Aidan Christie QC writes about a legal judgment of great significance to the reinsurance industry
Open a standard legal textbook on reinsurance (as one does on a quiet evening in), and you will probably find a statement to the effect that, as regards proportional facultative reinsurance at any rate, there is a presumption that the contract of insurance and the contract of reinsurance are ‘back-to-back’. Broadly it means that liability under the reinsurance is co-extensive with liability under the insurance and this reflects the fact that in a proportional contract the reinsurer takes a proportion of the premium in return for a corresponding proportion of the risk.
But how far does this presumption extend? What happens if, on the face of things, there is a mismatch between the terms of the two contracts and the cover provided by the reinsurance appears to be more restrictive? Do the terms of the reinsurance trump the insurance? Or could this amount, as Lord Justice Mance once suggested, to the tail wagging the dog?
In the late 1980s, in Vesta v Butcher, the House of Lords held in very trenchant terms that a warranty in identical terms in a direct Norwegian policy and a Lloyd’s reinsurance must be construed to have the same effect in both polices because the reinsurance was manifestly intended to be back-to-back with the original insurance. The result was that reinsurers were not discharged from liability under the reinsurance because, by contrast with the position in English law, under Norwegian law a breach of warranty discharged the insurer only if was causative of the loss and on the facts that was not the case. Similarly in Groupama Navigation v Catatumbo in 2000 the English Court of Appeal held that a reinsurance placed in the London market on terms ‘as original’ was to be construed so that the scope and nature of the cover afforded by the reinsurance was the same as the cover afforded by the underlying Venezuelan policy such that a non-causative breach of warranty did not discharge reinsurers.
But what are the limits? In one of its final decisions in July of this year, before its metamorphosis into the Supreme Court, the Judicial Committee of the House of Lords sought to grapple with the issue. The facts of Lexington Insurance Company v AGF Insurance Limited (probably better known as Wasa v Lexington) were unusual and possibly quite extreme.
Lexington provided all risks DIC (difference in conditions) property damage insurance to a Pennsylvania company, Aluminium Company of America (Alcoa) and a Delaware subsidiary, NWA, for the period from 1 July 1977 to 1 July 1980. There was no express choice of law but the contract included a standard US service of suit clause whereby Lexington agreed, at the request of Alcoa, to submit to the jurisdiction of any court of competent jurisdiction within the US.
The reinsurance was described in the slip as a contributing facultative reinsurance. The period of the reinsurance was 36 months at 1 July 1977. The form was ‘all risks of physical loss or damage excluding fire and allied perils &/or as original’ and the interest was ‘all property of every kind and description … and/& as original’. The conditions helpfully included ‘Full R/I Clause No 1 amended’ but unhelpfully there was no clue as to what that clause might be. (No particular surprise there.) It seems to have been agreed that it was a reference to the Reinsurance Warranty Clause issued in 1943 by which the contract was stated to be a ‘reinsurance of and warranted same gross rate, terms and conditions as and to follow the settlements of the Company …’. The House of Lords said that it was not necessary to consider the effect of the full reinsurance clause as regards incorporation of the terms of the insurance (although one Judge resurrected the doubts expressed about its effect by Lord Griffiths in Vesta) because the various references to ‘&/or as original’ on any view incorporated the relevant insurance provisions relating to the subject matter and risks into the reinsurance. The reinsurance was placed on the London market and Wasa and AGF subscribed a 2½% line. It was common ground that the reinsurance was governed by English law.
In the early 1990s Alcoa and NWA were on the receiving end of various claims by the US Environmental Protection Agency in respect of the clean up costs of contamination caused by their activities, going back to the 1940s, at over 50 sites within and outside the US including the State of Washington. In 1992 Alcoa and NWA started proceedings in the State of Washington seeking an indemnity in respect of such costs from numerous insurers who had participated on various policies issued between 1956 and 1985, including Lexington for a ten year period between 1974 to 1984.
Certain test cases were selected for trial. At an early stage the Judge ruled that the law of Pennsylvania should apply to all issues of contractual interpretation under the policies. The basis of that ruling was later held to be crucial but there was no appeal from it at the time. Lexington may yet rue the day because lurking in the background, like Duncan at the feast, was the spectre of Keene. For Pennsylvania was one of those US states which had adopted the Keene triple trigger theory in relation to asbestos exposure and Lexington was soon to learn, courtesy of the Washington Supreme Court (over-ruling the trial judge), that it was liable for all losses which flowed from the property damage, not just damage which occurred during the three year period from 1977 to 1980 but also damage which occurred before the policy incepted and after it expired provided that some part manifested itself (whatever that means) during the period of cover.
So far, so bad, for Lexington at least. But it got worse because when Lexington presented its losses to its reinsurers, Wasa and AGF had the temerity to suggest that they had not actually agreed to reinsure Lexington for damage which occurred before their reinsurance came into effect. After all, they said (albeit they might have expressed it more elegantly), our reinsurance is governed by English law and surely it is a fairly well-established principle of English property insurance law that we are liable only for property damage occurring during the three year period of the reinsurance. That is what property insurance does. It insures property against risks during a stated period and the stated period is fundamental. No doubt, they said, the Washington Supreme Court was perfectly entitled to reach the conclusion which it did applying Pennsylvania law, but it cannot mean that we are liable to indemnify you against losses which on any reading of our reinsurance were never intended to be covered.
Lexington did not share that view. Neither, it has to be said, did a unanimous Court of Appeal which agreed that Lexington was entitled to recover all of its losses. They pointed to the fact that the reinsurance was proportional, that it was placed expressly to cover the original policy and that the language of the insurance and reinsurance were identical. The obvious intention was to protect Lexington in respect of the whole of the risk (subject to the retention). In other words the insurance and reinsurance were back-to-back. The period clause in English reinsurance should be read in the sense given to it by the Washington court just as the warranties in the English reinsurances in Vesta and Catatumbo had been interpreted by the English court to have the significance attributed to them under Norwegian and Venezuelan law respectively.
The House of Lords unanimously agreed with the reinsurers and held that on the particular facts there was no basis for construing the insurance and reinsurance as back-to-back. But it may have been a closer run thing than is immediately obvious. In the normal run of events, where a proportional reinsurance is written on terms as original, there is a very strong presumption that the reinsurance will respond in the same circumstances as the insurance. Commercially that is what everyone expects. But there are limits and, crucially, it was the unusual combination of two factors which tipped the scales in reinsurers’ favour.
First, once it was conceded that the reinsurance was governed by English law, effect had to be given to the period clause under English law. It was as fundamental a term of the contract as the definition of the risks and could not bear the meaning which the Washington Supreme Court gave to provision in the insurance. Secondly, and pace the Court of Appeal (i.e. politely and with all due respect to their erroneous views), unlike the warranty cases where the applicable law could have been identified and the substantive law ascertained when the contract was placed, in this case no one could possibly have predicted in 1977 that a US court would apply Pennsylvania law to determine disputes under the policy between Lexington and Alcoa. The Washington Court had applied Pennsylvania law on a blanket basis to a large number of claims essentially on pragmatic grounds and relying on factors which were extraneous to the contract between Lexington and Alcoa. That could never have been foreseen. Indeed it was fanciful to say that such a conclusion would have been reached by a US lawyer in 1977.
Now, it might have been different if the law governing the contract between Lexington and Alcoa had been identifiable at the outset in 1977. If it had been, it might not have mattered that US law had not by then developed in the way it subsequently did with Keene. When an insurer writes a policy, it is elementary that it has to take the risk that the law might change during the period of cover and that it will be held liable in a manner which could not have been foreseen when the contract was placed. The rationale is that such decisions are merely declaratory of the existing law. The House of Lords was reluctant to pursue this analysis but the speech of Lord Mance in particular suggests that, despite the fact that the period clause was fundamental, the case might not necessarily have been decided as it was if there had been an express choice of Pennsylvania law in the direct contract. The point may yet arise. As regards future business, as Lord Mance pointed out, insurers might be advised to ensure that insurance and reinsurance are subject to one and the same identifiable or predictable governing law. In more refined and technical terms, that should prevent the tail from wagging the dog.
This article was contributed by Aidan Christie QC of 4 Pump Court, Temple