20 Aug 2009

"Back-to-back" contracts of reinsurance can lead to face-off in court if not drafted correctly

Do so-called "back-to-back" reinsurance contracts provide cover co-extensive with the insurance, particularly where similar terminology is used? The recent House of Lords decision in Lexington Insurance Company v Wasa International Insurance Company Ltd [2009] UKHL 40 has demonstrated that where insurance and reinsurance are subject to different governing law, that presumption may not hold. In Lexington v Wasa, the intended "back-to-back" nature of the reinsurance, inclusion of a "Full Reinsurance" clause, "as original" wording and a follow settlements clause were not enough to save the reinsured.

The back-to-back contracts

Lexington Insurance Company insured Alcoa against property damage at Alcoa's sites around the world, and then reinsured the risk with a number of reinsurers, including Wasa International Insurance Company Limited and AGF Insurance Ltd, by way of facultative reinsurance. The periods of both the insurance policy and the reinsurance agreement were 1 July 1977 to 1 July 1980, and the contracts were said to be "back-to-back" as regards their terminology, perils insured and, significantly, the period of cover. The most significant difference was that the policy was subject to US law, while the reinsurance was governed by the law of the UK.

Alcoa was required by the US Environment Protection Agency to clean up pollution it caused before the insurance policy commenced. It sought a declaration that it was entitled to insurance coverage for the clean-up costs. The Supreme Court in Washington State held that Lexington's insurance of Alcoa was to be construed as rendering Lexington jointly and severally liable with all other insurers covering the remedial costs of the environmental damage, irrespective of whether the damage has been sustained before, during or after the policy period.

Lexington settled Alcoa's claim for approximately US$103 million and then looked to its insurers for indemnity under the reinsurance contracts, at which point Wasa and AGF sought a declaration that they were not obliged to indemnify Lexington in respect of its settlement with Alcoa. The core of their argument was that the reinsurance only covered Lexington in respect of losses referable to the three year period of the reinsurance.

House of Lords decision

On 30 July 2009, the House of Lords upheld WASA's and AGF's contention, limiting the reinsurance recovery to three years' worth of property damage.

Lexington said that its intention was to cover itself in respect of the whole risk. Because of this intention and the identical language of the policies, it said, English law should read the language of the reinsurance to accord with the decision of the Washington Supreme Court. The House of Lords rejected this argument.

The key deciding points for the House of Lords were:

  • the fact that the two contracts were subject to different laws; and
  • the English law contract could not be read to extend coverage of damage occurring outside the period of coverage of the reinsurance contract, which was clearly stated as three years.

The facts that the facultative reinsurance carried with it a general presumption of "back-to-back" coverage, the inclusion of the Full Reinsurance Clause, "as original" wording, and a follow settlements clause, did override the affect of the plain language of the reinsuring provision, interpreted in accordance with the law of the contract.

Ultimately, it was a question of construction of the reinsurance contract and that the Wasa and AGF reinsurance contracts did not cover damage occurring outside the period of coverage. The court also commented that when considering the reinsurance under English law, it cannot be construed as a contract to indemnify Alcoa in respect of all contamination, whenever caused or occurring provided that part of the contamination manifested during the reinsurance period.

As Lord Collins noted, generally a reinsurance contract should be construed as to be consistent with the terms of the insurance contract on the basis that the intention is that they be back-to-back. Where however the contracts are governed by different law, it remains a question of construction of each contract under its applicable law to what risk is assumed.

Implications for Australian insurance and reinsurance contracts

  • Reinsurance is still a standalone, enforceable contract.
  • Reinsurance practitioners should try to ensure that the whole of any insurance and reinsurance is expressly subjected to a common governing law. Where this is not possible, include an explicit term to the effect that it is the intention of the parties that for the purposes of determining the reinsurer's response to claims, the provisions of the reinsurance contract shall be interpreted consistently with the manner of operation of the underlying insurance according to the law of the jurisdiction to which the latter is subject. This requires more than a standard "follow settlements" clause.
  • It is unsafe to rely upon catchphrases such as "full reinsurance", "follow settlements", and "back-to-back" to establish contiguity of cover between cedants' policy liability and reinsurance.
  • Every effort should be made to ensure that the same or semantically identical language in both the insurance contract and reinsurance contract is used for the insuring clauses as well as all key definition and operative terms.
  • The presumption of congruency of insurance and reinsurance has been shown to be rebuttable by plain words.
  • In UK law, the House of Lords has now determined that a reinsurance contract does not reinsure the liability of the reinsured under the insurance - it reinsures the subject-matter insured. This view is in accordance with traditional orthodoxy, which dates from the 19th century when reinsurance as such was illegal and could only be effected in the form of a second insurance of the underlying risk, the policy exposure providing the cedant with an insurable interest. It is, however, contrary to the views of a number of learned commentators and may well have unforeseen consequences.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.