UK: House Of Lords Reverses The Court Of Appeal In Wasa V. Lexington

Last Updated: 1 September 2009
Article by Anthony Menzies

The long-awaited decision of the House of Lords was handed down on 30 July 2009.

To understand the significance of this case, one needs to go back to the seminal decision in Vesta v. Butcher [1989]1 some 20 years earlier. In that case, a Norwegian insurer of a fish farm reinsured the risk in the London market on terms by which reinsurers followed the terms and conditions of the direct policy. The court held that the follow clause did not have the effect of importing the choice of law of the direct policy, Norwegian law, into the reinsurance. However, in applying the governing law of the reinsurance contract, that is English law, and as a matter of construction of the reinsurance contract, the clear intention was that the reinsurance be "back-to-back" with the underlying policy. In other words, if the governing law of the insurance policy (in this case, Norwegian law) imposed a liability on the reinsured to pay the claim, then the governing law of the reinsurance contract (English law) imposed upon the reinsurer an obligation to indemnify the reinsured in turn. At the time of contracting, reinsurers could see from the terms of the direct policy that any liabilities under it would be determined by reference to Norwegian law. At any time they could have reached for their Norwegian "legal dictionary", from which they would have been able to see exactly what it was they were agreeing to follow. Accordingly, reinsurers could not treat themselves as discharged from liability on account of the insured's non-causative breach of warranty, as such a remedy was unknown under Norwegian law.

That principle, which in Vesta v. Butcher survived two unsuccessful appeal attempts to the Court of Appeal and the House of Lords, has remained good ever since, and has been applied (arguably extended) in many subsequent cases.

The Commercial Court Decision

In April 2007, however, the Commercial Court distinguished the Vesta line of authorities in the decision of Wasa v. Lexington [2007]2. In this case, the underlying insurance, issued by Lexington, covered the risk of physical loss and damage occurring to property operated by the Aluminium Company of America (Alcoa) for a three year period, namely 1 July 1977 to 30 June 1980.

In the early 1990's, Alcoa was required by the US Environmental Protection Agency to clean up pollution that had accumulated at a number of its industrial sites over a 44 year period, from 1942 to 1986. Having expended the cost of that clean up operation, Alcoa then sought in turn to recover the cost from those insurers whose policies had been in place at the relevant time. There is, however, a long running debate in US jurisprudence about how such long-term damage or liabilities should be allocated between insurer interests. Some states apply a pro-rata basis of allocation (so a loss or liability of $100m accumulating over 10 years equates to a claim of $10m against each policy year). Others impose joint and several liability between the insurance periods (a development of the so-called "continuous" or "triple trigger" principle, which first emerged in the context of asbestosis claims) with the result that any one year's insurer may be sued for the full amount of the liability, in this case covering a period of more than 40 years. The latter concept is quite alien to English law.

In the event, Alcoa's claim against Lexington was determined by the Washington State Court, which determined the policy to be subject to Pennsylvania law. It held Lexington to be liable for the entire period of loss, on a triple trigger basis. Lexington paid the claim and in turn sought an indemnity under its facultative reinsurance.

The reinsurance was written in the London market. The slip described the Form and Interest as "as original", and the Period as "36 months [from] 1/7/77". It was common ground that the reinsurance was an English law contract. Relying upon Vesta and subsequent cases, however, Lexington argued that the reinsurance was intended to be back-to-back, and that reinsurers were therefore bound to indemnify in accordance with the decision of the US court on the underlying policy, however repugnant that decision may appear from an English legal perspective.

The trial Judge, Simon J. disagreed. Noting the Judgment of Hobhouse LJ in Municipal Mutual v. Sea Insurance [1998]3, namely that reinsurance is to be seen as distinct and independent from the underlying contract, the Judge's starting point was to look at the terms of the reinsurance contract, construed in accordance with its governing law (English law). If the loss objectively fell outside the period clause of the reinsurance, as construed under English law, there could be no indemnity, and that would be the end of the matter. The Judge added that it was in any case not obvious to the reinsurer that disputes under the policy would in fact be determined in the Washington State Court and/or in accordance with Pennsylvania law; neither were nominated expressly in the underlying policy. The matter might have gone before a different state court and/or by reference to a different state's law, with very different results. Moreover, in 1977 Pennsylvania law was still undeveloped in so far as concerns the question of allocation of long-term liabilities. At the time of entering into the contract the reinsurers could not have known which legal dictionary to reach for, and even if they had it would not have given them the answer. Accordingly, the Judge said, reinsurers must be taken to have contracted with the intention that such matters could only be determined by reference to English law, being the governing law of the reinsurance contract. Applying English law, there could be no liability for any losses other than those actually shown to have been incurred between 1977 and 1980.

The Court of Appeal Decision

The Commercial Court Judgment was overturned by the Court of Appeal in a decision handed down on 29 February 2008. The Judges in the Court of Appeal posed a different starting question: did the parties intend the period clause in the reinsurance to have the same meaning as that in the direct policy? Having concluded that they did, the reinsurers were bound by its legal effect, as determined by the Washington court. A contract of reinsurance was not a second contract on the same underlying subject matter; rather it was an agreement to indemnify the reinsured, Lexington, for its liability under the direct policy.

It was also irrelevant, said the Court of Appeal, that Pennsylvania law had not been expressly nominated as the governing law in the underlying policy; on the facts it was not unreasonable to suppose that Pennsylvania law would indeed be applicable, and it mattered not that Pennsylvania law had yet to crystallise its attitude to the whole question of long term liabilities by 1977. Ultimately, the law is what it is, whether it was revealed to be so by reported decisions before 1977, or subsequently. Indeed, even if it could be said that Pennsylvania law had actually changed between the date of the policy and the date of the claim, this was but a risk that insurers and reinsurers alike had agreed to accept. Accordingly, reinsurers were bound by the legal consequences of the contract contained in the direct policy, by reference to the governing law now found to be applicable to it, that is Pennsylvania law.

The House of Lords Decision

The House of Lords delivered its Judgment on 30 July 2009, unanimously reversing the decision of the Court of Appeal and reinstating the finding of the Commercial Court. The House of Lords held that the period clause in the reinsurance contract had to be given its ordinary meaning under English law, such that only loss and damage actually occurring during the specified three year period could be recovered. Accordingly, any claim paid, as here, merely on the basis of loss or damage spanning a period of 44 years, could not be recovered under the reinsurance.

Like the Commercial Court, the House of Lords was heavily influenced by the fact that the direct policy was silent as to its governing law. Contrary to the view of the Court of Appeal, it held that parties to the reinsurance contract could not have predicted, on the face of the direct policy, that Pennsylvania law would apply to it. Indeed, the decision of the Washington court in favour of Pennsylvania law had had little to do with this particular insurance contract at all; rather Pennsylvania was merely identified as the most common denominator across all of the policies spanning the relevant 44 period. It was "fanciful" to suppose that an American lawyer, asked in 1977 to identify the governing law of the Lexington policy in isolation, would have nominated Pennsylvania law. For its part, an English court would in fact have chosen the law of Massachusetts as being applicable. At any rate, at the time of the conclusion of the reinsurance contract there was "no identifiable legal dictionary... still less a Pennsylvania legal dictionary", and thus no basis for construing the contract of reinsurance "in a manner different from its ordinary meaning in the London insurance market". In this crucial respect, the case differed from the situation in Vesta v. Butcher.

This case was one with profound implications for the London and worldwide insurance markets. Following Vesta v. Butcher, and more recently Groupama v. Catatumbo in 20014, many practitioners in the market had come to treat reinsurance contracts such as these in practical terms in much the same way as liability insurance (an approach endorsed expressly by Lord Justice Sedley in the Court of Appeal, if not by Lord Justice Longmore). Thus, where the reinsured was found liable to pay the direct claim by any court of competent jurisdiction, the reinsurer would be obliged to indemnify in turn. This litigation arose because that approach yielded such an extreme result, although even then it is notable that only 2.5% of the subscribing reinsurance market was in dispute. While acknowledging that there is "much to be said for the view that in commercial reality reinsurance is liability insurance", the House of Lords has declined to embrace the idea, and has instead reaffirmed the traditional view. From the point of view of reinsureds, some careful re-drafting of policy wordings may be in order.

Footnotes

1.[1989] 2 AC 852

2.[2007] EWHC 896 (Com)

3. [1998] Lloyd's Rep IR 421

4.[2001] LRLR 142.

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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