UK: Reinsurance: Follow The Settlements

A recent case demonstrates that a follow settlements clause will not necessarily be sufficient to bind a reinsurer to a settlement, and the application of fundamental terms of the reinsurance, such as the period, may mean that a facultative reinsurance will not always respond to the same claims as the direct policy.

Lexington sought recovery from its facultative reinsurers of sums paid in settlement of environmental damages claims in the US. The underlying and reinsurance contracts were intended to be backtoback and the reinsurance contract contained a follow settlements provision. It was held that the reinsurers were not liable to indemnify Lexington because:

• The contracts were not entirely backtoback as they were governed by different applicable law.

• The reinsurers had only agreed to reinsure Lexington for the stated period of cover; although the US courts had construed the period of cover in the underlying contract to be wider the reinsurers had not agreed a period clause to be determined by a US law interpretation.

• The reinsurance only covered losses falling within the subject matter of the insurance and reinsurance, and did not cover liability assumed by Lexington to the underlying insured outside of that subject matter.

• To claim under the reinsurance the reinsured must show that the loss falls within (a) the scope of cover of the underlying insurance and (b) the scope of cover under the reinsurance contract.

The decision highlights that the existence of a follow settlements clause does not always mean that a facultative reinsurance will necessarily respond in the same way as the direct policy.

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A recent Commercial Court decision, Wasa International Insurance v Lexington Insurance Company, shows that it cannot be assumed that a facultative reinsurance contract is consistent with the original coverage despite the general back-to-back nature of the contracts and a follow settlements provision.

Lexington insured Alcoa for the risk of loss or damage to Alcoa’s property. The policy provided that the period of insurance was from 1 July 1977 until 1 July 1980 and liability was limited to US $20 million for physical loss or damage arising from one occurrence. Lexington entered into a facultative reinsurance contract with the reinsurers, Wasa and AGF, in respect of this underlying insurance for the same years and limit of liability.

As a result of environmental damage at various of Alcoa’s sites in the US, Alcoa began proceedings against numerous insurers, including Lexington, seeking a declaration of entitlement to coverage in respect of the remedial clean-up costs. Lexington’s insurance was construed as rendering Lexington jointly and severably liable for all these costs, irrespective of whether the damage was sustained before, during or after the inception date. The courts held that the policy wording: "Perils Insured: this policy insures against all physical loss of, or damage to, the insured property"; did not act to limit the period in which the loss or damage had to have occurred, and therefore physical loss or damage prior to the 1 July 1977 inception date was not excluded. Subsequently, Lexington entered into a settlement agreement with Alcoa on this basis and agreed to pay $103,140,500.00 in order to settle all past, present and future disputes under the insurance contract.

Lexington notified the reinsurers that they had settled and also made a claim for their legal costs incurred in defending Alcoa’s claims. Wasa and AGF issued proceedings seeking declarations that they were not liable under the reinsurance agreement.

The principle issue before the court was to determine whether the reinsurance contract required Wasa and AGF to indemnify Lexington in respect of the losses occurred between 1 July 1977 and 1 July 1980 or whether it also required them to indemnify Lexington for the damage that occurred before and after this three year period. It held that Wasa and AGF were not obliged to follow Lexington’s settlement with Alcoa.

In reaching its decision, the court discussed the general features of this type of arrangement and then considered these in light of the facts of the case.

The court considered that:

• A Full Reinsurance clause generally incorporates the original risk into the reinsurance contract, and both contracts become ‘back-to-back’. However in this instance, the contracts were not entirely back-to-back as they were governed by different applicable law.

• The stated period of cover in a policy is of fundamental importance and the reinsurers had only agreed to reinsure Lexington ‘during the continuance of the policy’ i.e. for the three year period as defined in the reinsurance policy (no earlier and no later). Even though the US courts had interpreted the insurance contract period of cover in relation to Lexington and Alcoa to be wider, the reinsurers had not agreed a period clause to be determined by a US law interpretation. Furthermore, the court stated how reinsurance contracts were distinct and independent contracts and terms within them should not be distorted or disregarded in order to make them fit with the original cover.

• Reinsurance is not liability insurance - the subject matter of the reinsurance was of Alcoa’s property, not of Lexington’s liability to Alcoa.

• A reinsurer is not obliged to indemnify the reassured unless the loss falls within both (a) the scope of the cover of the insurance contract; and (b) within the scope of cover created by the reinsurance contract. It is for the reassured to prove these matters and a follow settlements clause is an agreement on how the reassured can do this.
  To comply with (a), the reassured only needs to show that he acted honestly in making the settlement and that he took all proper and business like steps - Lexington complied with this first limb.
  The second hurdle (b) was not met by Lexington. The court held that the follow settlements clause and back-to-back nature of the insurance and reinsurance contracts did not displace the importance of the prescribed period of cover. Therefore (as discussed above), regardless of the US interpretation of the insurance contract period of cover, the reinsurers only agreed to reinsure Lexington for losses occurring ‘during the continuance of the policy’ i.e. the three year period under English law, and there was no evidence that the losses had actually occurred during that period.

• The court also held that Lexington’s defence costs in defending Alcoa’s claim did not fall under the reinsurance contract because the contract did not contain an express clause dealing with this; Lexington failed to prove an implied term could exist; and Lexington had not attempted to prove a universal practice in the London market in 1977.

Comment

This decision highlights how the existence of a follow settlements clause in a reinsurance contract does not always bind the reinsurer to the settlement and cannot be used as a mechanism to ensure that there is complete consistency in coverage. The case therefore also illustrates once again the English Courts’ reluctance to elevate the commercial pressure to oblige reinsurers to follow reinsureds’ fortunes over the strict interpretation of the language of the reinsurance contract.

Further reading: Wasa International Insurance v Lexington Insurance Company [2007] EWHC 896 (Comm)

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 10/05/2007.