LEGAL CLINIC
Attempts to use tighter contracts to ease tension between reinsurers and reinsureds over settlements of claims do not always make matters more straightforward, says Michael Mendelowitz
Lord Mustill in Hill vs Mercantile & General Reinsurance Plc noted that there is an inherent tension in reinsurance relationships, namely the need to avoid a reinvestigation by the reinsurer of an incoming claim which the reinsured has settled, while at the same time maintaining the integrity of the bargain between them. Lord Mustill went on to observe that in the resolution of this tension, there are only two rules. First, any loss for which indemnity is claimed must fall within both the original policy and the reinsurance; secondly, the parties are free to agree on how the requirements of the first rule are to be satisfied.
Over the years, attempts to resolve this tension have resulted in a variety of clauses which seek to bind reinsurers to loss settlements made by their reinsureds.
Such clauses fall broadly into two classes: pro cedant and pro reinsurer. Clauses which favour reinsureds usually contain the words 'follow settlements'. In Insurance Company of Africa vs Scor (UK) Reinsurance Company these words were interpreted as meaning that the reinsurer undertakes to indemnify the reinsured's admission or compromise of the underlying claim, provided that the claim falls within the risks covered by the reinsurance as a matter of law, and provided also that the settlement was honest and businesslike.
By contrast, pro reinsurer clauses commonly contain a proviso that the reinsured's loss settlements are within the terms and conditions of the original policies. A second proviso is sometimes added, namely that the settlements should also fall within the terms and conditions of the reinsurance, but it is well established that the reinsurer always has the right to argue that a particular loss is not covered, even when the contract does not make this explicit. In Hill vs M&G Re, the reinsureds argued that such provisos should not be construed literally, as otherwise there would be no purpose in the insertion of 'loss settlements binding' clauses in reinsurance contracts, and market chaos would ensue. The House of Lords insisted, however, that the words used by parties in their contracts should be taken to mean precisely what they said.
The difficulties which a restrictive form of loss settlements clause can occasion are well illustrated by Commercial Union vs NRG Victory. The case followed the grounding of the Exxon Valdez and the resulting oil spill in Prince William Sound, Alaska. A claim for the clean up costs by the original insured, Exxon Corporation, was denied by the insurers. Exxon then commenced proceedings against the insurers in Texas. Those proceedings were settled on the advice of the insurers' lawyer. This was to the effect that although the insurers had legal merit on their side, they were likely to lose the case partially because a local jury was likely to be biased against foreign insurers, denying cover to a Texas corporation. The insurers then made a claim on their reinsurers for indemnification under a contract which required, as a condition precedent to liability, that the reinsured's settlements should be within the terms of its original policies. The Court of Appeal held in favour of the reinsurers, on the grounds that the Texas lawyer's advice was not based upon the proper application to the facts of rules of policy construction, but rather upon extraneous commercial considerations. It was not enough for the insurers to establish that their settlement had been businesslike. In the absence of a 'follow settlements' clause in their reinsurance, they had to prove actual liability to Exxon.
So, what is a reinsured to do if liability under the original policy is fairly arguable either way? Is the reinsured bound to contest the claim all the way to judgment, or may it make a commercial settlement with the insured without forfeiting its entitlement to a reinsurance indemnity? At the very least, the reinsured should be given an opportunity to demonstrate that it would, on a balance of probabilities, have had to indemnify the original insured, had the underlying claim been adjudicated on finally. This might present the reinsured with a tactical problem if its settlement with the original insured was made on a 'without prejudice' basis, following a strenuous denial of cover.
The most significant recent development in this arena has been the Court of Appeal's judgment, earlier this year, in Wasa and AGF vs Lexington. Lexington was held liable to indemnify its insured, Alcoa, for the cost of cleaning up property exposed to environmental damage for 50 years. This was despite the fact that the policy, governed by Pennsylvania law, only covered losses occurring between 1977 and 1980. Wasa and AGF reinsured Lexington for the same period under an English law contract. The Court of Appeal held that the reinsurers were bound to indemnify Lexington, because the reinsurance was a facultative contract whose terms were largely to be found in the underlying policy and was intended to operate 'back to back' with the original cover and because it included a 'follow settlements' clause. In these circumstances, the effect of the period clause in the original policy and the reinsurance, which were almost identically worded, ought to be the same. A further appeal will be heard by the House of Lords later this year. Depending upon the outcome of the appeal, one may expect either reinsureds or reinsurers to argue that the 'tension of reinsurance' has been relaxed too far in favour of the other party and to seek the renegotiation of 'follow settlements'clauses to redress any perception of imbalance.
