Directors' and Officers' Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

Document

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9 THE REINSURANCE OF D&O POLICIES

I. INTRODUCTION

9.01 Much of the reinsurance business placed in the London market comes from abroad, as a result of market stability, expertise and capacity. There is a longstanding practice of reinsuring D&O insurance in London and the reinsurance of so-called “foreign direct risks” in the London market gives rise to a series of complex legal problems, which we analyse below. 9.02 Local insurers will usually act as fronts for London market reinsurers and business is conducted by way of reinsurance or retrocession. 2 There will often be a local law requirement that direct business is placed with a local insurer, 3 hence the need for “fronting”, 4 if the business is to find its way to London. The use of fronting in other jurisdictions gives rise to a number of important legal issues, which arise out of the fact that the direct policy and the reinsurance contract are entirely separate contracts.5 9.03 From the outset, D&O reinsuring parties may be faced with one or more of the following issues:

(a) First, and perhaps most significantly, the insurance 6 will be governed by local law, whereas the reinsurance will almost certainly be governed by English law.
(b) Secondly, it may be that certain of the liabilities recognised by the law applicable to the direct policy have no counterpart in English law.
(c) Thirdly, there may also be an issue as to the meaning of the policy terms themselves: it is the usual practice as regards facultative reinsurance 7 to incorporate the terms of the direct policy into the reinsurance. Yet incorporation has proved to be

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highly problematic 8 in that there may be a conflict between the agreed reinsurance terms and the incorporated terms, to say nothing of the different interpretations to policy wording which may be given by local courts and by English courts. 9
(d) Finally, it is also necessary to consider the effects of “follow the settlements” 10 clauses and the impact of such clauses on claims co-operation and claims control provisions. 11

9.04 In order to cope with these problematic areas it is necessary to determine the types of reinsurance which may be used to cover D&O risks. There are two main classes of reinsurance contract, facultative and treaty. 12

II. FACULTATIVE REINSURANCE: NATURE AND TERMINOLOGY

9.05 A facultative reinsurance contract involves the reinsurance of a single direct risk previously accepted by the insurer. The essence of facultative reinsurance is that it is optional: the insurer is not bound to offer, and the reinsurer is not bound to accept any such offer. Facultative reinsurance was the earliest form of reinsurance known to English law, 13 and in legal terms consists of an individual—one-off—contract between reinsurer and reinsured; to this extent it differs little from an ordinary contract of original insurance. Facultative reinsurances have generally been referred to by the courts as “policies”.14 9.06 Facultative reinsurances are for the most part proportional, that is, the insurer retains for himself an agreed proportion of the risk, the remainder being reinsured at the original premium paid minus the insurer’s commission. Since the costs of the reinsurer are greater under the facultative method, the commission allowed to the reinsured will normally serve merely to reflect the latter’s own costs and will not allow for profit. Facultative reinsurance is less attractive to an insurer than the use of a treaty for cover of the equivalent sum. 9.07 The use of “excess of loss facultative reinsurance” for certain types of business is increasing: by this type of arrangement the reinsurer does not contract for any given proportion of the risk but agrees to indemnify the reinsured against liability incurred under an original policy over and above a stipulated sum. In such instances reinsurance will usually be arranged in layers, with reinsurers accepting liability in excess of different monetary limits and, of course, making the agreement vulnerable to reinsurance aggregation disputes. 9.08 The fact that the reinsurer does not contract for a given proportion of the underlying risk but rather for a proportion of the reinsured’s liability under the original policy identifies facultative reinsurance as a separate species of liability insurance, 15 contrary to the earlier opinions of the English courts. 16 This explains why the reinsurer is obliged to indemnify the reinsured upon the establishment of the latter’s liability to the insured under the direct policy;

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or upon a reasonable and businesslike agreement where the reinsurer is obliged to “follow the settlements” as contractual term. 17 This is the distinguishing characteristic of liability insurance and explains why earlier views comparing facultative reinsurance with co-insurance or partnership contracts (in other words, with both reinsurer and reinsured sharing the same insurable interest in the risk) were misplaced. 18 9.09 With the development of treaties the use of facultative reinsurance has steadily declined. Once the parties have agreed upon the terms of a treaty, reinsurance is automatic 19 and the insurer can underwrite any relevant business falling within the scope of the treaty without either delay or incurring the cost of seeking ad hoc reinsurance for the particular liability in respect of which that business is written. 9.10 The advantages of proceeding by treaty (to which we turn immediately below) may be seen by considering briefly the processes commonly involved in arranging facultative reinsurance. This is normally done by means of a slip which details the risk to the reinsured and the size of the insurer’s retention. The slip is passed round potential reinsurers by the insurer or by a broker acting on the insurer’s behalf. Reinsurers will then initial the slip, indicating the proportion of the placement they are willing to accept, a process which continues until the slip is fully subscribed. If, as often happens where the placement is undertaken made by a broker, the slip is oversubscribed, the liability of each reinsurer has to be reduced proportionately, a process which is known as “signing down”. The expense of this system is obvious 20 and there is also a danger of delay, since it is uncertain from the outset whether adequate reinsurance will in fact be obtainable. 21 9.11 Nevertheless, facultative reinsurance remains of some significance, particularly in the underwriting of large liabilities which may fall outside treaty limits, or in cases where the insurer does not carry on enough business of any given class to justify the use of a treaty. Further, in many jurisdictions it is a requirement of local law that insurance is placed with a local carrier and in practice it is often the case that the insurer will reinsure some or all of its liability under a single contract in the form of a facultative reinsurance arrangement.

III. TREATY REINSURANCE

9.12 A reinsurance “treaty” (or “contract”) may be regarded as a master agreement for insurance and not of insurance 22 regulating a continuing relationship between insurer and reinsurer and under which a number of separate direct policies may be reinsured. In considering the nature of treaty reinsurance, two broad distinctions must be drawn: between proportional (surplus 23 and quota share 24) and non-proportional (excess of loss 25 and stop

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loss 26) treaties and between obligatory, 27 non-obligatory 28 and facultative-obligatory 29 treaties. 9.13 In essence, a proportional treaty is one under which the reinsured and the reinsurer effectively share the risk between them in agreed proportions, whereas a non-proportional treaty is based on financial limits and the interests of the reinsurer and reinsured are less obviously linked. Lord Mustill made this observation in his speech in Axa Reinsurance v. Field, 30 where the issue was whether the meaning of an excess of loss reinsurance should be construed in a manner consistent with that of the underlying direct policy even though the wording was different: Lord Mustill, with whom the other members of the House of Lords agreed, decided that there was no presumption of back-to-back cover in a non-proportional treaty: the wordings were to be construed in accordance with their ordinary meanings, even if the end result was that cover did not match. Lord Mustill also noted that proportional contracts in some respects resembled co-adventures between the reinsurer and the reinsured such that there was greater justification in their having a common meaning. 9.14 Treaties may be obligatory, non-obligatory or facultative-obligatory:

(a) An obligatory treaty is one under which the reinsured is obliged to cede all risks of a given description and the reinsurer is obliged to accept them: in most cases the process is automatic on both sides. 31 There are various terms implied into obligatory treaties, as laid down by the leading case of Baker v. Black Sea 32 : these relate to underwriting, claims handling and inspection.
(b) A non-obligatory treaty is one which provides a framework whereby individual risks accepted by the reinsured may be declared to the reinsurer and the reinsurer can then decide whether or not to accept that risk.
(c) A facultative-obligatory treaty is one by which the reinsured has the right to decide whether or not to declare an individual risk but, if he does, the reinsurer is obliged to accept it.

9.15 Whether a treaty is obligatory, facultative or facultative-obligatory is a matter of its proper construction. The point is not always easy, although it might be thought that there is some form of presumption in favour of a purely obligatory arrangement as these are the most common and easiest to administer. 9.16 In SA d’Interm`ediaires Luxembourgeois v. Farex Gie, 33 the open cover in question was non-obligatory and facultative in form, in that the reinsured was not required to make declarations to the open cover and the reinsurer was not obliged to accept any declarations made. The open cover contained two different “held covered” clauses. Under the first clause, the reinsured was entitled to treat new declarations as covered for seven days and under the second, the reinsured was entitled to treat renewals as covered for 30 days (in each case pending a final decision by the reinsurer). The reinsured argued that the “held covered” clauses converted the open cover into an obligatory agreement, in that the reinsured was entitled to the benefit of cover until it was refused. Gatehouse, J held that the inclusion of

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open cover provisions—which were not, in practice, used to any great extent—could not affect the non-obligatory facultative nature of the agreement. It did not, therefore, amount to a contract of reinsurance as such, but rather to a mechanism under which contracts of reinsurance could be arranged. 9.17 In Glencore International AG v. Ryan, The Beursgracht, 34 the assured was insured under a marine liability policy expressly described as an “open cover”. The period clause in the policy stated that it related to “all vessels chartered by” the assured in the relevant period; there was a further optional clause which gave the assured a discretion to include in the cover cargo insured by a third party. At first instance HHJ Hallgarten QC held that the insurance provided by the period clause was obligatory on both sides. While the use of the phrase “open cover” was not conclusive either way, the use of the word “all” in the period clause indicated that neither party was to have any discretion. Further, the additional optional clause under which the assured could declare risks insured elsewhere was to be contrasted with the period clause, which contained no such discretion. In the Court of Appeal the correctness of the judge’s reasoning was not challenged. 9.18 More recently in Glencore International AG v. Alpina Insurance Co, 35 Moore-Bick, J was of the view that the purpose of an open cover in a facultative/obligatory form, is to guarantee that cover is available on a permanent basis in regard to goods in the course of trading and that such cover remains at the insured’s disposal for as long as it may be required. 36

IV. CONTENT OF A FACULTATIVE REINSURANCE AGREEMENT

9.19 The traditional method by which a facultative reinsurance agreement is placed in the London market is by means of a single cover sheet—generally described as a “slip policy” —which is appended to the direct insurance policy to which it relates and in respect of which reinsurance is being given. The fact that the slip is referred to as a “slip policy” means that no further documentation is to be issued and that the direct policy taken with the cover sheet constitute the entire agreement between the parties. 9.20 The terms of the reinsurance cover are generally identified as being the same as those contained in the direct policy. This is achieved by the use of words similar to “as original”, which formulation has superseded earlier usages such as “warranted subject to the same terms and conditions as original”. The assumption to date has been that the phrase “as original” operates to incorporate the terms of the direct policy into the reinsurance agreement in light of the decisions in Forsikringsaktieselskapet Vesta v. Butcher 37 and Toomey v. Banco Vitalicio de Espana SA de Seguros y Reaseguros, 38 suggesting that the phrase “as original” amounted to a warranty that the terms disclosed to the reinsurers were those of the direct policy—that is, the phrase had an incorporating function. 39 It may be noted, however, that in the Court of Appeal’s decision in Toomey, 40 Thomas, LJ expressly refused to decide whether

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the phrase “as original” does indeed have an incorporating effect, echoing the doubts expressed by Lord Griffiths in Forsikringsaktieselskapet Vesta v. Butcher.41 9.21 The Slip Policy will generally contain a small number of terms of its own. The reinsurer usually agrees to “follow the settlements” or “follow the fortunes” of the reinsured: there is no English authority as to the latter formulation, but the former has been held to oblige the reinsurer to indemnify the reinsured where there has been a judgment or arbitration award against the reinsured or where the reinsured has entered into a bona fide and businesslike compromise with the assured relating to the assured’s claim under the direct policy. 42 Where the terms of the original policy have been incorporated and there is a “follow the settlements” obligation, the reinsurers are not entitled to rely upon the reinsuring provisions of the facultative contract to defeat a settlement by the reinsured which has been reached on the basis that the direct policy provides cover: see the decision of Assicurazioni Generali SpA v. CGU International Insurance plc. 43 9.22 It is also frequently the case that the obligation to follow settlements is tempered by a “claims control” or “claims co-operation” provision, by the terms of which the reinsurer is not to face liability unless the reinsured has either handed over to the reinsurer all responsibility for negotiating with the assured (claims control) or has at least kept the reinsurer informed of the progress of negotiations and has secured the reinsurer’s consent to any settlement (claims co-operation). 44 Although it remains common practice to include both “follow the settlements” and claims control provisions within the same slip cover, as noted below, 45 this tradition has proved meaningless in the sense that whenever reinsurers take control of the claim, any arrangement reached is binding on them not as a result of “following the settlements” of the reinsured but due to the fact that the reinsurer—by taking control—are party to the agreement itself. 46 The authors take the view that the rationale behind the inclusion of these two provisions is little more than a polite way of saying “I trust you, but only a little bit”. There may be other express terms relating, for example, to defence costs, 47 but for the most part the reinsuring terms are extremely limited.

(a) Incorporation from direct policy

9.23 English law permits the incorporation of a term into a contract by reference, so long as it is shown that the parties intended to incorporate that term into the new agreement. 48 As mentioned above, 49 the path the majority50 of D&O policies take to the London market is by way of reinsurance, it being necessary in a number of cases—due to local restrictions—to use fronting to achieve this purpose. 9.24 Quite why the London market has so readily embraced the incorporation of terms from the direct policy to the reinsurance, when the process is one fraught with legal difficulty, can only be guessed at: conservatism and/or laziness may be key factors. Regardless, the

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outcome is that reinsurers provide their services by doing no more than subscribing to a slip of paper containing a very simple phrase that might incorporate—if the term is appropriate—all the wordings contained in the direct policy. However, the courts have ruled that terms in the direct policy which are inconsistent with the reinsurance cannot be incorporated and equally those which are repugnant to the very nature of a reinsurance agreement will not be incorporated. 9.25 In Home Insurance of New York v. Victoria-Montreal Fire, 51 a fire insurance policy was reinsured, purporting to incorporate all the terms of the direct policy, including a clause which prohibited any legal proceedings to be taken unless commenced within the 12 months immediately following the loss. 52 The issue to be decided was whether this clause, which by its nature appeared to be inappropriate to reinsurance matters because it was inconsistent with the manner in which the reinsurance market operated, was incorporated. The Privy Council held not. Time-bar clauses were perfectly reasonable in policies insuring direct loss to specific property, since the insured was in control of the situation by being able to commence proceedings immediately after the occurrence. However, in cases of reinsurance against liability the situation differed, because the reinsured could not take action until the direct loss was “ascertained between parties over whom he [had] no control and in proceedings in which he [could not] intervene”. 53 9.26 In Municipal Mutual Insurance Ltd v. Sea Insurance Co Ltd, 54 a series of third party liability policies incepted and were reinsured from 1983. The policies provided protection for the Port of Sunderland Authority in respect of losses suffered by a third party to which it provided its services. The underlying policy was renewed for successive periods of insurance and amended by endorsements. For the years 1986-1987 and 1987-1988 reinsurance was placed and all the terms of the underlying policy were incorporated into the reinsurance. The insured port authority incurred liability to a third party and was found liable to pay a sum for which the insurer was itself required to provide an indemnity. That liability arose from a number of losses occurring over a three-year time span covering more than one period of insurance and the reassured sought to recover for the reinsurer. The reinsurers successfully contended that they were only liable to indemnify losses referable to the relevant policy year since the reinsurance policy happened to be a one-year policy, irrespective of being renewed on a yearly basis. Additionally, had the reinsured been successful in establishing reinsurance cover, the events which had occurred between 1987 and 1989 were subject to a deductible under the wording of both the underlying and reinsurance policy. The key aspect here, however, was the refusal to allow the incorporation of the duration provisions of the underlying insurance cover into a reinsurance which was specifically stated to be for a more limited period. 55 9.27 The issue of inconsistency was also dealt with in CNA International Reinsurance v. Companhia de Seguros Tranquilidade. 56 In this case the risk of cancellation of a Placido Domingo concert was insured by the defendant insurer and reinsured as to 90% by the claimant reinsurers. The concert was cancelled due to the illness of the performer’s mother. A claim was made against the insurer for both loss of profits and costs incurred and this was settled by the defendants, who sought recovery from the reinsurers.

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9.28 The insurance incorporated the Lloyd’s contingency policy NMA 2540 with the Lloyd’s standard non-appearance wording NMA 2396, it being intended that the terms should be the same for both insurance and reinsurance agreements. 57 Furthermore, a wording contained in the defendants’ standard “General Civil Liability Policy” was annexed as forming part of the agreement, giving rise to what has been described by Professor Merkin as “a curious mix of local and London terms”. 58 This mixture gave rise to a complicated issue of law, since the court had to determine which—if any—of the underlying policy’s clauses had been incorporated into the reinsurance given the fact that the direct policy had been written on the reinsurers’ form. Clarke, J reached two interesting conclusions:

(a) First, given that it was the intention of the parties to create a back-to-back contract, it did not matter that the reinsured had used a standard civil liability form to give effect to a risk characterised by being a first party loss.
(b) Secondly, in this regard it was held that the terms of the direct policy were to be incorporated and, in order to give effect to them; they had to be adapted so as to fit the purposes of the reinsurance. This issue was clearly addressed by Lord Griffiths’ speech in Forsikringsaktieselskapet Vesta v. Butcher.59 In that case, as explained below, 60 a fish farmer insured his stock under a direct policy which had been prepared from a Lloyd’s standard form that expressly stated that the underwriters reserved the right to replace lost stock (in that case, trout and salmon) with similar stock of a like species. The policy was reinsured by means of a slip stated to be “as original” and thus to be on the same terms and conditions as the direct policy. Lord Griffiths commented: “do we have to suppose that it was the intention of the parties that the reinsurers could have discharged their liability by delivering a load of live trout and salmons to the reinsured?” 61

9.29 Although there are a number of cases illustrating the point, 62 the decision in HIH Casualty and General Insurance v. New Hampshire Insurance 63 merits special consideration. In that case, David Steel, J attempted to clarify the principles governing incorporation, by formulating four statements:

(a) Incorporation may be achieved if the term is germane to reinsurance.
(b) The term must make sense, subject to permissible manipulation, in the context of the reinsurance.
(c) The term must be consistent with the express terms of the reinsurance.
(d) The term must be apposite for inclusion in the reinsurance.

9.30 However, the leading authority is the decision of the Court of Appeal in the same proceedings 64 where Rix, LJ, for the first time, clearly articulated the distinction between the “fact of incorporation” and “the effect of a term once incorporated”. This case 65 concerned

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pecuniary loss indemnity insurance—increasingly commonplace in the film industry—put in place to indemnify the insured investors in the event of a shortfall between the amount of finance provided and the revenue collected in the making of two separate groups of films. One group was to be co-produced by 7.23 Productions LLC and Flashpoint Ltd and the other by Rojak Films Inc and also Flashpoint Ltd. Two insurance policies were issued accordingly. These underlying policies contained a series of terms, of which clause 8 gave rise to the most contentious issues. Clause 8 was a disclosure and/or waiver of rights provision, by which the insurer agreed not to seek relief on the grounds of invalidity or unenforceability of any of its arrangements with the assured. 66 9.31 The insurer (HIH) reinsured both policies with Axa Reassurance SA and New Hampshire Insurance Co Ltd in respect of the two policies. Independent Insurance Co Ltd was also reinsurer but only in respect of the 7.23 Productions LLC policy. The reinsurance slip contained the wording “Cancellation Clause as Original Policy”. In the event the film producers did not make the requisite number of films and the assured investors obtained indemnity from the insurer up to US$31 million. In turn the reassured sought to recover under the reinsurance policy. The reinsurers refused an indemnity, relying in particular on breaches of warranty and breaches of the duty of good faith. The underlying policy contained a warranty that the assured had to make a slate of six or 10 films, respectively and the Court of Appeal was satisfied that the warranty had been incorporated into the reinsurance agreement. Additionally, the reinsurer’s consent was required for any amendment to the underlying policy. The reinsurers asserted that they were not obliged to make payment because the insurer had known, but had not informed them, that the requisite number of films had not been made and that in any event the failure to make the full number of films was a breach of the reinsurance warranty. For its part the reassured alleged that clause 8 had been incorporated from the direct policy into the reinsurance and precluded the reinsurers from relying upon breaches of warranty or breach of any duty of good faith unless fraud had been involved. 9.32 Although the Court of Appeal had to deal with a number of wide-ranging issues, two are of interest in the present context. The first was whether clause 8 had been incorporated into the reinsurance. The second was the effect of clause 8 in the reinsurance context, if it had indeed been incorporated. On the first issue, the Court of Appeal held that incorporation was achieved when there were appropriate words of incorporation sufficient to accomplish this and also when the term, so incorporated, made sense in the contractual context of reinsurance. On the second issue, David Steel, J at first instance had assumed that clause 8 was to be incorporated in a form which meant that it bore the same meaning at the reinsurance level as it had at the direct level, namely that the reinsurers had agreed to waive any “utmost good faith” defences otherwise open to them. To achieve this result it was necessary to “manipulate” the wording of clause 8 so that it referred to the reinsurance context, rather than the insurance context. The Court of Appeal disagreed with David Steel, J on this matter. Rix, LJ noted that if the clause had been incorporated, it could take effect in the reinsurance in either

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a manipulated or non-manipulated form. In its manipulated form, the incorporated clause operated as a waiver of disclosure rights by the reinsurers. In a non-manipulated form, clause 8 merely amounted to a statement to the reinsurers that the reinsured had waived its right to avoid the direct policies and accordingly that an indemnity could be sought from the reinsurers even though the reinsured would—but for clause 8—have had a good defence against the investors. The Court of Appeal preferred the latter interpretation, holding that clause 8 had been incorporated in an non-manipulated form and was no more than a “follow the settlements” clause, that is, a promise by the reinsurers that they would provide an indemnity in the event that clause 8 precluded avoidance of the direct cover. 67

(b) The presumption of back-to-back cover

9.33 The presumption of back-to-back cover is the result of a simple interpretation of the nature of a reinsurance contract that is written on a proportional basis. The reinsurers and the reinsured share a common goal since the purpose of the reinsurance is to transfer some or (in the case of fronting) all of the risk to the reinsurers, by means of the reinsurance in return for an agreed proportion of the premium. 68 From this perspective it is logical that the two policies are to be construed as back-to-back. Were it otherwise, the reinsured might face loss for which no indemnity was available. This presumption works upon three well-established premises:

(a) first, the risk at both levels (insurance-reinsurance) is alike;
(b) secondly, the duration of the two contracts is interpreted as matching; and
(c) thirdly, the warranties contained in the reinsurance contract should be given the same effect so as to not contradict those contained in the direct policy. 69

9.34 In Forsikringsaktieselskapet Vesta v. JNE Butcher, Bain Dawes Ltd,70 the House of Lords held that, by reason of the “full reinsurance clause” under which the terms of the direct policy were to be incorporated into the reinsurance, it was plainly intended that the reinsurance was meant to be back-to-back with the underlying policy. This case concerned a fish farmer in Norway who sought insurance against, among other risks, that of the loss of living fish. The insurer—Vesta, a local Norwegian company—arranged reinsurance with the defendant up to 90% through a subsidiary of Lloyd’s brokers. Reinsurance was obtained by means of a standard form London market slip which provided that property covered was that described in the original policy. As noted above,71 the slip included the full reinsurance clause under which the reinsurance was stated to be on the same terms and conditions as the direct policy and also stating that the reinsurers would “follow the settlements” of the reinsured. The problem in this case was that the reinsured acted in breach of a warranty contained in the direct policy (by failing to maintain a 24-hour watch on the fish farm), but under Norwegian law—which governed the direct policy—that breach did not discharge the insurers, because it had not been causative of the loss. However, under English law, which applied to the reinsurance agreement, a breach of warranty had the automatic effect of

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discharging the reinsurers’ liability. Lords Bridge, Templeman and Lowry held that the full reinsurance clause operated to incorporate the terms of the direct policy into the reinsurance, but that in order to ensure that the cover was back-to-back it was necessary to construe the English policy in the same way as the direct policy, that is, in accordance with Norwegian law. Their Lordships were thus prepared to distort the principle that the applicable law governs all matters of construction in order to achieve back-to-back cover. Lord Griffiths agreed that the reinsurers could not rely upon the reinsurance warranty, but was able to reach that conclusion purely on the basis of the presumption of back-to-back cover and felt that there was no need to resort to any principle of incorporation.72 9.35 The presumption of back-to-back cover has been taken even further than Forsikringsaktieselskapet Vesta v. Butcher. In Groupama Navigation et Transports v. Catatumbo CA Seguros,73 the Court of Appeal declined—in the interests of finding that back-to-back cover was in place—to give effect to an express clause in the reinsurance contract governed by English law regarding a warranty as to the obligation to maintain two vessels in class. In that case, a Venezuelan insurance company provided hull and machinery cover to a local company in respect of two vessels. The underlying policy contained a clause in the following terms: “Guarantee of maintenance of class according to the ABS (American Bureau of Shipping) Standards and Rules.” The insurer sought facultative reinsurance in respect of liability under the insurance contract; the policy which was in the form of a slip providing: “All terms clauses conditions warranties … as original and to follow all decisions settlements agreements of the same in every respect … Warranted existing class maintained.”74 9.36 The two vessels were badly damaged in a storm and it turned out that by the time of the casualty they were not, and in fact never had been, classed. Nevertheless, the insurer agreed to indemnify the costs of repair since under Venezuelan law—which governed the underlying policy—a breach of warranty did not discharge the other party to a contract unless it was causative of the loss. The insurer in turn sought to recover under the reinsurance policy. The reinsurer sought a declaration that a failure on the part of the assured to maintain the vessels in class constituted a breach of warranty contained in the reinsurance slip and that in accordance with English law—which governed the reinsurance—it had been discharged from the obligation to provide an indemnity. 9.37 The Court of Appeal held the two policies were, in absence of clear words to the contrary, intended to be back-to-back, thus producing the same effect at both levels. Consequently, the warranty in the direct policy was to be regarded as having been incorporated into the reinsurance and was to be construed in accordance with Venezuelan law so that a breach which did not cause any loss was to be disregarded. This is a significant extension of the Vesta principle, in that in order to reach its conclusion the Court of Appeal had to ignore the express warranty in the reinsurance. The Court of Appeal was able to do this by noting that the insurance and reinsurance warranties were similarly worded and that in any event the reinsurance warranty had presumably been inserted as a precautionary measure to cover the possibility that the direct policy did not contain an equivalent provision: once the direct policy was found to contain a classification warranty, the reinsurance warranty could be presumed to have been ousted. The authors’ view is that this decision takes the notion of back-to-back cover to its outer limits.

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9.38 The boundaries of the presumption of back-to-back cover have been tested in two more recent cases. In GE Reinsurance Corporation v. New Hampshire Insurance Co,75 the reinsurance slip was issued “as original” but contained a series of conditions which did not appear in the underlying policy. The issue before the Commercial Court was to ascertain whether or not the presumption of back-to-back cover worked to eliminate reinsurance provisions which had no equivalent in the reinsurance cover. Langley, J was of the view that a condition in the reinsurance slip requiring the continuing employment of two of the insured’s employees was a warranty, the breach of which discharged the reinsurers from their obligation to indemnify the reassured in respect of the resulting loss. The judge distinguished Groupama on the basis that in the earlier case the direct policy and the reinsurance had contained equivalent provisions and it was appropriate to construe them, ultimately, in the same way: this was not possible where the reinsurance agreement contained its own provisions which had no direct equivalent, as it was necessarily the case that the reinsurance was intended not to be back-to-back to that extent. 9.39 Goshawk Syndicate Management Ltd v. XL Speciality Insurance Co,76 was one of a number of insurance claims arising out of the 11 September 2001 terrorist attacks, in that case relating to the loss of retail stock by a company with outlets in the World Trade Center in New York. The underlying policy was subject to an annual aggregate limit deductible of US$5 million, such that cover did not attach until that figure had been reached. There was also a variety of per claim deductibles. For present purposes, the key provision was contained in a further clause which provided that individual claims in excess of US$1 million would be covered even though the annual aggregate deductible figure had not been reached. Reinsurance was sought and arranged “as original” 100% for two-thirds of the premium for a maximum of US$20 million, also including an annual aggregate limit of US$5 million. The reinsurance was written on the basis that it was subject to the original deductibles. The insured sought indemnity when its stores and stock were destroyed as a result of the collapse of the twin towers of the World Trade Center. The claim was in excess of US$1 million (the total sum at stake being about US$10 million), although the annual aggregate deductible figure had not been reached. The insurers, having paid the claim, sought indemnification from the reinsurers, but this was refused on the basis that the reinsurance contained an aggregate deductible of US$5 million, a sum which had not been reached. The issue before the Commercial Court was to determine whether the terms of the direct policy were to be regarded as having been incorporated into the reinsurance. Morison, J held that the clause providing for payment of losses in excess of US$1 million was a “deductible” clause and accordingly the reinsurers were bound to make payment. The decision illustrates the strength of the notion of back-to-back cover, because the insurers themselves had expressly refused to argue that the US$1 million clause was a deductible. Morison, J nevertheless took the view that the policies had been written on a back-to-back basis and that the only way to give effect to the parties’ intentions was to adopt this (somewhat generous) interpretation of the word “deductible”. Although Morison, J gave permission to appeal (as he had indicated during the course of argument of the reinsurers’ application for summary judgment), it appears that the matter settled before the hearing of the appeal. If the learned judge’s reasoning is correct, it appears that the back-to-back presumption can override the actual words of the reinsurance in a manner not even contemplated by Groupama v. Catatumbo.

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9.40 At the time of publication the reinsurance market eagerly awaits the result of the appeal to the House of Lords in Wasa International Insurance Co Ltd v. Lexington Insurance Co,77 which some in the market have described as the most important reinsurance decision of the last 20 years. 9.41 In August 1977 Lexington insured the Aluminium Company of America (“Alcoa”) from noon on 1 July 1977 until noon on 1 July 1980 against loss or damage to property and business interruption risks, with a limit of liability of “$20,000,000 loss or damage arising from any one occurrence” and a per occurrence deductible for property damage of $250,000”. Lexington obtained facultative reinsurance from the London reinsurance market, including Wasa International Insurance Co Ltd (“Wasa”) and AGF Insurance Co Ltd (“AGF”), “as original”, the period of cover being stated to be “36 months 1.7.77 L/U &/or pro rata expiry of original”, and the amount reinsured being $20,000,000 each occurrence and in the annual aggregate. The slip policy referred to a “full reinsurance clause”, the “J1 or NMA 1779” forms, which stated “Being a reinsurance of and warranted same gross rate, terms and conditions as and to follow the settlements of the [reinsured]” (J1) and stating that reinsurers would “ … pay or make good to the Reinsured all such Loss as aforesaid as may happen to the subject matter of this Reinsurance, or any part thereof”, and that the reinsurers agreed to indemnify the reinsured in respect of loss to the insured subject matter “during the continuance of this Policy” (each NMA 1779). Wasa subscribed to a 1% line and AFG subscribed to a 1.5% line. Although there was no express choice of law clause in either the insurance contract (which contained a US Service of Suit clause) of the reinsurance contract, it was common ground that the reinsurance contract was governed by English law. 9.42 In the early 1990s the US Environmental Protection Agency and various state regulators required Alcoa to clean up a pollution at some 35 sites that Alcoa had used for some 50 years. In turn, Alcoa began proceedings in Washington state against various property liability insurers, including Lexington, who had provided insurance and been on risk from 1956 to 1985, seeking a declaration that they were entitled to insurance coverage in respect of the clean-up costs at the Alcoa sites. The trial judge of that action, applying the law of Pennsylvania (where Alcoa was incorporated and had its centre of business) held that there had been two occurrences—wastage from manufacturing units and wastage from other sources—and that it was possible to attribute specific remedying costs to the damage, and that the appropriate apportionment was to divide the total repair costs for each site by the number of years in which damage occurred and then to allocate the appropriate proportion to each year. The evidence showed that the damage had occurred over many years up to the date of the inception of the insurance in 1977, and indeed for some years thereafter; and so by using this allocation formula Lexington was liable for only a relatively small percentage of the overall loss (and at some sites losses were below Alcoa’s deductible). In fact, Alcoa did not have effective cover in place for a number of years and therefore as a result of the first instance judgment, had significant uninsured losses. Alcoa appealed, arguing that under Pennsylvanian law the full costs of remedying the damage at any particular site could be recovered provided only that some damage occurred at the relevant site during the years in which Lexington was on risk. The Supreme Court of Washington held that this was indeed the law of Pennsylvania, meaning that the insurers, including Lexington, were jointly and severally liable to Alcoa for all property damage, including damage that had occurred before the 1977 cover incepted. The result was that Lexington was faced with a claim for $180m,

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which it settled for $103m, payable over a two-year period on this interpretation of the law. Lexington then sought to recover their losses from their reinsurers, Wasa. 9.43 Wasa refused to pay this claim, arguing that the reinsurance policy was governed by English law and that, as a matter of English law, reinsurers could only be liable for the costs of remedying damage to property which occurred between 1 July 1977 and 1 July 1980 (and that they could not be liable for the costs of remedying damage which occurred before or after the period of the reinsurance). Wasa issued proceedings in the Commercial Court in London seeking a declaration that they were not liable. At first instance, Simon, J held that the reinsurers were not bound by the settlement and upheld these contentions. The Court of Appeal unanimously reversed Simon, J. 9.44 The Court of Appeal said that the key question to be asked was not whether the policy was intended to be back-to-back (Lexington’s position) or whether the reinsurance was intended to apply only to loss and damage occurring within the policy period (Wasa’s position), but rather whether the fact that the parties has used the same or equivalent wording in the reinsurance as the direct insurance meant that they intended that wording to have the same meaning in both contracts such that the two contracts were to be construed in the same way. The Court held that the period clauses in the insurance and reinsurance contracts, although in slightly different terms, were effectively identical and the parties had intended those clauses to have the same meaning. The interpretation of the language in the direct policy as decided by the Supreme Court of Washington applying the law of Pennsylvania was therefore applied to the meaning of the period clause in the reinsurance wording. Longmore, LJ stated that the general principle in such circumstances was that the same or similar wordings in contracts would be given the same construction and, if this was not to be the case, there would need to be clear indications to the contrary. In both Forsikringsaktieselskapet Vesta v. Butcher 78 and Groupama Navigation et transports v. Catatumbo CA Seguros,79 as we have seen, identical words were given the same meaning regardless of the fact that they were governed by different applicable laws. Simon, J had therefore erred in holding that those cases did not apply to the situation where the words used were not capable of dictionary definition (there being no settled meaning for the direct period clause at the time the reinsurances were placed as a result of the service of suits clause) or where clear words were given an unexpected meaning.80 9.45 The Court of Appeal rejected any notion that the London market ought not to be landed with an unsatisfactory US Court decision and that such decisions ought to remain with US insurers in these circumstances, Longmore, LJ said that: “No one can pretend that the decisions of the United States courts in relation to asbestosis and pollution claims are remotely satisfactory from the point of view of insurers let alone reinsurers. Reinsurers’ arguments in the present case had the whiff of an assertion (although they were careful not to say so expressly) that Lexington were an American Corporation and had therefore to take unsatisfactory decisions on the chin, while reinsurers were English (or doing business in the English market) and could not be expected to do so. That, of course, will not do.” Longmore, LJ also commented that reinsurers had to take the risk of a change of law in a competent

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American jurisdiction if they insured an American company, just as insurers had to take the same risk.81 The learned judge also noted that, if parties to a reinsurance contract were concerned that any disputes regarding that contract might be decided unexpectedly the were at liberty to choose how disputes were to be decided, for example by using the Bermuda Form, which provides for jurisdiction, forum and choice of law.82 9.46 Sedley, LJ also commented forcefully that a contract of reinsurance (re)insures the reinsured’s liability and is not, on a proper analysis, a type of insurance of the original subject matter. Longmore, LJ, the only other member of the court to mention the point, was of the view that this was a jurisprudential matter that did not affect the proper interpretation of the reinsurance contract in question. The point is an interesting one because the exact legal nature of reinsurance remains uncertain on the authorities and is highly relevant, for example, to questions of limitation. 9.47 The Court of Appeal’s decision is perhaps unsurprising given the uncertainly created by Simon, J’s first instance decision in relation to how to determine which clauses were to be interpreted on a back-to-back basis and which terms were not. However, the English courts have, in the main, found in favour of reinsurers in “follow the settlements” disputes where the insurance and reinsurance contracts have different wordings.83 The Court of Appeal’s decision in Wasa v. Lexington reverses this trend and the House of Lords’ decision, and indeed its ambit, will be interesting to see. 9.48 Looking at the notion of incorporation and the presumption of back-to-back cover, the authors take the view that it is possible that the first concept does more harm than good for the successful resolution of reinsurance disputes. If it is understood that reinsurers are protected by a strong presumption of back-to-back cover with regard to the reinsuring clause, there is simply no need to incorporate the terms of the underlying policy in the reinsurance. This point becomes even clearer by reasserting the nature of facultative reinsurance as liability insurance on its own and the fact that the underlying policy might not be one on liability (for example, a fidelity policy),84 thus impeding a sensible construction of two policies that by nature exclude each other.85 In any case, reinsurers are well-protected without requiring recourse to the notion of incorporation in two possible situations. First, where there is a variation of a term in the underlying policy, such modification requires reinsurer’s consent to be binding on them. Secondly, where there is a breach of warranty in the direct policy, the notion of back-to-back cover also discharges reinsurers, on the grounds that both policies bear the same construction. Support for this may be gleaned from the recent approach of Thomas, LJ to the presumption of back-to-back cover in Toomey v. Banco Vitalicio de Espana SA de Seguros y Reaseguros.86

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V. MEANING OF TERMS AND POLICY INTERPRETATION: D&O INSURING CLAUSE

9.49 Having ascertained the background against which issues of incorporation and/or back-to-back cover arise, we turn now to consider the effect of reinsuring “as original” in respect of D&O policies. Although the market offers a number of different wordings, the majority of policies agree:

“to pay on behalf of the Directors or Officers of the Company Loss arising from any claim first made against them during the period of insurance and duly notify to the insurers during the same period by reason of any wrongful Act committed in the capacity of Director or Officer of the company … ”

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