Reinsurance transactions carry inherent risks for both parties. One risk is the substantial increase in liability that can result from an unexpected or unfair court decision. In such situations, the facultative cedant must have comfort that its reinsurer will cover its share of the loss, at least when the reinsurance cover is worded similarly to the underlying insurance and a court has adjudicated important issues relating to the cedant’s liability. While the insurance and reinsurance industry has some expectation of U.S. courts protecting insureds and claimants at the insurers’ and reinsurers’ expense, insurers historically have not expected English courts to protect reinsurers from a cedant’s claim for the reinsurer’s share of such losses.
Until now. In a recent decision, the House of Lords held that, notwithstanding an American court decision governing the cedant’s exposure, the reinsurer’s liability was not governed by that adjudication. See Wasa Int’l Ins. Co. v. Lexington Ins. Co., [2009] UKHL 40 (July 30, 2009). The result is that a cedant that paid a loss in accordance with a binding court decision will not be reimbursed under a facultative cover that even the Lords agree was “back to back” with the underlying policy.
The Lords’ decision is wrong. It ignores the purpose of reinsurance and the realities of the reinsurance market. At best, the decision devalues reinsurance obtained through the London market. At worst, it is simple protectionism. See Wasa, par. 18 (Opinion of Lord Mance) (“The issue in this case is whether certain financial consequences can be passed by a Massachusetts insurer ... to two London reinsurers....”).
Some background is in order.
Lexington provided Alcoa with Difference in Conditions insurance, which provided property and business interruption cover between July 1, 1977, and July 1, 1980. The insurance contract did not include a choice of law clause but included a service of suit clause consenting to jurisdiction anywhere in the United States. Lexington obtained facultative reinsurance for the same period through the London market. Several reinsurers participated, including the English reinsurers Wasa and AGF Insurance Ltd. The facultative contract was expressed to be “as original,” and the Lords recognize the coverage provisions of the insurance and reinsurance as fundamentally the same.
Alcoa later was required by various governmental agencies to clean a number of its sites that sustained environmental damage between 1942 and 1986. Alcoa had no environmental coverage for some of the years in question and, therefore, would have significant uninsured losses, if each insurer was liable only for spills during its respective policy period.
Facing these issues, Alcoa sued Lexington and other direct insurers in the Superior Court of King County, Washington, arguing that all insurers were liable for all environmental damage, regardless of the occurrence date. The insurers maintained that liability must be allocated based on the occurrence dates. The Supreme Court of Washington, ostensibly applying Pennsylvania law, agreed with Alcoa. See Aluminum Co. of Am. v. Aetna Cas. & Surety Co., 998 P.2d 856 (Wash. 2000). The court held that the policy’s language, that it “insure[d] against all . . . damage to the insured property . . ., except as hereinafter excluded or amended” covered preexisting damage, because the coverage language of the policy did not expressly state that it covered only losses occurring within the policy period. Id. at 883-885.
In light of this adverse decision, Lexington settled its exposure and dunned its reinsurers. Most paid, but Wasa and AGF did not. They argued that, regardless of the coverage afforded by the direct insurance, the reinsurance was governed by English law. A fundamental precept of English insurance law is that an insurer (or reinsurer) would be liable only for spills occurring during the policy period.
Wasa and Lexington sued for declaratory relief in the Commercial Court in London. After a decision in favor of the reinsurers, Wasa Int’l Ins. Co. v. Lexington Ins. Co., [2007] EWHC 896 (Comm.), Lexington appealed to the Court of Appeal. The Court of Appeal found in favor of Lexington, holding that the issue was not choice of law, but whether the same or similar wording in the insurance and reinsurance contracts should be accorded the same meanings, i.e. whether the coverages should be treated as “back to back.” Wasa Int’l. Ins. Co. v. Lexington Ins. Co., [2008] EWCA Cir. 150.
The House of Lords reversed. While recognizing that the wording in the insurance and reinsurance contracts were fundamentally the same and that “almost invariably” this would render the reinsurers liable, even if English law would dictate a different decision, the Lords nonetheless found in favor of the reinsurers. The Lords noted that the period of reinsurance clause was fundamentally important, that the parties in 1977 could not have predicted that Pennsylvania law would apply to the underlying policy or that the policy would be construed in such a manner.
The reasoning is suspect. Since Alcoa was based in Pennsylvania, it is not surprising that the Washington court applied Pennsylvania law. Aluminum Co., 998 P.2d at 862. Indeed, neither Alcoa nor Lexington disputed this issue on appeal. Id.Similarly, given the service of suit clause in the original policy, it is not surprising that litigation was commenced in Washington. Alcoa could sue Lexington in any state, and the forum state’s choice of law clause would apply.
The Lords’ focus on choice of law, notwithstanding the back to back coverages, is disconcerting. The tension is not just English law versus the law of a U.S. state, but could be between the laws of two U.S. states. Not all U.S. states would agree with the Washington Supreme Court. Carried to the limits of the Lords’ logic, reinsurers could avoid liability if the cedant’s liability was determined under the law of one U.S. state, while the reinsurer’s liability was determined under the law of another U.S. state.
The Lords’ statement that in 1977 the insurer and reinsurers could not have predicted the nature of the Washington court’s holding, i.e. that Lexington would be liable for pre-existing pollution, probably is factually correct. It is unlikely that Lexington or the reinsurers would have covered this risk if they had understood the scope of risk accepted.
But, so what? That is part of what insurance and reinsurance are for. Neither insurance nor reinsurance heretofore has been subject to a “cockamamie court decision” exception to contractual liability.
The House of Lords’ decision would not be particularly noteworthy if it merely followed from a cedant’s settlement without a court decision. It is generally accepted that follow-thesettlements does not bind the reinsurer to settlements outside the terms of the insurance policy or the reinsurance agreement. But this is different. The Wasa case involved a facultative certificate covering the single underlying insurance policy at issue. The covering language was similar in both agreements, and a court of competent jurisdiction, i.e. the Supreme Court of Washington, held that the language allowed for joint liability throughout the period of environmental contamination.
The Washington court’s decision is not easy to defend. While minimally supported by a literal reading of one portion of the insurance policy, i.e. the coverage language itself does not expressly limit the coverage to occurrences within the policy period, and a prior Pennsylvania court decision, the court’s decision is completely divorced from the reality of the insurance marketplace and simply provided a windfall for Alcoa.
But the business world has been exasperated by American court decisions for years. Insurers should not be deprived of their reinsurance because a court makes a wrong decision. Any underwriting of coverage must account for that risk.
Wasa teaches two lessons. First, American judges need to understand that judicial decisions have economic consequences. In this case, an insurer that bargained for, and received premiums for, four years of risk suddenly is on the hook for over thirty years of losses. The London reinsurance market and court system have served notice that they no longer will serve as enablers to the continued confiscation of insurer assets by judicial fiat. Those that advocate broad tort and product liability cite the benefits of spreading societal costs throughout society. Wasa announces that the cost of expansive tort liability no longer will be spread throughout the world via the international reinsurance system. Rather, the cost will be spread solely within the U.S. insurance market and, therefore, U.S. society.
The second lesson of Wasa is that reinsurance through the London market is not as valuable or reliable as previously thought. If the reinsurer’s liability under a back to back facultative cover does not follow an adjudication against the cedant, then it is of limited protection. If choice of law trumps back to back cover, then the reinsurers have an escape. The reinsurers need not test the protection via litigation in England or elsewhere; the threat to do so will be enough to trigger settlements at a discount.
One of three things is likely to happen. First, American courts may begin to consider the effect on an insurer when catastrophic losses are imposed that may not be covered by English reinsurance. In my view, that is unlikely to happen. To the contrary, American courts have a history of bankrupting corporations over expansive tort claims.
Second, American insurers may begin to insist on contractual protections, such as an express incorporation of the law of an American state or, better yet, exclusive U.S. jurisdiction. Of course, this is akin to closing the barn door after the horse’s exit. English reinsurers bound to occurrence-based reinsurance will remain protected from past environmental and product coverages.
Third, American insurers may eschew the London market to avoid judicially created gaps in their reinsurance coverage. Indeed, state insurance regulators may restrict the use of English reinsurers on domestic risks or may require the application of the law of a U.S. state to English reinsurance contracts. This also would be of scant current benefit to American cedants with outstanding risks. But more importantly, regulatory action against English reinsurers would be deleterious to the continued primacy of the London reinsurance market.
An insurer, American or otherwise, must have confidence that its reinsurance program will pay when triggered. It is not unreasonable to require the ceding insurer to obtain a judgment of a court on a novel theory of law, rather than simply settling the case and passing all or part of the bill to the reinsurer. However, when the cedant goes to court to adjudicate the dispute and obtains a court ruling, the reinsurer should be bound. That is particularly true where the reinsurance is a facultative certificate issued for a particular underlying insurance policy with back to back cover.
One final note. The Wasa decision was one of the House of Lords’ last as the highest court. The United Kingdom now has a United Kingdom Supreme Court.
Lew Hassett is Co-Chairman of the firm’s Insurance and Reinsurance Practice. His practice concentrates in the areas of complex civil litigation, including insurance and reinsurance matters, business torts and insurer insolvencies. Lew received his bachelor’s degree from the University of Miami and his law degree from the University of Virginia.
