said "might or might not" result in such damage. In the former case, damage would be regarded as inevitable and thus irrecoverable in principle; in the latter case the damage was fortuitous but resulted from an inherent vice, that is to say the moisture present in the cargo at the time of shipment. In that particular case the claim succeeded because the policy expressly included such loss, by way of an extension covering "heat, sweat and spontaneous combustion".

Most recently, the point came up again in the case of Global Process Systems Inc v. Syarikat Takaful Malaysia Berhad. The claim concerned the loss of a jack-up rig being towed on a barge from Galveston to Malaysia. The jack-up rig design allows a working platform to be floated into position and jacked up on cylindrical legs, to suit the sea depth at the point of operation. Steel pins are engaged into the legs through pinholes spaced at six foot intervals and, to reduce stress at the corners of the pinholes, circular holes are incorporated at each corner roughly an inch and half in diameter. For the present tow, the rig was carried on a barge with its legs in place and elevated in the air above the deck.

The tow was interrupted mid way through the voyage, near Cape Town, where some cracking was found in the way of certain of the pinhole corners. Repairs were carried out and the voyage resumed, but soon after, three of the legs fell off into the sea.

The rig was insured as cargo under Institute Cargo Clauses (A), containing the standard exclusion in respect of loss or damage caused by "inherent vice or the nature of the subject matter insured".

Insurers argued that the loss was inevitable and as such there was a lack of the necessary fortuity. Alternatively, they relied upon the inherent vice exclusion. They argued that the legs were not capable of withstanding the normal incidents of the tow, as demonstrated by the fact that they failed in weather conditions that could reasonably have been expected on this voyage. For their part, the assured contended that the question of inevitability had to be judged subjectively; thus, they argued, a claim for inevitable loss would be recoverable unless it could be shown that the assured knew the loss to be inevitable when taking out the insurance. As to inherent vice, the assured contended that the true proximate cause was the failure to carry out adequate repairs in Cape Town.

In the Commercial Court, the trial Judge determined that the failure of the legs, though very probable, could not be said to be objectively "inevitable." Citing the British & Foreign case, the Judge noted that the onus of proving fortuity "represents a low hurdle for the assured", which in this case the assured had cleared. As such, the insurers' defence of lack of fortuity failed.

However, a loss could still be caused by inherent vice though not be inevitable. In appearing to apply the test described by Mr Justice More-Bick in Mayban General Insurance v. Alstom Power Plants [2004]¹⁰ the trial Judge noted that the legs had broken off despite the fact that the weather experienced was "within the range that could reasonably be contemplated". That was enough to lead to the conclusion that the cargo was incapable of withstanding the ordinary incidents of the voyage, and as such the cause was inherent vice.

That ruling was, however, reversed by Court of Appeal, in a Judgment handed down on 17 December 2009. Having reviewed the authorities and academic texts in some detail, the Court of Appeal came to the conclusion that the test for claims on a cargo policy should in principle be no different to that for hull policies. If the action of the sea is the immediate cause of the loss, which clearly was true here, a claim may still lie under the policy even though the conditions were within the range of "what could reasonably be anticipated". If, on the other hand, the cargo had been damaged by the motion of the vessel in weather that could be described as "perfect" or "favourable", then the obvious inference in most cases would be that any damage was indeed the result of inherent vice or the nature of the cargo.

In the present case, the wave conditions may well have been foreseeable but the Court of Appeal considered that they were not so benign at to create, on their own, an inference of inherent vice. On the evidence, metal fatigue was not the sole cause of the loss of the legs. Rather it was a "leg breaking wave" that had caused the starboard leg to break off, something that was "not bound to occur in the way it did on any normal voyage round the Cape". The loss of the starboard leg led to the others being at greater risk and so they, in turn, also broke off. Though with hindsight this may have been a "highly probable" chain of events that was not enough to render the proximate cause something other than the perils of the sea, a risk for which the assured was covered under the policy.

Result: Judgment for the assured.

REINSURANCE

Wasa v. Lexington: The Final Word

Lexington Insurance Co v. Wasa International Insurance Co Ltd & Anor [2009]¹¹

House of Lords, 30 July 2009

To understand the significance of this case, one needs to go back to the seminal decision in Vesta v. Butcher [1989]¹² some 20 years earlier. In that case, a Norwegian insurer of a fish farm reinsured the risk in the London market on terms by which reinsurers followed the terms and conditions of the direct policy. The court held that the follow clause did not have the effect of importing the choice of law of the direct policy, Norwegian law, into the reinsurance. However, in applying the governing law of the reinsurance contract, that is English law, and as a matter of construction of the reinsurance contract, the clear intention was that the reinsurance be "back-to-back" with the underlying policy. In other words, if the governing law of the insurance policy (in this case, Norwegian law) imposed a liability on the reinsured to pay the claim, then the governing law of the reinsurance contract (English law) imposed upon the reinsurer an obligation to indemnify the reinsured in turn. At the time of contracting, reinsurers could see from the terms of the direct policy that any liabilities under it would be determined by reference to Norwegian law. At any time they could have reached for their Norwegian "legal dictionary", from which they would have been able to see exactly what it was they were agreeing to follow. Accordingly, reinsurers could not treat themselves as discharged from liability on account of the insured's non-causative breach of warranty, as such a remedy was unknown under Norwegian law.

That principle, which in Vesta v. Butcher survived two unsuccessful appeal attempts to the Court of Appeal and the House of Lords, has remained good ever since, and has been applied (arguably extended) in many subsequent cases.

The Commercial Court Decision

In April 2007, however, the Commercial Court distinguished the Vesta line of authorities in the decision of Wasa v. Lexington [2007]¹³. In this case, the underlying insurance, issued by Lexington, covered the risk of physical loss and damage occurring to property operated by the Aluminium Company of America (Alcoa) for a three year period, namely 1 July 1977 to 30 June 1980.

In the early 1990s, Alcoa was required by the US Environmental Protection Agency to clean up pollution that had accumulated at a number of its industrial sites over a 44 year period, from 1942 to 1986. Having expended the cost of that clean up operation, Alcoa then sought in turn to recover the cost from those insurers whose policies had been in place at the relevant time. There is, however, a long running debate in US jurisprudence about how such long-term damage or liabilities should be allocated between insurer interests. Some states apply a pro-rata basis of allocation (so a loss or liability of $100m accumulating over 10 years equates to a claim of $10m against each policy year). Others impose joint and several liability between the insurance periods (a development of the so-called "continuous" or "triple trigger" principle, which first emerged in the context of asbestosis claims) with the result that any one year's insurer may be sued for the full amount of the liability, in this case covering a period of more than 40 years. The latter concept is quite alien to English law.

In the event, Alcoa's claim against Lexington was determined by the Washington State Court, which determined the policy to be subject to Pennsylvania law. It held Lexington to be liable for the entire period of loss, on a triple trigger basis. Lexington paid the claim and in turn sought an indemnity under its facultative reinsurance.

The reinsurance was written in the London market. The slip described the Form and Interest as "as original", and the Period as "36 months [from] 1/7/77". It was common ground that the reinsurance was an English law contract. Relying upon Vesta and subsequent cases. However, Lexington argued that the reinsurance was intended to be back-to-back, and that reinsurers were therefore bound to indemnify in accordance with the decision of the US court on the underlying policy, however repugnant that decision may appear from an English legal perspective.

The trial Judge, Simon J. disagreed. Noting the Judgment of Hobhouse LJ in Municipal Mutual v. Sea Insurance [1998]¹⁴, namely that reinsurance is to be seen as distinct and independent from the underlying contract, the Judge's starting point was to look at the terms of the reinsurance contract, construed in accordance with its governing law (English law). If the loss objectively fell outside the period clause of the reinsurance, as construed under English law, there could be no indemnity, and that would be the end of the matter. The Judge added that it was in any case not obvious to the reinsurer that disputes under the policy would in fact be determined in the Washington State Court and/or in accordance with Pennsylvania law; neither were nominated expressly in the underlying policy. The matter might have gone before a different state court and/or by reference to a different state's law, with very different results. Moreover, in 1977 Pennsylvania law was still undeveloped in so far as concerns the question of allocation of long-term liabilities. At the time of entering into the contract the reinsurers could not have known which legal dictionary to reach for, and even if they had it would not have given them the answer. Accordingly, the Judge said, reinsurers must be taken to have contracted with the intention that such matters could only be determined by reference to English law, being the governing law of the reinsurance contract. Applying English law, there could be no liability for any losses other than those actually shown to have been incurred between 1977 and 1980.

The Court of Appeal Decision

The Commercial Court Judgment was overturned by the Court of Appeal in a decision handed down on 29 February 2008. The Judges in the Court of Appeal posed a different starting question: did the parties intend the period clause in the reinsurance to have the same meaning as that in the direct policy? Having concluded that they did, the reinsurers were bound by its legal effect, as determined by the Washington court. A contract of reinsurance was not a second contract on the same underlying subject matter; rather it was an agreement to indemnify the reinsured, Lexington, for its liability under the direct policy.

It was also irrelevant, said the Court of Appeal, that Pennsylvania law had not been expressly nominated as the governing law in the underlying policy; on the facts it was not unreasonable to suppose that Pennsylvania law would indeed be applicable, and it mattered not that Pennsylvania law had yet to crystallise its attitude to the whole question of long term liabilities by 1977. Ultimately, the law is what it is, whether it was revealed to be so by reported decisions before 1977, or subsequently. Indeed, even if it could be said that Pennsylvania law had actually changed between the date of the policy and the date of the claim, this was but a risk that insurers and reinsurers alike had agreed to accept. Accordingly, reinsurers were bound by the legal consequences of the contract contained in the direct policy, by reference to the governing law now found to be applicable to it, that is Pennsylvania law.

The House of Lords Decision

The House of Lords delivered its Judgment on 30 July 2009, unanimously reversing the decision of the Court of Appeal and reinstating the finding of the Commercial Court. The House of Lords held that the period clause in the reinsurance contract had to be given its ordinary meaning under English law, such that only loss and damage actually occurring during the specified three year period could be recovered. Accordingly, any claim paid, as here, merely on the basis of loss or damage spanning a period of 44 years, could not be recovered under the reinsurance.

Like the Commercial Court, the House of Lords was heavily influenced by the fact that the direct policy was silent as to its governing law. Contrary to the view of the Court of Appeal, it held that parties to the reinsurance contract could not have predicted, on the face of the direct policy, that Pennsylvania law would apply to it. Indeed, the decision of the Washington court in favour of Pennsylvania law had had little to do with this particular insurance contract at all; rather Pennsylvania was merely identified as the most common denominator across all of the policies spanning the relevant 44 period. It was "fanciful" to suppose that an American lawyer, asked in 1977 to identify the governing law of the Lexington policy in isolation, would have nominated Pennsylvania law. For its part, an English court would in fact have chosen the law of Massachusetts as being applicable. At any rate, at the time of the conclusion of the reinsurance contract there was "no identifiable legal dictionary... still less a Pennsylvania legal dictionary", and thus no basis for construing the contract of reinsurance "in a manner different from its ordinary meaning in the London insurance market". In this crucial respect, the case differed from the situation in Vesta v. Butcher.

This case is one with profound implications for the London and worldwide insurance markets. Following Vesta v. Butcher, and more recently Groupama v. Catatumbo [2001]¹⁵, many practitioners in the market had come to treat reinsurance contracts such as these in practical terms in much the same way as liability insurance (an approach endorsed expressly by Lord Justice Sedley in the Court of Appeal, if not by Lord Justice Longmore). Thus, where the reinsured was found liable to pay the direct claim by any court of competent jurisdiction, the reinsurer would be obliged to indemnify in turn. This litigation arose because that approach yielded such an extreme result, although even then it is notable that only 2.5% of the subscribing reinsurance market took the dispute to litigation. While acknowledging that there is "much to be said for the view that in commercial reality reinsurance is liability insurance", the House of Lords declined to embrace the idea, and has instead reaffirmed the traditional view. From the point of view of reinsureds, some careful re-drafting of reinsurance contract wordings may be in order.

Result: Judgment for reinsurers.

Actuarial modelling as proof of loss

Equitas Ltd v. R&Q Reinsurance Co (UK) Ltd

Equitas Ltd v. Ace European Group Ltd [2009]

Commercial Court, 11 November 2009

These actions concerned claims by Equitas (as assignee of the rights of 1992 and prior year Lloyd's underwriters) under various contracts of excess of loss retrocession written by the Defendants within the London Market Excess of Loss ("LMX") spiral.

The background to the dispute went back some 20 years, to the grounding of the "Exxon Valdez" in March 1989, and to the Iraqi invasion of Kuwait in August 1990, leading to the seizure of 15 aircraft belonging to Kuwait Airways, together with spares for the fleet, and the subsequent loss of a BA aircraft. The latter aircraft was destroyed, not in the course of the initial invasion, but rather during the later liberation of Kuwait by coalition forces in February 1991.

Initially, the Kuwait Airways and BA losses were presented to and paid by insurers and reinsurers within the LMX spiral as one event, with the date of loss being the date of the Iraqi invasion. The initial losses involved sums of approximately US$300 million, all of which were claimed and paid on an aggregated basis under a single cat code. The market continued to operate on this basis in relation to inwards and outwards claims for a period of about five years. However, from 1996 onwards the correctness of this approach came to be challenged by certain retrocessionnaires within the LMX spiral, at which point various participants stopped paying claims. The matter was eventually settled by the court in Scott v. Copenhagen Re Co (UK) Ltd [2003]¹⁶, in which the Court of Appeal held that the Kuwait Airways and BA losses in fact ought not to have been aggregated, as they arose from separate events.

In the meantime, matters were also unravelling in relation to the "Exxon Valdez" loss. Various losses having been paid by the market in the years immediately following the disaster, certain reinsurers began to challenge liability in the mid to late 1990s, most significantly in relation to a settlement of losses presented under Exxon's Global Corporate Excess ("GCE") Policy. Again the matters in dispute went to litigation, leading to a judgment of the Court of Appeal in Commercial Union v. NRG [1998]¹⁷ and subsequently in King v. Brandywine Reinsurance Co. [2005]¹⁸. The net effect was that significant sums paid under the GCE Policy were subsequently found by the court not to be recoverable, and so ought not to have been included amongst the losses entering the LMX spiral.

It was common ground in the present litigation that the LMX spiral was incapable of being reconstructed retrospectively, stripping out the irrecoverable or wrongly aggregated sums attributable to Exxon Valdez and the Iraq invasion respectively; the nature of the spiral was simply too complex to achieve that. So what was to be done?

Equitas sought to employ actuarial modelling techniques, to achieve what it believed to be the best approximation of the position as it would have been in the absence of the erroneous claims. In essence, the models employed discounts intended to eradicate the exaggeration in the UNLs. The Defendants for their part contended that this was simply not good enough; they referred in particular to the terms of the Loss Settlements Clause in the contracts of retrocession, by which settlements were to be binding upon them but only:

Relying upon the decision of the House of Lords in Hill v. Mercantile & General Reinsurance Co Plc [1996]¹⁹, they argued that the onus lay with Equitas actually to prove that the sums claimed were properly due, contract by contract, and by reference to the various attachment points and limits of each of the relevant reinsured syndicates. Since this could not now be done, there could be no liability.

Having reviewed the authorities, the Commercial Court found for Equitas. The Judge concluded that, while it was indeed a requirement of law that Equitas must satisfy both elements of the Loss Settlements Clause, a position made clear by the House of Lords in Hill v. M&G, it was not a requirement of law that this could only be done by actually proving each loss at each stage of the LMX spiral. Precisely how Equitas discharged its burden of proof was a matter of evidence, and the evidential standard it had to clear was the balance of probabilities. While accepting that actuarial modelling was complex and imperfect, and that in utilising upon such evidence it was "plainly necessary to proceed with caution", the Judge nevertheless held that this was still "preferable to leaving the losses to lie crudely where they fall". Having analysed the models used in some detail, he concluded that they offered an "acceptable, soundly based route to establishing the properly recoverable minimum losses sustained by the syndicates, having regard to the applicable burden and standard of proof". Accordingly, Equitas was entitled to declaratory relief in its favour.

Result: Judgement for the retrocecedants.

EXCESS LIABILITY

Difference in conditions and "Drop Down"

Flexsys America LP v. XL Insurance Co Ltd [2009]²⁰

Commercial Court, 20 May 2009

The US claimant, Flexsys, was a manufacturer and distributor of various chemicals used in the rubber industry. It was insured for public and products liability under a local policy issued in Ohio by XL Select Insurance ("Select"). The local policy included coverage for "Personal and Advertising Injury", defined to include injury arising out of any publication of material which slanders or libels a person or organisation, or which disparages their products. The policy imposed a general aggregate $1m limit of liability for personal or advertising injury, and a sub-limit, again of $1m, in respect of such injury "sustained by any one person or organisation".

Above the prescribed local policy limits, Flexsys had recourse to a master policy protecting its Belgian parent company, Flexsys Holdings BV, and all group entities. The master policy was issued by the Defendant (XL) and was subject to a limit of indemnity of $25m any one event, and a sub-limit of $25m for product liability. The master policy also covered public and products liability in similar terms throughout, save that "Advertising Injury" appeared by way of a policy extension, and it was defined more narrowly than in the local policy, applying only to liability arising from the advertising of the insured's own products or services.

In April 2006, Flexsys and others were sued in California by Korea Kumo Petrochemical Company ("KKPC") alleging an unlawful conspiracy to monopolise the US market and to prevent KKPC competing against it. The litigation was successfully resisted by Flexsys at every stage, but in doing so it incurred some $2m in irrecoverable defence costs, for which it sought a policy indemnity. For its part, Select denied that the claim against Flexsys was one falling within the insuring clause of the local policy, but nevertheless entered into a without prejudice settlement of the policy claim, equivalent to the applicable limit of $1m.

Flexsys then sought to recover the balance of $1m from XL under the master policy, and at the same time it asked the English court for a declaration that XL must respond to any further potential liability to KKPC, up to its policy limit of $25m.

It was common ground that KKPC's claim against Flexsys fell outside the narrower definition of "Advertising Injury" as it appeared in the master policy. However, Flexsys sought to rely upon a drop down clause in the master policy, in the following form:

Flexsys argued that the master policy was obliged to drop down in accordance with the clause, and in doing so to assume all the terms and conditions of the local policy, even where these were in conflict with the master. So long as actual liability under the local policy could be shown, Flexsys argued, the master policy must follow.

The court held, firstly, that the reference to "partial exhaustion" in the first sentence of the drop down clause was designed to deal with the situation where the aggregate limit had been partially eroded by earlier claims. So, for example, two prior claims of $400,000 each would leave only $200,000 remaining on the underlying policy. In the event of a third loss, of say $10m, would the insured be expected to have suffered $1m (i.e. the local policy limit), of which $800,000 would be uninsured loss, before the master policy became engaged? The court held not. The concept of partial exhaustion was intended to bridge that gap.

However, the court also found that, whether the master policy became engaged upon partial or total exhaustion of the local cover, the fact remained that it could only be liable in accordance with its own terms and conditions. In this case, the wording of the master policy dealt specifically with the case where the insuring terms of the master were broader than those in the local policy (the broader terms would prevail) but it said nothing about the reverse situation, as here. It was to be inferred that, ordinarily, the master policy would not respond in circumstances where a claim, although within the scope of the local policy, was outside the terms of the master.

In the present case, it having been accepted that the claim against Flexsys fell outside the definition of "Advertising Injury" in the master policy, the court held that the second sentence of the drop down clause did not change the position. The clause was not intended to bring about a "wholesale expansion of the cover" afforded by the master policy. To hold otherwise would be to render otiose the limitations appearing in the master policy, since the master policy would only ever be engaged when it was required to "drop down".

Having reached its decision in favour of XL on the meaning of the drop down provision, it became irrelevant whether KKPC's claim was one which actually fell within the wider terms of the local policy. Nevertheless, the court went on to consider the position as a matter of its own governing law (the law of Ohio) and concluded that there was in any event no such liability under the local policy.

Result: Judgment for the insurer.

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