UK: In Or Out, Incorporation Of Direct Policy Terms In Reinsurance Contracts

Last Updated: 8 January 2002

Article by Edward Mann and George Mortimer

First published November 2001

The commercial nature of proportional facultative reinsurance raises a strong presumption that the original cover and the reinsurance will be "back to back"; the reinsurance will respond when the direct policy does, unless there has been a separate or adopted non-disclosure, misrepresentation or breach of warranty by the reinsured, or a breach of claims control or other failure to comply with conditions specific to the reinsurance.

Conventionally, reinsurance contracts seek to ensure that they are "back to back" with the direct policy by including in the slip "subject to the same terms and conditions as original", or a similar provision, which the courts have interpreted as incorporating the direct policy terms as conditions of the reinsurance.

Professor Robert Merkin has argued that incorporation is an archaic concept which fails to recognise the modern understanding of reinsurance, which is that a reinsurer covers not the underlying risk, but the reinsured’s liability to his insured. However, the courts have continued to decide cases on the basis that direct policy terms were incorporated. A number of difficulties arise…

1. What happens where the original policy and the reinsurance are subject to different systems of law?

This will often be the case where a foreign insurer reinsures business into the London market, as happened in Vesta v Butcher 1 , the first modern English court decision on incorporation. In that case, it was conceded that a warranty in the Norwegian direct policy (that a 24 hour watch be kept over the insured fish farm) was incorporated as a term of the reinsurance (which was subject to English law), because the reinsurance was "warranted same terms and conditions". The original insured’s breach of this warranty had not caused the loss, and under Norwegian law, unlike English law, a breach of warranty could only bar a claim if it was causative. The warranty, as incorporated in the reinsurance and if interpreted in accordance with English law, would therefore bar a claim under the reinsurance, but the reinsureds remained liable under the direct policy.

The House of Lords’ reluctant solution was to accept incorporation of the warranty, but to hold that the back to back nature of the two contracts dictated that it had to be construed by reference to the intent of the parties that it should bear the same meaning in both contracts; the words of the warranty in the reinsurance should therefore be construed in their Norwegian sense with the result that the cedant could claim from reinsurers.

2. What happens if the incorporated term is inconsistent with an express term in the resinsurance?

This arose in Groupama v Catatambo 2 . The London market reinsured a marine policy issued by a Venezuelan insurer which included a warranty that classification of the vessels would be maintained. The reinsurance was stated to be "all terms, conditions, warranties … as original", but also included an express warranty that class would be maintained. As in Vesta, the local law of Venezuela only barred a claim for breach of warranty where the breach was causative. Following Vesta, the Court of Appeal held that the warranty in the direct policy was incorporated in the reinsurance, and would be given the same meaning as in the original policy. The reinsurance therefore included an incorporated warranty which, if interpreted according to Venezuelan law, did not bar a claim, and an express warranty, which, if construed under the English law of the reinsurance contract, did bar the claim.

To solve this problem the Court of Appeal extended the principle in Vesta and construed the express warranty in the reinsurance so that it was in line with the incorporated Venezuelan warranty. The back to back nature of the contracts prevailed over the evidence that the parties to the reinsurance had agreed an express warranty, presumably intending it to be given effect in English law.

3. Which clauses should be incorporated?

The courts will not take general words of incorporation as a licence to incorporate the terms of the direct policy wholesale. Whether a clause is incorporated may depend on its subject matter. For example, the courts decline to incorporate arbitration provisions from direct policy wordings, and in AIG v The Ethniki 3 the Court of Appeal refused to allow incorporation of a local jurisdiction clause because it did nothing to define the risk, and its terms were inappropriate to a dispute under the reinsurance.

This is because terms governing arbitration, jurisdiction and choice of law are all viewed by the courts as personal to the parties to the original policy and collateral to the main insuring agreement. For example in GAN v Tai Ping, the Court of Appeal refused to incorporate Taiwanese law into the reinsurance contract under a general incorporation clause.

The courts have been less consistent about other claims conditions. For example, in MMI v Sea Insurance Limited 4 , the court refused to incorporate notice of loss and claims control conditions into the reinsurance.

In contrast, in CNA v Companhia de Seguros Tranquilidade 5 , the Commercial Court considered each of a number of direct policy terms in turn, and held that it was possible to incorporate clauses governing notification and admission to liability, to fill gaps in the reinsurance. So that these terms would make sense in the reinsurance, the court "manipulated" their wording so that references to the "insured" would be read as "reinsured", and references to "insurers" as "reinsurers".

4. How do we know which clauses will be incorporated?

In the recent case of HIH v New Hampshire (see RPC INSURANCE August 2001), the English Commercial Court and the Court of Appeal considered film finance reinsurance contracts in which the reinsureds argued that "subject to all terms and conditions as original" was effective to incorporate a direct policy clause waiving non-disclosure and misrepresentation defences.

At first instance, the Mr Justice David Steel reviewed the previous cases and identified four broad criteria to identify clauses which could be incorporated:

    • is the clause "germane" to the reinsurance, ie is it material to the scope of the risk?
    • does it make sense in the context of the reinsurance, subject to "permissible" manipulation?
    • is it consistent with the express terms of the reinsurance - (although in Catatambo, as seen above, inconsistency did not prevent incorporation)?
    • is it otherwise apposite or appropriate for incorporation in the reinsurance?

The judge held that the waiver clause was relevant to the scope of the risk, could be manipulated to make sense in the context of the reinsurance, was consistent with the express terms of the reinsurance, and rejected an argument that it was inappropriate because the reinsurers could not rely on separate warranties given to the reinsureds by the film producers, and referred to in the clause.

Although the Court of Appeal accepted the four principles Steel J had identified, it applied them to come to a different result. Lord Justice Rix agreed that the clause was incorporated, but refused to manipulate its terms, because to do so would go beyond the presumed intention of incorporation which was to bring the two covers back to back, and because it would significantly modify the important common law duty on the reinsured to make a fair presentation to the reinsurer.

The effect of the waiver clause, incorporated in an unmanipulated form, was to clarify that reinsurers could not mount a defence based on non-disclosure by the reinsureds of material which had been the subject of non-disclosure by the original insured. Incorporation of the clause therefore did little more than acknowledge that the reinsureds were constrained by its presence in the direct policy, and that reinsurers had to follow that policy notwithstanding non-disclosure by the original insured. One might question whether incorporation was necessary at all if the reinsurance expressly followed the reinsureds’ settlements in any event.

5. Where does this leave us?

The 12 years since Vesta has seen a great deal of litigation focusing on the incorporation of terms in reinsurance contracts. Professor Merkin may be right to question whether incorporation is necessary, and the Court of Appeal’s approach in HIH -incorporating the waiver clause, but restricting its effect to confirmation of the follow the settlements basis on which most facultative reinsurance is written - may herald a more restrictive approach from the courts.

To avoid disputes over the incorporation of direct policy terms parties should ensure that the basis on which the reinsurance is provided is clear, and that matters such as notification and claims control, as well as applicable law and dispute resolution, are clearly specified in the slip. If the reinsurance is intended to be "back to back" it is vital that reinsurers are aware of, and have agreed the terms of the direct policy which the reinsured is to issue, and how it will be interpreted under local law, so that reinsurers’ potential liability to indemnify the reinsured is fully appreciated.

FOOTNOTES

1 [1989] 1 Lloyd’s Rep 331, HL

2 [2001] Lloyd’s Rep 112 141

3 [2000] 2 A11 ER S66

4 [1998] Lloyd’s Rep IR 421

5 [1999] Lloyd’s Rep IR 289

 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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