UK: Reinsurance: Notification Of Loss/Claims Co-Operation Clauses

The Commercial Court has reiterated that "loss" in a notification clause means actual loss to the reinsured.

In a number of recent decisions the courts have considered issues relating to claims provisions in reinsurance contracts. In AIG v Faraday the court held:

• No loss was suffered by the reinsured unless an actual loss was a "proven fact".

• "Potential loss" is a difficult concept and certainty was needed in view of the "draconian consequences" of breach of a condition precedent.

• "Loss" is an essentially different term from "alleged", "claimed" or "potential" loss.

The decision marks a further move away from the decision in Lumberman’s v Bovis – to see our Law Now please click here. It is also a further demonstration of the courts’ tendency to construe claims notification and co-operation clauses narrowly – especially where the clause is a condition precedent to the reinsurers’ liability.

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In a number of recent decisions the courts have considered issues relating to claims provisions in reinsurance contracts. In AIG v Faraday the court held:

• No loss was suffered by the reinsured unless an actual loss was a "proven fact".

• "Potential loss" is a difficult concept and certainty was needed in view of the "draconian consequences" of breach of a condition precedent.

• "Loss" is an essentially different term from "alleged", "claimed" or "potential" loss.

The decision marks a further move away from the decision in Lumberman’s v Bovis – to see our Law Now please click here. It is also a further demonstration of the courts’ tendency to construe claims notification and co-operation clauses narrowly – especially where the clause is a condition precedent to the reinsurers’ liability.

For information on the Commercial Court’s recent decision on follow the settlements clauses click here.

In the recent reinsurance case of AIG Europe (Ireland) Ltd v Faraday Capital Ltd the Commercial Court examined the issue of how to construe and interpret common claims cooperation clauses. The decision has important implications for reinsurers seeking to ensure timely notification of losses.

Morison J also commented on the role of extrinsic evidence in the ascertainment of losses and liability. The decision appears to be another nail in the coffin of Colman J’s decision on the extrinsic evidence point in the Lumberman’s case.

AIG Ireland provided D&O cover to Smartforce, an Irish company providing e-learning courses and reference material for the IT industry. Faraday reinsured AIG Ireland. In September 2002 Smartforce merged with Skillsoft. On 19 November 2002 the management of the newly merged enterprise announced that they intended to restate the financial statements of Smartforce for the previous three years. After this announcement Smartforce’s share value fell.

On 25 November 2002 AIG prepared an internal loss notification document which noted the fall in value. Subsequently, the shareholders initiated various class actions in the US against Smartforce and some of its directors.

AIG posted a reserve on 23 February 2004 of US $7.5 million on advice of their counsel in anticipation of a possible settlement. At the beginning of March 2004 the courts ordered mediation and on 2 March 2004 AIG filed an internal Management Alert Memorandum that referred to the possibility of the claim against Smartforce exceeding the limits of their cover. Shortly thereafter AIG filed a mediation statement "AIG recognises that the insureds face significant potential exposure in connection with the underlying law suits". A Memorandum of Understanding was prepared between the parties at the mediation on 23 March 2004 and the class actions were settled for US $30 million on 25 March 2004. AIG notified Faraday of its loss on 19 April 2004 and, having paid Smartforce’s claim under its D & O policy for the full limit, sought recovery under its reinsurance.

The claim was paid by all reinsurers except Faraday.Faraday contended that AIG had breached the notification of loss/claims cooperation clause and as compliance with that clause was a condition precedent to liability Faraday was therefore not liable under the contract. The clause read as follows:

Faraday argued that:

• The losses were notified to them too late;

• When properly construed the clause obliged AIG to notify Faraday of circumstances that might give rise to a claim against Smartforce as well as the actual losses. Faraday argued that AIG had not done so "as soon as reasonably practicable" or " within 30 days" of AIG’s knowledge of the loss;

• Even were the clause only to cover actual losses AIG were aware of the losses when the shares fell in value;

• In any event the losses were not notified "as soon as reasonably practicable" even if they were notified within 30 days;

• The legal costs of the original shareholders and Smartforce were known " actual losses" and were also not notified in accordance with the claims cooperation clause.

AIG argued in response that it had given proper notice under the claims co-operation clause, because:

• The clause did not require notification of potential loss but only an actual loss;

• AIG had not been aware of any "actual loss" until the settlement in March 2004. Neither the notification dated 25 November 2002, the preliminary assessment made on 12 February 2004, nor the reserve posted on 23 February 2004 amounted to a proved loss;

• Although AIG knew that the shareholders and Smartforce had incurred attorney fees the legal costs were not a loss for the purposes of the claims cooperation clause.

Morison J first examined the claims cooperation/loss notification clause in question and remarked that this was a " standard clause" in common use. He referred to the case of Royal & Sun Alliance Plc v Dornoch (2005) which concerned the interpretation of a similar clause. The Court of Appeal in that case, examining the issue of whether loss had to be "alleged loss" or "actual loss" recognised that although it may be good business common sense to view loss as alleged loss, they would rely on the principle that a party would only be exempted from liability in reliance on a claims cooperation clause if the words of the clause were clear. The Court of Appeal held that a claimant did not suffer loss unless an actual loss was a proven fact.

Morison J, applying those principles to the facts in AIG v Faraday disagreed with Faraday’s submission that "loss" meant "potential or alleged". He further commented;

• In construing the clause the loss had to be the loss of the shareholders who were the claimants of the US class actions. No loss was suffered unless an actual loss was a "proven fact".

• There are inherent difficulties in the concept of a "potential loss" - would a mere possibility be enough or would there need to be a likelihood that actual loss would in fact happen? Certainty was required in this situation given the "Draconian consequences" if the clause was not complied with.

• The words "loss" or "losses" were essentially different from "alleged", "claimed" or "potential" losses.

Morison J held that on the facts of the case there was no loss known to AIG until at the earliest 23 March 2004, the date when the Memorandum of Understanding was agreed following the mediation. At that point a "might be loss" turned into an "actual quantifiable loss" for the purposes of the reinsurance. The fact that AIG had posted a reserve did not establish knowledge of a loss; it was merely a process by which insurance companies anticipated the possibility of a loss on a policy. The notification on 19 April 2004 therefore fell within 30 days of the actual loss arising, and the claims cooperation condition precedent had not been breached.

Morison J also confirmed that expenses incurred by the claimants in providing their claims did not fall within the meaning of the word "loss" in the claims co-operation clause as those costs were not sums which could be adjusted or settled by AIG or Faraday.

Finally, he addressed Faraday’s argument that the claims cooperation clause contained two conditions precedent to be fulfilled to advise "as soon as reasonably practicable" and to advise "within 30 days". He held that if this was the case the clause would be ambiguous and unfair and that if this had been the intention of the parties then it should have been spelled out. In any event in his view the notification was given as soon was reasonably practicable.

Morison J also took the opportunity to comment on Colman J’s decision in Lumberman’s Mutual Casualty v Bovis Lend Lease Limited (2005). In that case, which concerned disputes under a building contract and a subsequent global settlement, Colman J had found that liability to third party must be established or "ascertained" by judgment, award or agreement and that , the Court could only look at the terms of the settlement itself to determine whether liability was ascertained, and on could not consider extrinsic evidence.

This was a controversial finding and in the subsequent case of Enterprise Oil v Strand Insurance Company (2006) Aikens J, although not reaching any different finding on need for ascertainment, disagreed with Colman J on sources of evidence. He observed that Colman J’s findings would "lead to great commercial inconvenience and to artificial statements in judgments, awards and settlement agreements".

In the present case Morison J weighed in on Lumberman’s issue and sided with Aikens J’s position in Enterprise v Strand. He commented that: "I doubt that the decision [in Lumberman’s v Bovis] is right but it cannot, I think, apply to a reinsurance case where there is a follow the settlements clause… the decision is "controversial" and was doubted by Aikens J in Enterprise… In my judgment, Aikens J has correctly identified the flaw in Colman J's reasoning which led him to what is an instinctively surprising conclusion. He rejected the idea that extrinsic evidence could be called to explain the losses and to make the attribution to insured and uninsured items. I do not understand why this is so."

The decision on the loss notification point is a further demonstration of the courts’ tendency to construe claims cooperation clauses - especially those that operate as conditions precedent - fairly narrowly. To have any real bite, reinsurers need to ensure that such clauses are carefully drafted to include notification of potential losses as well as actual losses.

As regards the issue of extrinsic evidence in ascertainment of loss and liability, it should be borne in mind that although two Commercial Court judges have now criticised the Lumberman’s decision, Lumberman’s has not yet been overruled, and the Court of Appeal will need to address the issue before Lumberman’s can be dismissed. Pending a Court of Appeal decision, it is still prudent, where possible, for reinsureds to draft settlements to particularise and identify the basis of each head of liability or, better still, to obtain reinsurers’ agreement before any settlement.

Further reading: AIG Europe (Ireland) Limited v Faraday Capital Limited [2006] EWHC 2707

For information on the Commercial Court’s recent decision on follow the settlements clauses click here.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 12/03/2007.