John Butler looks at the issue of custom and practice in reinsurance.

Reinsurance is without doubt a truly international business and it must be said that this is nowhere more apparent than at gatherings such as the Rendezvous de Septembre in Monte Carlo. It almost goes without saying therefore that reinsurance practices are also largely international, although there are national and market differences and some of those, paradoxically enough, relate to the basic nature of reinsurance market practice or, as it should perhaps more accurately be described, usage.

The problem arises from the fact that although whether something is a market practice or not is a question of fact to be determined by the evidence, the consequences of establishing any such practice and the criteria which have to be satisfied in order to do so are matters which have to be decided in accordance with the applicable national law which varies from one jurisdiction to another.

Under English law the courts will imply terms into a contract or construe words in accordance with commercial practice or usage in the market concerned provided that it is satisfied not only that the alleged practice or usage was not contrary to the law but also that it was notorious, certain and reasonable.

In this particular context "notorious" is understood to mean that the practice was one that was so well established and was so universally used in the industry concerned that anyone engaged in the business should have known of it irrespective of whether he did or not.

Consequently the parties will be taken to have contracted with reference to the usage that will be taken to have been incorporated into the contract unless it is excluded.

There is no need to say much about certainty as it is fairly obvious that any alleged practice has to be one which is capable of being both identified and delimited with a fair degree of precision. As regards reasonableness, the alleged practice must not run counter to the tenor of the contract itself, so that for example, in North and South Trust Co v Berkley in 1971, the custom whereby a Lloyd's broker, in certain circumstances, would act for the underwriters as well as his principal, the insured, was held to be unreasonable because it purported to authorise the broker to do something which an agent is forbidden by law to do. That is to say, to accept instructions from a third party that were inconsistent with those he had received from his principal. In addition it may be noted that an alleged practice can only be incorporated where it does not conflict with or contradict any of the express or necessarily implied terms of a contract.

These principles were endorsed this year in the context of reinsurance by the House of Lords in Baker v Black Sea and Baltic, where Lord Lloyd cited with approval the test proposed in the Court of Appeal by Lord Justice Millett that in order to prove a market practice evidence was needed of a universal and acknowledged practice of the market for reinsurers to comply with the practice whether that was expressly provided for in the treaty or not; or (to put it another way) that it was well understood by underwriters that if it was not intended that the practice was to be followed, it had to be expressly excluded.

The question of the existence of a reinsurance market practice also came before the Ninth Circuit US Court of Appeals in National American Insurance Co of California v Certain Underwriters at Lloyd's London in 1996, where one of the issues was whether, if a facultative reinsurance agreement did not contain a "follow the settlement" clause, such a clause should be implied on the grounds that there was an established custom or usage in the reinsurance industry to that effect.

The underwriters had contended that in the absence of a "follow the settlements" clause, it was settled law that a reinsurer had the right to assert against the reinsurers such coverage defences as might have been available to the reinsured against the insured at the time of settlement and that the existence of such a rule precluded evidence of a custom or usage to the contrary. National American, on the other hand, had argued that it was the custom and usage of the reinsurance industry to imply such a clause: producing expert evidence that it was widely understood within the reinsurance industry at the time the certificates were issued that these clauses were a tacit part of every facultative reinsurance agreement.

The District Court, applying the law of California, had accepted this argument and granted summary judgment to National American and the Ninth Circuit Appeals Court had affirmed. However, the decision that, in effect, what was ultimately referred to as the "follow the settlements" doctrine, applied even where no such clause was contained in the reinsurance contract had provoked a considerable amount of dissent. The court had then proceeded to amend its opinion and in the amended version had relied exclusively on the alleged failure of underwriters to counter National American's expert testimony. The previous reference to case law in the original opinion, which had consisted of two decisions from other states and had, moreover, ignored all contrary decisions including, it may be noted, that of the California Supreme Court in Royal Insurance Co v Caledonian Insurance Co in 1920, was quietly abandoned.

In its final opinion the court accepted that the dictum of the California Supreme Court in Royal Insurance Co accurately represented the common law rule in California but declined to accept the underwriters' contention that this precluded evidence of a custom or usage to the contrary. The Court of Appeals justified this apparent departure from the principle that custom and usage cannot overcome a contrary rule of law on two grounds.

The first was that underwriters had been unable to point to a single California case where a court had applied this rule to preclude evidence of custom and usage contrary to common law rather than "positive" statutory law. In the Court of Appeal's opinion such a distinction was eminently rational because evidence of custom and usage should not be used to evade legislative enactment.

The second ground advanced, based on the California Commercial Code and two cases, was that the rule that custom or usage cannot overcome a contrary law was subject to the important qualification that it does not apply to law which may be excluded by agreement. That, in the court's opinion, was the nature of the rule of law in the case before it. At most, cases such as Royal Insurance Co only suggested the reinsurer did not have to follow a settlement in the absence of an agreement to the contrary.

Therefore, because Royal Insurance Co merely described what occurred when no express understanding existed, it did not preclude evidence of custom or usage to the contrary.

As California law would permit a "follow the settlements" clause to be implied into a reinsurance contract by a custom or usage and National American had presented evidence that such a custom or usage existed, which had not been contradicted, the District Court had implied such a clause and held that the underwriters "must honour the cedant's settlement of contested claims, unless those settlements were the product of fraud, collusion, bad faith or were ex gratia in nature."

However, as a result of taking a fresh look at the record the Court of Appeals discovered that in fact the underwriters had, "albeit obliquely", controverted National's evidence by offering expert testimony to the contrary and which meant that a genuine issue of material fact existed. The court decided that as there was a factual question as to whether a custom or usage to "follow the settlements" existed a trial was necessary on that issue.

In the event the parties settled, so that the question as to whether there was, as a matter of fact, a custom or usage implying a "follow the settlements" clause in facultative reinsurance agreements remains unresolved. however, it may be ventured that any conflict between the principle that evidence of custom and usage cannot overcome a contrary rule of law, and the suggested exception as regards law which only applies in the absence of agreement to the contrary falls away if the requirements for establishing a custom or usage are strictly adhered to.

So, for example, the citation made by the court from 25 Corpus Juris Secundum. Custom and Usages section 10 (1966), to support its contention that the principle that custom or usage applies with less force where the law derives not from statute but the common law states: "[O]bjections on the ground of contrariety to the general or common law is entitled to little weight where the custom or usage assailed embraces an entire business, and has been concurred in for a long time by all persons engaged therein."

In practice it is suggested that it would be difficult, if not impossible, to prove the latter requirements unless there was indeed a situation where the parties may be taken to have contracted with a view to being subjected to the custom or usage concerned.

John Butler is president of the International Association for Insurance Law (Association Internationale de Droit des Assurances -AIDA) and a consultant to Barlow Lyde & Gilbert, London. Tel: +44 (0) 171 782 8598. Fax: +44 (0) 171 782 8509.