In a UK judgment with possible wide-ranging implications for the London reinsurance market and the overseas reinsureds who deal with it, the House of Lords, in Lexington Insurance Company v Wasa Insurance Company and Lexington Company v AGF Limited  UKHL 40, has held that a facultative proportional reinsurance governed by English law was not to be construed on a "back to back" basis with an underlying insurance governed by a US 'service of suit' clause, despite a "full reinsurance" and "follow the settlements" clause. The judgment not surprisingly has generated widespread interest in the reinsurance community.
Alcoa, the underlying insured, was ordered by the US Environmental Protection Agency to clean up pollution occurring between 1942 and 1986 at a number of its manufacturing sites in the US. Alcoa sought to recover part of its clean up costs from Lexington, the insurer, who had insured Alcoa for a three year period from 1977 to 1980 in respect of physical loss and damage to Alcoa's property worldwide. Notably, the insurance policy contained a US "service of suit" clause, which required the State in which Alcoa commenced litigation to apply its law to the dispute. The US court held that Pennsylvanian law was the governing law of the underlying insurance and that Lexington was jointly and severally liable for the whole of Alcoa's clean up costs, even though the insurance policy covered the risk for only three years, as opposed to the 44 years during which pollution had taken place. Lexington settled Alcoa's claims and sought an indemnity from its reinsurers. Reinsurers denied liability on the basis that the reinsurance policy under English law provided cover only in respect of damage actually sustained during the three year policy period.
It was accepted that the decision of the US court was not perverse, and that Lexington had acted in a proper and business-like manner in settling Alcoa's claims in the light of that decision.
Prior to the House of Lords decision, it was settled law that there was a rebuttable presumption that a reinsurance contract using equivalent wording to the underlying insurance contract was intended to have the same meaning, even though their governing laws differed (ie. that they were "back to back"). Thus the reinsurer was obliged to follow the settlements of the insurer provided that (1) the claim fell within the risk covered by the reinsurance, and (2) the insurer acted honestly and took all proper and business-like steps in handling the claim, even though the result may have been different under the law of the insurance than it would have been under English law. Here, there had been property damage and Lexington had acted properly, but the reinsurers were relying on the fundamental principle of English reinsurance law that a policy confines recovery for damage occurring only during the policy period.
The lower court decisions
At first instance it was held that the reinsurers were not obliged to follow Lexington's settlement with Alcoa, because the loss fell outside the three year coverage period. The Court of Appeal unanimously disagreed with the first instance decision, holding that the same or equivalent wording in the insurance and reinsurance contracts should generally be construed on a "back to back" basis unless there are clear indications to the contrary, none being present here.
The House of Lords' decision
The House of Lords unanimously allowed the appeal and held for the reinsurers. Their Lordships did not disturb the general presumption in favour of back to back coverage, but held that, in this particular circumstance, at the time the insurance contract was effected, there was no identifiable governing law of the insurance policy (there was only the 'service of suit' clause) which could provide a basis for construing the insurance policy any different to its ordinary meaning under English law. Further, the court held that the reinsurance could not be construed to mean that it would respond to any liability the insurer may in due course be found to have by any US Court. In those circumstances, the court held that the reinsurance should take its ordinary English law meaning, namely that it only responded to damage occurring during the three year policy period.
Markets as significant as the London reinsurance market rely in large measure on the certainty of the contracts under which they do business. Thus, whilst the House of Lords in this judgment has maintained the strong presumption of liability under a proportional facultative reinsurance being back to back with the insurance (because the essence of the bargain is that the reinsurer takes a proportion of the premium in return for the share of the risk), the judgment has added uncertainty by opening the issue as to when exactly that presumption should be rebutted. It would seem that there are some "fundamental" aspects of English law reinsurance contracts (such as, here, the requirement for loss to occur during the period of cover) which will always be covered by English law, absent at the very least clear wording to the contrary, but that the presumption will not allow reinsurers to rely on "uncommercial and technical points" where English law may have different consequences to the law of the underlying insurance (e.g. in the case of a breach of warranty). The uncertainty engendered by the judgment is precisely where the line is to be drawn between these two concepts. This is not just a technical legal issue – reinsurance operates to transfer huge amounts of risk and the insurance markets of many countries (in Asia and elsewhere) cannot operate without valid risk transfer.
It remains to be seen whether the decision makes the London market less attractive for overseas insurers. It certainly means that parties will have to pay more attention to their wordings going forward. It may not be acceptable (or possible) for the underlying insurance to be governed by English law, and in many cases one would imagine the London market will not accept a non-English governing law clause in their reinsurance contracts. In such cases, the parties need to make it clear which parts of the reinsurance coverage are intended to be back to back, and which are not.