The ‘follow the settlement clause’ in reinsurance contracts is designed to avoid disputes between reinsurers and reinsureds. This newsletter discusses the recent Commercial Court decision in Wasa and AGF v Lexington  All ER (D) 205 (Apr). NEWS
The ‘follow the settlement clause’ (FTS clause) in reinsurance contracts is designed to avoid disputes between reinsurers and reinsureds. Commercial considerations will often dictate that reinsurers will pay up when there is no strict legal obligation to do so. Nevertheless, disputes relating to FTS clauses are not uncommon, with reinsurers understandably reluctant to follow blindly settlements entered into between the reassured and the underlying assured. The recent Commercial Court (the Court) decision in Wasa and AGF v Lexington  All ER (D) 205 (Apr) is the most recent in a long line of decisions relating to such clauses.
Lexington insured Aluminium Company of America (Alcoa) in respect of loss or damage to property under a policy dated 22 August 1977 (the Insurance), with cover provided from noon on 1 July 1977 until noon on 1 July 1980. Lexington entered into a reinsurance contract in respect of the Insurance with Wasa and AGF (the Reinsurance) providing cover for all risks of physical loss or damage to the property occurring in the same period covered by the Insurance. It contained a clause that stated: ‘Being a reinsurance of and warranted same gross rate, terms and conditions as and to follow the settlements of the [reassured]’. Environmental damage was sustained at various Alcoa sites in the US during the relevant three-year period arising out of acts and omissions by Alcoa, which first occurred and began causing damage in 1942, continuing until at least 1986. Alcoa brought proceedings against Lexington in the US.
In 2000, the Washington Supreme Court held that, as a matter of Pennsylvanian law, the Insurance rendered Lexington jointly and severally liable for the costs of cleaning up the damage. Thereafter, Lexington settled with Alcoa on the basis that the Insurance covered the cost of cleaning up the damage, irrespective of whether the damage had been sustained before, during or after the period specified by the Insurance. Wasa and AGF sought declarations in England that they were not liable under the Reinsurance in respect of the settlement.
Mr Justice Simon summarised the position under English law in relation to this type of insurance and reinsurance contract.
The effect of the full reinsurance clause referred to above is that the subject matter of the original risk is effectively incorporated into the reinsurance contract. To this extent the Insurance and Reinsurance were accurately described as ‘back-to-back’, although they were not back-to-back insofar as the applicable law of the contracts was concerned.
The subject matter of the Reinsurance was Alcoa’s property; it was not a reinsurance of Lexington’s liability to Alcoa under the Insurance. Under English law a reinsurer is not obliged to indemnify the reassured unless the loss falls within:
- the scope of the insurance contract; and
- the scope of the reinsurance contract – Hill v Mercantile  Lloyd’s Law Rep 341.
Absent any express clause in the reinsurance contract, the reassured must prove both matters. The parties can, however, agree how either or both matters may be proved (Hill v Mercantile).
The FTS clause is one way the parties can agree (Assicurazioni Generali v CGU  1 Lloyd’s Law Rep 725 (Generali)).
Under an FTS clause a reassured does not have to prove that the loss actually fell within the scope of the insurance. Rather, it must prove that:
- the claim as recognised by the reassured fell within the scope of the reinsurance and;
- it acted honestly in making the settlement and took all proper and business-like steps in settling the claim – Insurance Co of Africa v Scor  1 Lloyd’s Rep. 312.
It was common ground that when settling with Alcoa, Lexington acted honestly and took all proper and business-like steps. The issue was therefore whether the claim, which was recognised by Lexington and which it wished to pass on to reinsurers, fell within the risks covered by the Reinsurance as a matter of law.
As the Court stressed, the crucial issue when considering the first Scor proviso is not that the original loss falls within the cover created by the reinsurance, rather that the claim recognised by the reassured falls within the risks covered by the reinsurance as a matter of law (Generali). The question was therefore whether the claim recognised by the Alcoa settlement fell within the Reinsurance as a matter of law, in particular, whether it was excluded by the terms of the period clause.
The Court relied on Municipal Mutual Insurance v Sea Insurance  (CA) Lloyd’s Law Rep. I & R 421 for the propositions that a period clause in a time policy is of fundamental importance. Ordinarily the reassured must satisfy the Court that physical loss or damage has occurred in the year covered by the Reinsurance.
Because the Insurance and Reinsurance are expressed to be back-to-back ‘as original’ does not mean that the natural meaning of a period clause in a time policy can be ‘distorted’ or ‘disregarded’.
Lexington argued that the parties intended that the scope of the period clause in the Reinsurance was the same as the scope of the period clause in the Insurance, relying on Vesta v Butcher  AC 852 (Vesta) and Groupama v Catatumbo  2 Lloyd’s Law Rep. 350 (Groupama).
The Court dismissed this argument, distinguishing both Vesta and Groupama on the basis that, unlike in those two cases, where it would have been possible to establish the meaning of the disputed words (in both cases, ‘warranty’) in the relevant reinsurance contract, there was no identifiable US law interpretation that could be placed on the period clause.
The Court concluded that, although the FTS clause and the back-to-back nature of the contracts were relevant, they were not sufficient to displace the importance of the prescribed period of cover. Reinsurers had not agreed to reinsure Lexington in relation to an earlier or later period, nor in relation to a period of cover that might be determined by whatever US law interpretation might be placed on the period clause in the Insurance. So the loss claimed by Lexington was not a loss that fell within the Reinsurance as a matter of English law. The Court therefore granted the declarations sought by the reinsurers.
This case is a salutary reminder for reassureds that an FTS clause is no guarantee that reinsurers will pay up in respect of settlements made under the underlying insurance contract, even where such settlements are honest, reasonable and business-like