7/23/2011

Wasa International Insurance Company Limited v. Lexington Insurance Company Limited and others

Wasa International Insurance Company Limited v. Lexington Insurance Company Limited and others: how “back to back” is “back to back”?

The recent decision of Mr. Justice Simon in Wasa International Insurance Company Limited v. Lexington Insurance Company Limited and others[1] raises a number of interesting issues about the interrelationship of a facultative reinsurance contract and the original insurance contract when they are governed by different systems of law. Wasa and AGF had provided “contributing facultative reinsurance” to Lexington in respect of its liability under a “Difference in Condition” or “DIC” insurance provided by Lexington to the Aluminium Company of America (“Alcoa”). The DIC insurance provided property and business interruption cover.

The terms of the insurance and reinsurance contracts

The period of the DIC insurance was for 36 months from 1 July 1977 to 1 July 1980. The policy did not contain an express choice of law clause, but contained the following standard US service of suit clause:

“In the event of the failure of this Company to pay any amount claimed to be due hereunder, [Lexington] at the request of the insured, will submit to the jurisdiction of any Court of Competent jurisdiction within the United States and will comply with all requirements necessary to give such Court jurisdiction and all matters arising hereunder shall be determined in accordance with the law and practice of such Court”.

The reinsurance was placed in London. The reinsurance contract also provided cover for the period of “36 months 1/7/77 L/U &/or pro rata to expiry of original”. The form interest and location clauses also stated, inter alia, “&/or as original” and the reinsurance incorporated a full reinsurance clause as follows:

“Being a Reinsurance of and warranted same gross rate, terms and conditions as to and to follow the settlements of the … Company and that said Company retains during the currency of this Policy at least …. On the identical subject matter and risk and in identically the same proportion on each separate part thereof, but in the event of the retained line being less than as above, Underwriters’ lines to be proportionately reduced”.

The claim under the direct insurance

Alcoa sustained environmental damage at a number of sites in various of the United States, as a result of failures on Alcoa’s part which had caused damage between 1942 and at least 1986. The US Environmental Protection Agency and various state agencies required Alcoa to clean up this pollution and contamination. Insurance coverage litigation was commenced by Alcoa against Lexington and others before the Superior Court of King County in the State of Washington, in order to determine whether, and to what extent, Alcoa was entitled to be indemnified against these costs. One of the coverage issues considered in this litigation was whether pollution damage which had spanned more than one period of insurance should be allocated to the period of any particular policy, and, if so, how. Applying Pennsylvania law (the state where Alcoa’s headquarters were located), the Supreme Court of Washington State held that in these circumstances, each of Alcoa’s insurers was liable for the remedial costs of cleaning up all the environmental damage at various specified sites which were manifested during the policy period, whether it occurred within the insured period or not[2]. The Court held that the insuring clause in the direct insurance was:

“very broad and contains no limitation as to the time of the physical loss of or damage to property. There is no exclusion in the policy for physical loss or damage that may have been spreading before the policy inception.

….

It seems clear from the policy language that any physical loss or damage manifesting itself during the time a DIC policy was in effect covered by the policy, including pollution damage starting before the policy inception”..

Following extensive litigation, Lexington settled Alcoa’s claims on the basis that the insurance covered the cost of cleaning environmental damage at the relevant sites, irrespective of whether the damage had been sustained before, during or after the period 1 July 1977 to 1 July 1980.

The position under the reinsurance contract

After Lexington had made a demand for an indemnity under the reinsurance contract, Wasa and AGF commenced proceedings before the Commercial Court in London seeking a declaration that they were not obliged to indemnity Lexington in respect of its settlement with Alcoa. The principal defence raised was that the claims settled by Lexington did not fall within the terms and conditions of the reinsurance, because the settlement was on the basis that Lexington was liable under the insurance for the cost of cleaning environmental damage which had occurred outside the period 1 July 1977 to 30 June 1980, whereas the reinsurance contract only provided cover for losses occurring during that period.

It was common ground that the reinsurance contract was governed by English law. The reinsurers contended that they had only covered Lexington for the risk of loss and damage occurring within the three-year period. Lexington, it was said, could not rely on the “follow settlements” obligation” because the loss claimed did not fall within the scope of the reinsurance contract. In return, Lexington contended that the reinsurance and insurance contracts were intended to be “back to back”, and that the parties to the reinsurance contract would have contemplated that any dispute between Alcoa and Lexington would be determined in the courts of one of the United States (and probably the courts of the state of Pennsylvania). In these circumstances, Lexington contended that the ambit of the period clause in the reinsurance contract should be construed so that it was extensive in its meaning and effect with the ambit of the identically worded period clause in the insurance contract, as construed by the Supreme Court of Washington State.

The judgment

Mr. Justice Simon upheld the reinsurers’ claim for a declaration of non-liability, and rejected Lexington’s claim for an indemnity. The judge noted that under English law, a reinsurer is not obliged to indemnify the reinsured unless the loss falls within the scope of the cover of insurance contract and the reinsurance contract)[3]. Properly construed, the “follow the settlements” clause required that the claim, as recognised by Lexington, fell within the risks covered by the reinsurance contract as a matter of English law[4]. Applying Municipal Mutual Insurance Ltd. v. Sea Insurance Co. Ltd.[5], he held that the stated period of cover clause in the reinsurance was of fundamental importance, and must be given effect to.

Against this background, the Judge rejected the argument, advanced in reliance on the decisions in Forsirkingsaktielselskapet Vesta v. Butcher[6] and Groupama Navigation et Transports and ors v. Catatumbo CA Seguros[7] that the period clause in the reinsurance contract should be construed “back to back” with the period clause in the insurance contract as construed by the Supreme Court of Washington State applying Pennsylvanian law. The judge reached this conclusion for three reasons.

The Judge’s first and second reasons are to be found in the following passage, in which he observed that in both Butcher and Catatumbo:

“it would have been possible with the assistance of a legal encyclopaedia or dictionary to establish the meaning of the disputed words in the relevant reinsurance contract. The position is different in the present case. There was no identifiable US law interpretation that could be placed on the Period Clause; and I reject the submission that the period provision in this Reinsurance Contract can properly be construed by reference to the particular interpretation that was subsequently placed upon a similar provision in the original insurance by a particular US State court which happened to be seised of the underlying insurance dispute over twenty years later”.

It is helpful to distinguish between the two different contentions made in this paragraph.

First, that it was not appropriate to construe the reinsurance provisions as having “back to back” effect with the provisions of the insurance contract, by reference to a decision which may have represented the law of Pennsylvania in 2000 when the Supreme Court handed down its judgment, but no trace of which would have been found in Pennsylvania law when the insurance and reinsurance contracts were concluded in 1977. Hence the Judge noted that “… unlike the reinsurance contracts in Vesta v. Butcher and the Catatumbo case, there was no US law interpretation of the Period Clause in 1977 which could be `written into’ the Insurance Contract and by reference to which one could infer that the parties to the Reinsurance Contract had contracted”.

Second, that it was not appropriate to construe the period clause in the reinsurance contract by reference to Pennsylvania law which the Supreme Court of Washington State (the “particular US State court which happened to be seised of underlying insurance dispute over twenty years later”) had applied in 2000. Again, the judge noted that when the reinsurance contract was concluded, “there was no certainty … as to … which law would apply” and that there was “nothing inevitable about the Washing State Courts being seised of Alcoa’s claim or that any court would apply Pennsylvania law”.

The Judge’s third reason rested upon the “fundamental” importance of the period clause. He held that the “follow the settlements” clause, and the back-to-back nature of the insurance and reinsurance contracts, both of which strongly suggested that the reinsurer was to share the fortunes of the reinsured on coverage issues, were “not sufficient to displace the importance of the prescribed period of cover”.

It is respectfully suggested that of the bases of the Judge’s decision are open to question, and merit further judicial consideration. It is helpful to consider them in turn.

There was no relevant law in 1977 which could be “written into” the reinsurance contract

It is no doubt the case, as the Judge found, that any examination of Pennsylvania legal sources in 1977 would not have identified any principle of law by which coverage under “DIC” property insurance would extend to any property damage, no matter which occurring, which manifested itself during the policy period, providing that some damage had occurred during that period. Indeed the chances are that such an examination would not have identified any principles of Pennsylvania law relating to the interpretation of “DIC” insurance contracts: it appears from the decision of the Supreme Court of the State of Washington that “DIC polices were written for only a short period pf time (the late 1970s to the early 1980s) so there is either no authority or only sparse authority for their interpretation”.

However the “back to back” approach to construction applied in decisions such as Vesta v. Butcher and Catatumbo cannot depend on whether or not the particular coverage issue which later arises under the insurance contract had already been addressed by the relevant foreign law when the reinsurance contract was written, nor the further requirement that the understanding of the law on that issue should not have changed between the date when the reinsurance contract was concluded, and the date when the claim under the insurance contract is subsequently presented and determined.

It is helpful to consider the status of the direct insurance first. It is obvious that the proper law governing disputes arising under such a contract is not limited to those precedents which existed when the insurance contract was concluded. When a claim arises, it will be determined by reference to the authorities and judicial sentiment which prevail at that time. If the law on a particular issue has “changed” in a manner adverse to the insurer in the interim, the insurer will be found liable, nonetheless. While the absence of a prior understanding of that the law was to the effect contended for by the assured may be relied upon to support the insurer’s construction of the policy[8], it will not be determinative. No doubt there are many employer’s liability insurers who could say that the law as determined by the House of Lords in Fairchild v. Glenhaven Insurance Services Ltd[9] could not have been found in any legal encyclopaedia or dictionary of English law when their insurances were written, and that the principles of English law which it embodies are far removed from those understood at that time, but they will nevertheless find themselves bound to indemnify against liabilities determined on this basis. Such “developments in the law” can, to some extent, be accommodated within the convenient “fairy tale” that the law does not change, it is merely “discovered”, and previous inconsistent interpretations subsequently shown to be correct[10].

Does the analysis change at the reinsurance level? Where the reinsurance contract is governed by a different legal system, the role of the law governing the insurance contract operates at one remove from the proper law of the reinsurance contract, and the courts have had to evolve other means of reconciling the different proper laws which govern the two contracts with the expectation of the parties that the cover provided by a facultative reinsurance contract will be “back to back” with that of the original insurance. One attempt which did not find favour was to hold that the reinsurance contract was subject, in effect, to two proper laws, with those clauses which were “back to back” being governed by the same law as the original insurance[11]. Another approach was to imply a term in the reinsurance contract that the “back to back” terms would only have such effect in the reinsurance contract as they have under the original insurance[12]. However the preferred solution is that as a matter of construction, those clauses in the reinsurance which are “back to back” with the terms of the original insurance are to be given the same meaning in the reinsurance contract as they have in the original insurance under its proper law[13].

Achieving this “back to “back” effect through a process of construction might lend some credence to the view that regard can only be had to principles of the law governing the insurance contract as known and understood when the reinsurance contract was concluded. It is certainly counter-intuitive to construe a contract by reference to matters which have only been recognised since the contract was concluded. However it is even more counter-intuitive to suggest that while the terms of an insurance contract are subject to the developments and discoveries of the law in the period after that contract is concluded, those “back to back” terms of the reinsurance contract are to be interpreted only by reference to the principles of the same legal system as known and understood when the contract was concluded. Rather the reinsurers should be as much at risk as the insurers if the relevant principles of law governing the insurance contract have been incompletely or “imperfectly” discerned when the contracts are concluded.

It was not clear in 1977 that any claim under the insurance contract would be determined under Pennsylvania law

Many purchasers of insurance do not want the law which will applicable to claims under that contract to be fixed for all purposes and for all time when the insurance was concluded. Many sellers of insurance are prepared to accommodate this customer preference. The standard service of suit clause used in this case – under which the law applicable to disputes under the policy will be determined by the law of the place where the insured commences proceedings – is one way in which this is achieved.

English law requires a contract to have an identifiable proper law at the outset, although it will recognise clauses which provide that that proper law can subsequently be varied in certain circumstances, and “service of suit” clauses of the kind included in the insurance contract here have been rationalised on this basis[14]. If the terms of the insurance contract allow for a change in the applicable proper law, there does not seem to be any obvious reason why the reinsurance contract should not also do so, so that the role of the proper law of the insurance contract in interpreting the “back to back” terms of the reinsurance contract would, after an effective change in the proper law of the insurance contract, thereafter be performed by reference to the “new” proper law. The position envisaged by the judge – in which the reinsurance contract would not “follow” the effect of any change in the proper law of the occasioned by the standard USA service of suit clause – is one which would introduce a significant mismatch between the two contracts, and as Lord Griffiths noted of a similar argument in Vesta v. Butcher, it must be doubted “if there is any market for such a reinsurance”[15].

In any event, it is not clear if Lexington would have needed to go this far on the facts of the case. The judge did not make any finding as to what the (original) proper law of the insurance contract was. In circumstances in which Alcoa had its head quarters in Pennsylvania, and in which the contract contained a USA service of suit clause, Pennsylvania law looks as good a candidate for that proper law as any other, with the result that the parties to the reinsurance contract could be taken to have been aware in 1977 that the ambit of the insurance contract would be determined by Pennsylvania law.

The period clause in the reinsurance contract “trumps” the back-to-back nature of the insurance and reinsurance contracts

The final ground of Mr. Justice Simon’s judgment was that the “period” clause was “fundamental” and was not one of the terms of the reinsurance which could be subject to a Vesta v. Butcher “back to back” interpretation. In this respect, the “period clause”, it would seem, is to be treated differently from the warranties considered in Vesta and Catatumbo. There are obvious difficulties in determining which clauses are sufficiently “fundamental” to “trump” the Vesta v. Butcher approach to construction of “back to back” insurance and reinsurance contracts. A warranty, after all, is part of the definition of the risk. If identical words defining the period of insurance can have different meanings and effect as between the insurance and reinsurance contracts, when they are governed by different proper laws, then an equally strong case could be made for a similar disparity in relation to terms defining the contractual limits (for example as to the meaning of expressions such as “any one event” or “originating cause”); the geographical limits of the risk; “internal” time limits such as the 72 hours clause; and other such terms. And yet both Vesta and Catatumbo have been relied upon to support the “back to back” construction of terms defining the contractual limits of a policy of retrocession (admittedly without the complicating presence of different proper laws)[16].

In addition to the difficulties which arise as to the “hierarchy of terms” in a back-to-back reinsurance contract, there is also the further issue of the correct characterisation of the issue decided under the proper law applicable to the insurance contract. If the Washington State Supreme Court had decided that Lexington was liable even in the absence of “trigger” occurring within the period of Alcoa’s insurance contract, then an English court might well take the view that there had been no “interpretation” of the period clause as a matter of Pennsylvania law at all, but rather a decision to ignore the period clause altogether. In these circumstances, it is very doubtful that an appeal to a Vesta v. Butcher construction could have assisted Lexington. However, the Supreme Court decision does not appear to have gone this far. Having found that loss and damage occurred during the period of the insurance contract, the Supreme Court then held that Alcoa’s insurers were liable for all damage which had manifested itself during that period, including damage which had occurred prior to the period of the insurance contract. However if a “trigger event” has occurred within the policy period of the reinsurance contract (even giving that clause a purely English law construction), there must be at least an argument that a determination of the consequences of that trigger – including whether it carries with it liability for loss or damage which had already occurred but which manifested itself in the policy period – is an issue on which it was entirely appropriate to adopt a Vesta v. Butcher construction.

Conclusion

These are difficult issues, the answers to which are not necessarily straightforward. The case reflects the familiar tensions between the commercial desirability of “back to back” cover, and the applicability of different legal systems to the insurance and reinsurance contracts. Mr. Justice Simon refused to give permission to appeal against the judgment, but it is suggested that the issues considered in the case merit further consideration.

This article was first published in Issue 127 (May) of Sweet & Maxwell’s Insurance and Reinsurance Law Briefing



[1] [2007] EWHC 896 (Com).

[2] Aluminium Company of America et al v. Aetna Casualty & Surety Company et al 140 Wn.2d 517; 998 P. 2d 856; 2000 Wash. Lexi 831; 30 FLR 20536 (4 May 2000).

[3] Citing Hill v. Mercantile & General Reinsurance Co. Plc. [1996] 1 Lloyd’s Rep. 341.

[4] Citing Insurance Co. of Africa v. Scor (UK) Reinsurance Ltd. [1985] 1 Lloyd’s Rep. 312 at 330 and Assicurazioni Generali v. CGU International Ins. Plc. [2003] 1 Lloyd’s Rep. 725..

[5] [1988] Lloyd’s Rep. IR 421.

[6] [1989] AC 852.

[7] [2000] 2 Lloyd’s Rep. 350.

[8] As for instance in Sunsport Shipping v. Tryg-Baltica International (UK) Ltd, The Kleovoulos of Rhodes [2003] EWCA Civ. 12.

[9] [2002] UKHL 22.See also Barker v. Corus [2006] 2 WLR 1027, a decision of the House of Lords endorsing a pro-rating approach to the allocation of indivisible disease which was reversed by section 3 of the Compensation Act 2006 so far as mesothelioma are concerned.

[10] Although not always. The intellectual gymnastics involved are addressed in Kleinwort Benson Ltd. v. Lincoln City Council [1999] 2 AC 349. The characterisation of this approach as a “fairy tale” is that of Lord Reid Lord Reid in "The Judge As Law Maker" (1972-1973) 12 J.S.P.T.L. (N.S.) 22.

[11] Hobhouse J. in Vesta v. Butcher [1989] 1 Lloyd’s Rep. 179 at 193-194.

[12] The approach of Sir Roger Ormrod in Vesta v. Butcher [1988] 1 Lloyd’s Rep. 19 at 35.

[13] The approach of Neill LJ in Vesta v. Butcher at p.33 and of the House of Lords, [1989] AC 852, certainly in the judgment of Lord Lowry at 910. Lord Templeman holds that the effect of breach of warranty in the two contracts must be the same, without specifically identifying whether this is because of an implied term to this effect or because the warranty in the reinsurance is to be construed as having the same effect as the warranty in the original insurance. The “construction” approach is adopted in Groupama Navigation et Transports v. Catatumbo SA Seguros [2000] 2 Lloyd’s Rep. 350.

[14] Amin Rasheed Shipping Corporation v Kuwait Insurance Co [1984] AC 50 at 65 per Lord Diplock; Du Pont de Nemours & Co and Endo Laboratories Inc v Agnew [1987] 2 Lloyd’s Rep 585 at 592; King v. Brandywine [2001] 1 Lloyd’s Rep. IR 554 at para. 45.

[15] [1989] 1 AC 582 at 895.

[16] Mann and ors v. Lexington Insurance Co. [2001] 1 Lloyd’s Rep. IR 179.

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