The judgment of the Commercial Court in WASA and AGF v Lexington shows that a “follow settlements” clause in a reinsurance contract will not obviate the need for the reinsured to demonstrate that an inwards settlement falls within the terms and conditions of its outwards reinsurance. Partner Michael Mendelowitz reviews the judgment.

Lexington insured the Aluminium Company of America (Alcoa) against loss of or damage to property and business interruption risks for three years from 1 July 1977. The original policy was reinsured in London under a slip applying to all risks of physical loss or damage to the property insured occurring during the same 36 month period. The slip also provided: “Being a reinsurance of and warranted same gross rate, terms and conditions and to follow the settlements of [Lexington]”.

Environmental damage was caused at 58 Alcoa sites by the escape of waste products and the failure of manufacturing units to contain pollutants. The relevant causative acts and omissions first occurred in 1942 and continued until at least 1986. In the early 1990s, the US Environmental Protection Agency and various state environmental agencies demanded that Alcoa clean up contamination of water and soil at the polluted sites. Alcoa began legal proceedings against a number of insurers (including Lexington) seeking indemnity for the clean-up costs. The insurance coverage proceedings were settled after a ruling by the Supreme Court of Washington that insurers were jointly and separately liable to Alcoa for all property damage, including damage which had occurred before individual policies incepted. Under the settlement agreement, Lexington agreed to pay Alcoa a total of more than $100 million.

The reinsurance dispute

The principal issue which arose between the parties was whether the reinsurance contract required WASA and AGF to indemnify Lexington in respect of the settlement with Alcoa, in particular for the remedial costs incurred in cleaning up environmental damage which happened prior or subsequent to the three year term of the reinsurance. The reinsurers contended that they had agreed to indemnify Lexington for a three year period and not for a period of almost fifty years, notwithstanding the “follow the settlements” language of the contract and the decision of the Supreme Court of Washington. Lexington argued that the insurance and reinsurance contract were intended to be “back to back” and that reinsurers must have contemplated that the scope of the direct policy, including the period clause, would be determined by a court of competent jurisdiction in the USA.

Judgment

Simon J observed that the effect of the full reinsurance clause was that the subject matter of the original risk was incorporated in the reinsurance contract. To this extent, the insurance and reinsurance were accurately described as “back to back”.

On the other hand, it was common ground that the reinsurance contract was governed by English law, but the original policy by the law of one of the states of the USA. In this respect at least, therefore, the contracts were not back to back.

The judge pointed out that under English law, a reinsurer is not obliged to indemnify a reinsured unless the loss for which indemnity is claimed falls within the scope of both the cover created by the insurance policy and that created by the reinsurance contract. In the absence of express agreement to the contrary in the reinsurance contract, it is for the reinsured to prove both of these matters. A “follow settlements” clause of the type found in the reinsurance contract in this case was one way in which the parties could agree on how the reinsured was to prove these matters. The effect of the clause was that the reinsured did not have to prove that the loss actually fell within the scope of the insurance, but only that it acted honestly and in a businesslike manner in settling the claim. That aspect was never in dispute. The crucial issue therefore became whether the claim recognised by Lexington fell within the risks covered by the reinsurance as a matter of law - in particular, whether it was excluded by the period clause.

Simon J held that the settlement did not fall within the terms of the reinsurance. That contract provided that the reinsurers would indemnify the reinsured for loss “as may happen to the subject matter of this reinsurance … during the continuance of this policy.” The period clause in the reinsurance was of fundamental importance, and the fact that the contracts were intended to be “back to back” did not have the consequence that the natural meaning of the period clause could be distorted or disregarded. As Simon J put it:

“The reinsurers … agreed to reinsure Lexington in relation to Alcoa’s property damage occurring between noon on 1 July 1977 and noon on 1 July 1980 .… The reinsurers did not agree to reinsure Lexington in relation to an earlier or later period, … nor in relation to a period of cover which might be determined by whatever US law interpretation might be placed on the period clause in the insurance contract. … [I]t was plainly possible … to identify damage which occurred during the policy period. This is not one of those cases where there was a dispute as to when damage occurred, so that Lexington might argue that a settlement was made on the basis that damage might have occurred during the policy period. This was a case in which Lexington settled the case on the basis that it was liable for the cost of remedying damage outside the period of cover ….”

It followed that the loss claimed by Lexington was not one that fell within the reinsurance contract as a matter of English law. The declaration of a non-liability which WASA and AGF had sought was accordingly granted. The judge expressly left open the question whether Lexington could make a claim under the reinsurance in respect of losses occurring within the three year period from 1 July 1977 to 1 July 1980.

Conclusion

The judgment is a timely reminder of the proviso to “follow settlements” clauses in reinsurance contracts. It is not sufficient that the reinsured achieves a settlement with the original insured on terms which are advantageous from the reinsured’s point of view; compliance with the reinsurance contract is an additional factor which it is always necessary for the reinsured to prove, so that the integrity of the reinsurance bargain is not eroded by an underlying compromise over which the reinsurer has no control.

WASA International Insurance Company Limited and AGF Insurance Company (2007) EWHC 896 (Comm)