UK: The reinsurance implications of Hurricane Katrina

Hurricane Katrina is widely being described as the costliest natural catastrophe in history with estimates of insured damage ranging between $35billion and $60 billion. It will undoubtedly have a huge impact on the global and London reinsurance markets. This article briefly considers some of the key reinsurance issues which we anticipate will arise out of Katrina including the extent to which insurers are able to bind their reinsurers to follow their settlements and the extent to which an insurer can aggregate Katrina claims.

Full Article

Hurricane Katrina is widely being described as the costliest natural catastrophe in history with estimates of insured damage ranging between $35billion and $60 billion. It will undoubtedly have a huge impact on the global and London reinsurance markets. This article briefly considers some of the key reinsurance issues which we anticipate will arise out of Katrina including the extent to which insurers are able to bind their reinsurers to follow their settlements and the extent to which an insurer can aggregate Katrina claims.

The major insurance claims are expected to result from damage to on shore and offshore energy installations in the Gulf of Mexico, property damage and business interruption. The starting point for these insurers (and exposed reinsurers) is going to be the cause of the underlying loss and relevant policy exclusions. Alternative causes will include the hurricane itself, the swell/tidal surge and (in the case of New Orleans) the flooding caused by the levee breaches (assuming neither of the latter are attributable to the hurricane). Some $10bn is said to turn on this issue – primarily because the typical US household policies in the areas affected by Katrina (specifically New Orleans) do not cover flood damage.

As only half of homeowners bought the required second (flood) policy through the National Flood Insurance Programme the rest will be wholly or partially uninsured unless the cause of their loss is found to be the hurricane. This has caused commentators to point to the potential risk of either legislative/judicial intervention to bring uninsured losses within existing policies along the lines seen in Florida following the damage caused by the four hurricanes of 2004¹. Other insurance issues are likely to include whether a grace period will be allowed for premiums to be paid on National Flood Insurance Programme policies and the computation of business interruption claims.

For obvious reasons, the reinsurance industry will be watching closely as the direct market resolves these issues. Very quickly thereafter, insurers will turn their attention to recovering from their reinsurers - domestic and international. We highlight below where we anticipate English law will be relevant.

The majority of the reinsurances written by London market reinsurers of the direct carriers in the homeowners/commercial property market will probably be subject to US arbitration provisions/US law. However, a high proportion of the retrocession protections purchased by London market (direct) reinsurers are likely to be governed English law. This is also likely to be true of the reinsurances of the London market participants on direct commercial property and energy risks. There will obviously be exceptions such as where the reinsurer benefits from group protections.

The legal (recovery) rights of these cedants under English law will depend on their ability to demonstrate liability for the underlying losses (and whether the claim has been paid pursuant to an award/judgment or by way of a settlement at a level purporting to reflect the insurer's potential legal liability will be fundamental to this issue) and the contractual provisions which govern the extent to which they have to prove that liability (i.e. whether there is a follow the settlements provision or not and if so, what kind). A concern reinsurers are likely to have in relation to Katrina claims is that settlements are not related to legal liability. This is particularly the case in the direct property (homeowners/commercial) market where the political/economic pressure to release insurance funds to rebuild is palpable and the possibility of a bad faith suit following a rejected claim is high. We consider briefly below the contractual provisions which will affect the ability of a reinsured to recover a settlement and the impact of the reinsurance being silent on this issue.

The extent to which cedants can recover from their reinsurers (and the number of deductibles payable) will also be dependent on whether the basis of aggregation accords with the policy wording.

The inclusion of some form of "follow the settlements" provision in a reinsurance is intended to speed up the process of recovering on settlement payments (such that a reinsured is not required to prove actual liability and quantum in order to recover).

Wordings vary. The broadest forms of wording are often found in facultative reinsurances (e.g. "Being a reinsurance of and warranted same…terms and conditions as and to follow the settlements of ..") and (where written) proportional treaties (e.g. "follow the fortunes"). In these cases, the interests of the insurers and reinsurers are broadly the same which means that (subject to what is said below) it will generally be easier for a reinsured to bind its reinsurers to its settlements. Non proportional treaties (where the terms of the reinsurance may not be the same as the underlying and the interests of the parties less aligned), commonly employ more onerous provisions giving the reinsurer more scope to reopen the underlying claim before payment (e.g. "All loss settlements by the reinsured shall be binding upon reinsurers provided that such settlements are within the terms and conditions of the original policies and within the terms and conditions of this policy..").

As a matter of general principle, under the terms of the language referred to immediately above, a reinsured will be able to require its reinsurer to follow its Katrina settlement provided two basic requirements are met. First, the claim must fall within the risks covered by the policy of reinsurance (and if the contract says so - the insurance also –see above) as a matter of law. Whilst there is a question mark over the proximate cause of the underlying loss ie. hurricane or flood, which will determine whether or not the reinsurance responds (say there is a flood exclusion), a reinsurer may look to resist payment under the follow provision on this basis. Second, the insurer must have acted honestly and taken all proper and businesslike steps in making the settlement. This may not be the case if on examination, it becomes apparent that an insurer bowed to intense political/commercial pressure and paid a claim where there was in fact a valid defence or paid too much. Whilst the above provides some guidance, close consideration must always be given to the actual wording used as this will ultimately govern the position on settlements in each case.

In the event that there is no follow provision in a reinsurance policy wording, it will be incumbent on the settling reinsured to provide a reinsurer with evidence sufficient to prove its legal liability and quantum and a reinsurer will in theory be able to take any points against an insurer that would have been available to it during its settlement negotiations with the original insured. Generally speaking, a court judgment/arbitration award will be sufficient proof of legal liability and quantum. Thus, if an (hurricane) insurer is sued in the US courts and unsuccessfully defends a claim on the basis that the proximate cause of the loss is flood (which is an excluded peril under the policy), the US court judgment in which the insurer is found to be liable (on the basis that the proximate cause of the loss was in fact the hurricane) is likely to be sufficient to establish liability for the purpose of recovering under a reinsurance governed by English law².

Reinsureds must also be careful to ensure that any settlement is drafted in a way that it demonstrates their liability and the amount of that liability has been properly ascertained.³

The second main issue for the reinsurance market is likely be the extent to which insurers can aggregate their Katrina claims so as to limit the number of deductibles payable. Catastrophe excess of loss policies usually incorporate hours clauses. Because the duration of Hurricane Katrina exceeded the usual 72 hours for a hurricane loss, insurers may seek to divide their Hurricane Katrina losses in to two or more loss occurrences (presumably paying two deductibles) if they have enough cover and their wording allows this. Further, if (as has been suggested by RMS in the US), the flooding of New Orleans was caused by the failure of the city's flood defences and not the hurricane itself, then losses deriving from the flood may constitute a separate loss occurrence (subject to a different period of cover – commonly 168 hours).

Hurricane Katrina losses might also be presented under a whole account reinsurance which does not contain an hours clause but retains the "event" based aggregation wording. Lord Mustill, a leading insurance judge, said in AXA v Field⁴ that "in ordinary speech, an event is something which happens at a particular time, at a particular place and in a particular way". Katrina hit the US at two different times (25^th/ 29^th August) at two different places (Florida/the Gulf Coast) and in two different ways (first as a category 1 then as a category 4 hurricane). This could give rise to questions as to whether there were two "events". As could the issue whether the New Orleans flooding (as caused by the breach of the levees) is a separate "event" (to Hurricane Katrina).

Different considerations will apply where a protection employs the broader "originating cause" wording (as opposed to "event") as the basis for aggregation or it includes language which allows the reinsured to be the sole judge of a loss event.

Hurricane Katrina is expected to have a far greater impact on the London reinsurance market than all four hurricanes of 2004 combined. While all members of the market will wish to play their crucial part in the reconstruction efforts following Katrina, they will need to bear in mind the issues rehearsed in this article, and carefully consider the language of their inward and outward policies, as part of that process.

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 19/09/2005.