Keeping schtum

Be quiet

With the end of the case of Wasa v Lexington, David Murphy and Leon Taylor explain that what the House of Lords did not say, rather than just what it did, seems to be far more revealing.

On the day the House of Lords marked the end of an era before its reconstitution as the UK's first Supreme Court, it brought to a close another long-running legal saga in the case of Wasa v Lexington (Post, 6 August 2009, p8).

In a landmark decision, the Law Lords have provided London market reinsurers with greater certainty over the scope of their exposures to overseas cedants, while simultaneously reaffirming the general presumption in favour of a 'back-to-back' interpretation of proportional facultative reinsurance contracts. However, as is so often the case in legal decisions of this kind, the devil lies not so much in the detail but in what their Lordships deliberately chose not to say.

The dispute arose out of US long-tail environmental exposures of the kind that has vexed risk carriers for decades. Lexington provided property damage and business interruption cover to the Aluminium Company of America, known as Alcoa, for the period 1 July 1977 to 1 July 1980. Importantly, there was no express choice of law clause in the policy but, pursuant to a standard US 'service of suit' clause, Lexington agreed to submit to the jurisdiction of any competent court in the US.


Material difference

For the same period, Lexington had arranged facultative all-risks reinsurance cover on the standard London market slip and on an apparently 'back-to-back' basis with the underlying cover. The only material difference between the contracts was that the reinsurance was implied to be governed by English law.

When, in the early 1990s, US environmental agencies required Alcoa to clean up pollution at various of its manufacturing sites throughout the US, Alcoa sued its insurers" including Lexington" in the Washington State courts, claiming an indemnity in respect of the clean-up costs. The Washington Supreme Court, applying the law of Pennsylvania to the risk, ruled that provided some damage at a site had 'manifested' in the relevant period, all the damage" which spanned decades" could be recovered, including the clean-up costs incurred prior to the inception of Lexington's three-year period of cover.

However, two of Lexington's London market reinsurers, Wasa and AGF, declined to pay. They argued that the reinsurance was governed by English law and, as such, reinsurers could not be liable for the costs of remedying damage that occurred outside the three-year period of the reinsurance cover.

Following decisions of Mr Justice Simon at first instance (which found for Wasa and AGF), and then the Court of Appeal (which found for Lexington), a unanimous House of Lords has now come down firmly on the side of the reinsurers. It decided that the otherwise "strong presumption" that an English law reinsurance placed back-to-back with an underlying cover must be construed consistently with the underlying contract" even if the governing law of that contract is different" could not apply in this case. This presumption was earlier laid down by the English courts in the leading cases of Vesta v Butcher (1989) and Groupama v Catatumbo (2000).


System of law

According to the court, what distinguished this case was the absence of an identifiable system of law governing the direct insurance. This meant that, when the reinsurance was issued in 1977, no one could have predicted what law would govern questions of policy coverage. The House of Lords even disagreed with the Court of Appeal's own analysis that Pennsylvania law was the correct law, saying that Massachusetts had the closer connection to the risk. This simply served to emphasise the unpredictability of the matter at the time the reinsurance was placed.

In Lord Mance's words, reinsurers had no foreign "legal dictionary" to which they could turn to ascertain the extent of their potential exposure, and were, therefore, entitled to rely on English law" the governing law of their own contract" to determine the scope of their liability.

On this point the judges were unequivocal: "nothing could be clearer" in English law than that an insurer or reinsurer under a losses-occurring policy could only be liable in respect of losses arising during the period of cover. They could not be made to indemnify losses, such as the Washington Court had found Lexington liable for, which occurred before inception or after expiry of the cover. This was "fundamental" and enough to rebut the Vesta presumption that reinsurers should stand or fall with their cedants.

It is now clear that, in the absence of an identifiable system of law that would apply to the direct insurance, reinsurers cannot be held liable for losses occurring outside the temporal scope of an English law reinsurance.

The decision raises interesting questions for reinsurers and cedants alike: firstly, what other contract terms, in addition to the period clause, might be considered sufficiently fundamental in defining the risk so that they might 'trump' the back-to-back presumption in similar circumstances? Why should limiting provisions such as 'any one occurrence' clauses or aggregation provisions not be regarded as just as important?

Secondly, if the distinguishing factor which defeated the Vesta presumption in this case was the absence of an ascertainable governing law in the direct cover, what about the potentially far more common situation encountered in many developing markets where there is an express foreign law provided for in the cover, but the law in that jurisdiction is not sufficiently developed to provide a clear answer to the coverage question at the time the reinsurance is placed. That's to say, the foreign 'legal dictionary' exists, but its pages have yet to be written?


Extraordinary liability

If, perhaps many years later, a foreign court then imposes an unpredictable and extraordinary liability on a cedant, which could not have been reasonably contemplated at the time of placement, why should reinsurers not be equally justified to rely on English law to avoid the loss?

The answer is perhaps to be found in the court's acknowledgement that an insurer or reinsurer must take the risk of a change in the law after the inception of the cover, which suggests that reinsurers will be expected to stand behind their cedants in jurisdictions where the legal dictionary was unwritten at the time of placement.

However, it is not entirely clear how this fits with the rationale underpinning their Lordships' decision that the question must turn on an analysis of the parties' commercial expectations at the time the contract was entered into. The House of Lords' suggestion that this is a matter for another day is unsatisfactory and may simply store up trouble for the future.

In the meantime, facultative reinsurers will be closely examining their programmes to establish just how back-to-back they really are. On the other side of the fence, cedants and brokers must take even more care with their wordings to ensure they provide the complete protection they need.


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