The Lumbermen's decision seems to have raised more questions than it has answered according to Ian McKenna and Sarra Zemmel

The decision of Colman J in Lumbermen's Mutual Casualty Company v Bovis Lend Lease Ltd has raised some interesting legal and practical issues as to the recoverability of losses under a global commutation agreement.

The facts

Bovis were insured under a construction, engineering and design professional liability policy and a commercial excess liability policy. Disputes arose under a building contract for the design and construction by Bovis of the Braehead Retail and Leisure Centre in Glasgow. The employer was Braehead Glasgow Ltd, a retail property developer. Proceedings were commenced in the Technology and Construction Court by Bovis for amounts it said were due under the building contract.

Bovis claimed £37,778,226, being the balance outstanding under the building contract after giving credit for amounts paid by Braehead. The amount claimed was made up of amounts due and payable in respect of common user, post novation design fees, an amount due in respect of preliminaries and loss and expense, a management fee and interest.

Braehead served a defence and counter-claim for mismanagement of the project by Bovis. Its counter-claim was made up of a claim for £49,524,189, being the difference between Bovis' claim under the contract and the amount which the works would have cost if the project had been properly managed, together with some additional items said to be caused by defective management. The claim for mismanagement was put in the alternative in the sum of £21,700,047, made up of eight specific instances of mismanagement plus additional costs on nine sub-contract packages together with professional and management fees. The counter-claim also included a claim for £46,685,178 in respect of defective and non-compliant work and a claim for LADs (Liquidated and Ascertained Damages) in the sum of £7,385,000. The insurers contended that some parts of the counter-claim were in respect of liabilities outside the scope of cover.

The litigation was settled by a global settlement agreement under which Braehead agreed to pay Bovis £15m in "full and final settlement" of all disputes under the building contract. However, the method of calculation of that global sum was not identified in the agreement and there was no indication in particular as to what extent Bovis' claim of £37,778,226 had been treated as validly in excess of the settlement sum of £15m or which, if any, of Braehead's counter-claims had been treated as valid. Further, although it seems to have been common ground that, at least in principle, the amount paid purely to settle the counter-claims would properly fall for indemnity, there was no reliable evidence of what portion of the global settlement amount should be attributed to settlement of the counter-claims.

Bovis claimed indemnity under its policies for losses it said were caused by its liability to Braehead in relation to its breaches of duty under the building contract in the sum of £19,222,722.40. In this respect, Bovis relied on the assessment of its solicitors, in an earlier report, estimating that Braehead had a valid counter-claim for £19,463,221. Insurers sought negative declaratory relief that they were not liable under the policies and the question of whether Bovis' liability to Braehead had been "ascertained by judgment, award or settlement" fell to be determined as a preliminary issue.

The decision

It has been established beyond doubt by the Court of Appeal in Post Office v Norwich Union Fire Insurance Society Ltd [1967] 2 AB 363 that the insured only acquires a right to sue insurers when its liability to a third party has been established so as to give rise to a right to indemnity. That liability must be ascertained and determined to exist, either by judgment of the court or by an award in arbitration or by agreement.

In Lumbermen's, Colman J found that this was an implied term of a contract of indemnity insurance. Further, he held that in the case of a settlement agreement, that which must be distinctly ascertained is the cost of the insured liability. The global settlement agreement entered into between Bovis and Braehead in respect of the parties' claims and counter-claims did not satisfy the requirement of "ascertainment" of loss since it did not impose on Bovis any identifiable loss in respect of any identifiable insured eventuality. Bovis could not rely on extrinsic evidence (such as its solicitors' assessment of the validity of Braehead's counter-claim) in order to prove its liability for the purposes of the insurance policies. Accordingly, Bovis had no cause of action against insurers for its losses. The decision does not appear to have been appealed.

Recoverability of commuted amounts

It is well established that the basic position, in terms of the recoverability of commuted amounts (where there is no "follow the settlements" clause in the reinsurance contract), is that the reinsured is obliged to prove actual liability for the commuted losses and that the settlement sum agreed by way of commutation was reasonable.

The decision in Lumbermen's has brought into sharp focus the necessity for reinsureds to ensure that they can rely on the commutation agreement as evidence that they have met the requirement of "ascertainment" of loss, which is a pre-condition of any cause of action against reinsurers to recover commuted amounts. It highlights the critical importance of allocation, within the body of any global commutation agreement, between policy years and re/insurance contracts and the need for precisely quantified losses.

However, there may still be problems with recovering certain categories of losses from reinsurers, even where these are identified clearly in the commutation agreement, for example IBNR or outstanding (reserved) claims. The nature of these future liabilities means that the reinsured may not always be able to prove actual liability to pay IBNR or reserved claims - at least until such time as those liabilities have crystallised.

The recovery of paid claims might also be prejudiced if they are not distinguished from IBNR or reserved claims within the commutation agreement as there must be a real risk that, by "mixing" the claims, the reinsured would fail to satisfy the requirement of "ascertainment" of losses and so find itself unable to recover even those losses for which it does have an actual liability.

Where the reinsured has the benefit of a clear-cut (unqualified) "follow the settlements" clause, it seems that it will be in a better position to oblige reinsurers to pay commuted amounts, although this would remain subject to the requirements laid down in ICA v Scor, namely, that the claim falls within the risks covered by the reinsurance and that in settling the claim, the reinsured had acted honestly and taken all proper and businesslike steps in making the settlement. In addition, the reinsured must always ensure that it has complied with any conditions incorporated into the "follow the settlements" clause, for example in relation to notification, co-operation or control. That said, even where the reinsured has the benefit of a "follow the settlements" clause, issues may arise as to whether certain categories of commuted losses (in particular future liabilities such as IBNR or reserved claims) are "settlements of losses" for the purposes of a "follow the settlements" clause. As always, much will turn on the exact wording of the clause in question.

Where to now?

The safest course for reinsureds must be to ensure that any global commutation agreement clearly identifies the losses being commuted and the insured eventuality giving rise to the reinsured's liability for such losses. Allocation between policy years and contracts is critical, as is the precise quantification - within the body of the commutation agreement - of all such losses. Reinsurers' prior written consent to the terms of any global commutation agreement, regardless of what the reinsurance contract provides, should also be sought.

In order to try to circumvent the potential for questions to be raised about a reinsured's liability for IBNR and reserved claims, it may be that a new generation of "follow the settlements" clauses begin to appear in reinsurance contracts, expressly providing for reinsurers' obligation to pay both actual and future liabilities.

In the absence of any "test" case, the likelihood of further disputes over the recoverability of commuted amounts seems almost certain.

- Ian McKenna is a partner and Sarra Zemmel an assistant solicitor at Mayer Brown Rowe & Maw.