UK: Court Of Appeal Upholds Market Expectation On Exhaustion Of Layers And Ordering Of Losses

Last Updated: 23 December 2011
Article by James Roberts and Chris Dunlop

In February 2011 we reported on the judgment of the English Commercial Court in Teal Assurance v WR Berkley & Aspen, a case which demonstrated the tensions that can arise in cases involving insurance programmes consisting of more than one layer of cover. In a ruling handed down on 15 December 2011, the Court of Appeal has revisited the issue, and in so doing brought clarity to the market by again finding in favour of WR Berkley and Aspen, represented by Clyde & Co.

At the heart of the case was excess layer language in standard market form (LSW055), but a major dispute nevertheless arose as to whether the top excess layer policy was triggered by incurred losses at a time when the underlying insurers had reserved in full in respect of other potential future losses but had not paid out their full limits.

A brief reminder of the facts

Teal is the captive insurer of Black & Veatch ("B&V"), a major international engineering company based in the USA. For the 2007/2008 policy period B&V had structured its professional liability insurance as follows:

  • Excess its each and every claim deductible, a self-insured retention ("SIR") of US$10m any one claim and US$20m in the aggregate, responding to worldwide claims.
  • Thereafter, a Primary Layer of US$5m any one claim and in the aggregate, responding to worldwide claims.
  • Above that, spread across three excess layers (all underwritten by Teal), a further US$55m worth of cover (any one claim and in the aggregate), each responding to worldwide claims and each reinsured.

B&V effectively therefore had US$60m worth of aggregate cover responding to worldwide claims, excess its SIR and its deductible, collectively referred to as the underlying tower.

Above the underlying tower was an additional layer also underwritten by Teal ("the Top and Drop Layer"), which provided cover of Ł10m (sterling) each and every claim with no aggregate limit, but which excluded US and Canadian claims ("American claims"). The Top and Drop Layer was reinsured by WRB and Aspen.

All of the relevant policies incorporated by reference the Primary Policy. The Primary Policy provided standard professional indemnity cover in respect of B&V's liabilities to third parties. By endorsement, the cover also provided the common extension for necessary costs and expenses incurred in rectifying design defects, i.e. cover for first party losses incurred in mitigation attempts.

Each of the excess layer policies within the tower and the Top and Drop Layer underwritten by Teal contained wording in common market form (referred to as "Clause 1") to the effect that: "Liability to pay under this Policy shall not attach unless and until the Underwriters of the Underlying Policy/ies shall have paid, or have admitted liability or have been held liable to pay, the full amount of their indemnity inclusive of costs and expenses."

The issue

The issue before the Court can be summarised by reference to a generic assumed example, which broadly reflects the factual scenario which led to the dispute.

B&V faced a major American claim in the policy period, which would necessitate ongoing and extensive remedial works (potentially in excess of US$200m). B&V also faced two Non-American claims, again involving ongoing remedial works, one of which involved losses of some US$10m, the other one of which involved losses which might ultimately be in the region of US$35m.

The question for B&V and Teal was whether they could present losses to the re/insurance programme regardless of the order and timing of the establishment and ascertainment of B&V's liability or of the incurring of loss by B&V. To put that in perspective:

  • On B&V/Teal's case, B&V could hold back incurred losses on the two Non-American claims until such time as the underlying tower had paid out on the future expected losses on the American claim, and then collect two total or near total losses under the Top and Drop Layer;
  • Whereas on WRB and Aspen's case, the incurred losses on the two non-American claims had to go in order and come out of the underlying tower before any future losses on the American claim – meaning that on the particular facts B&V was unlikely to be able to access the Top and Drop Layer to any significant extent and would have greater uninsured losses on the American claim.

The case at first instance

Teal issued declaratory proceedings against WRB and Aspen seeking a declaration of indemnity in respect of the two Non-American claims. WRB and Aspen denied indemnity, on the basis that the underlying tower had not yet paid out, and that the losses incurred on the two non- American claims should therefore fall to the underlying tower (which responds to worldwide claims). The parties agreed that this core issue of principle as to attachment would be heard as a preliminary issue.

Teal argued that the Clause 1 operated effectively as a primary insuring clause, such that the underlying tower could not be treated as exhausted until all underlying insurers either admit or have been held liable to pay the full amount of their indemnities. Effectively therefore Teal could decide to pay the American claim first (in the underlying tower), and then look to the Top and Drop Layer for the (deferred) Non-American claims.

WRB and Aspen argued that to treat Clause 1 in this manner was to give it unwarranted significance, given it was standard market excess layer attachment language. B&V's entitlement to indemnity, and thus Teal's liability to B&V, arose when B&V's liability was established and ascertained (for the purposes of third party cover), or when losses were incurred (for the purposes of first party losses). Thus Teal was already liable to B&V for the Non- American losses on the underlying policies, and these should be presented to the underlying reinsurers. Clause 1 simply created an additional precondition to payment, by emphasising that no insurer would actually be liable to make payment unless and until underlying insurers had paid.

On 28 January 2011, Mr Justice Andrew Smith of the Commercial Court found for WRB and Aspen, and so reiterated the principle of chronological ordering of ascertained losses for the purposes of exhaustion of primary and excess layers.

The Court of Appeal

The Court of Appeal has endorsed the decision of the Commercial Court, and so endorsed the market's understanding of the appropriate operation of Clause 1, and indeed of excess layer policies of this nature generally.

In particular, the Court took the view that Clause 1 had to be read in the context of the various excess layer policies, which included other terms which made clear the manner in which the policies were designed to "drop down" and replace the Primary Policy (and effectively thereafter operate "as primary") sequentially upon the exhaustion of the underlying policies. Clause 1 thus did no more than determine the inter-relationship between layers of cover, and act as a condition precedent to payment under a layer in question. It was irrelevant to the fundamental question of attachment.

In agreeing with the submissions put forward by WRB and Aspen, Longmore LJ stated: "There can, in my judgment, be little doubt that this is the commercial common sense of the top and drop policy. Any other conclusion would mean that Teal (which, as a matter of fact, are an associated company of [B&V], known in the insurance trade as a "captive") could determine when they (Teal) admitted liability further up the layer and could themselves organise the lower levels to pay American claims, leaving reinsurers to face non-American claims where those claims should otherwise have exhausted the tower. Such ability to manipulate liabilities is unlikely to have been the intention of the parties."

Longmore LJ concluded: "The fact is that the construction of the policies of insurance, for which [Teal] contends, does not lead to a sensible commercial result, while the reinsurers' construction (that the policies are exhausted in an orderly manner depending on the time when liability is established against [B&V]) does produce a commercially sensible outcome."

The potential dangers of such an approach not being correct were highlighted by Tomlinson LJ who warned that: "The anarchy which would ensue from [Teal's] approach can readily be imagined if once it is supposed that the first, second and third excess layers had been underwritten by different insurers."

Conclusions – and the future

The unanimous decision of the Court of Appeal (applicable to all classes of insurance, and to reinsurance as well as to direct covers) is to be welcomed as it upholds market expectations, reaffirming as it does the principle of chronological ordering of ascertained losses for the purposes of determining exhaustion of primary and successive excess layers. The Clause on which Teal's argument turned was an extremely common form of standard excess layer language, and had the Court of Appeal held otherwise then there was potential for significant effects to be felt in the market.

Parties to the insurance contract of course remain free to choose the language they wish and to depart from this principle of ordering of losses. It is therefore possible that in another case with different wording that the courts would not reach the same conclusion. Ensuring that policy wordings (including standard terms) are suitable for the particular programme as ever remains key.

Finally, Teal has already expressed its intention to seek leave to appeal to the Supreme Court, not only in relation to the appropriate interpretation of Clause 1, but also (even more fundamentally) on the question of when the liability of insurers under a policy is established.

Clyde & Co acted for the successful defendant reinsurers in this case.

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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James Roberts
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