Note: this decision has now been upheld by the Court of Appeal, in a judgment rendered on 6 April 2004. For a note on the Court of Appeal judgment, click here

Background
The original insured, Pirelli Cables Inc, was engaged by Hydro Quebec to supply and install three single armoured, high-density submarine power cables between the north bank of the St Lawrence River and the Île aux Coudres in Quebec. In February 1997, Pirelli approached Generali for EAR ("erection all risks") cover. Under an arrangement Generali had with Continental Insurance Company regarding Canadian risks, Continental fronted the cover and issued the policy for Pirelli, passing 100% of the risk on to Generali.

The underlying policy covered transportation, temporary storage, installation, testing and maintenance of the cables and included a further "maintenance guarantee period" of 24 months from the date of take over. Under section 1, insurers would indemnify Pirelli if, at any time during the policy period, the cables suffered any "unforeseen and sudden physical loss or damage from any cause other than those specifically excluded". Specific exclusions included, at (c), loss or damage due to faulty design, defective material or casting and bad workmanship (other than faults in erection) and, at (d), wear and tear, corrosion, oxidation and incrustation.

However, under the special conditions of the policy, exclusion (c) was abrogated. Where the cause of the loss was defective workmanship, material or design, cover would include the cost of repair or replacement of insured items, provided that the insured property had been lost or damaged as a consequence of the defect. In addition, exclusion (d) was limited to those parts of the items immediately affected and not to any consequences of the wear and tear, corrosion, oxidation or incrustation.

The relationship between Continental and Generali was governed by a quota share reinsurance agreement, which provided that Generali's liability "shall follow that of [Continental] in every case, and shall be subject in all respects to all the general and special stipulations, clauses, waivers and modifications of [Continental's] policies and any endorsements thereto".

Generali reinsured 80% of the risk with seven ILU reinsurers and various Lloyd's syndicates under a broker's open cover. The cables project was the subject of a declaration, which provided under the heading "Conditions":

"As original: anything herein to the contrary notwithstanding, this reinsurance is declared and agreed to be subject to the same terms, clauses and conditions, special or otherwise, as the original policy or policies and is to pay as may be paid thereon and to follow without question the settlements of the Reassured except ex gratia and/or without prejudice settlements".

The cables were installed by the end of August 1997. About a year later, one of them failed as a result of abrasions caused by rock on the riverbed. Pirelli notified the claim to Generali and also asked for an extension of the policy to cover the repair work. The extension was agreed, Generali having first obtained an extension from its reinsurers. Unfortunately, the repair operation was not a success and resulted in all three cables being lost.

The claim gave rise to a host of issues, including whether there was one occurrence or two, whether the losses came under the wear and tear exclusion, whether they could be described as "unforeseen and sudden", whether there had been an effective agreement to extend the cover for the repairs or whether the second loss came under the maintenance guarantee and, of course, quantum.

After some months of correspondence, Generali settled Pirelli's claim for Can$4million. It then claimed under its reinsurance, setting out the basis on which it considered that it had been liable for the loss: that there had been one loss not two, that it had been caused by faulty design and/or fault in erection/bad workmanship and that it fell within the cover provided by the maintenance guarantee.

The Lloyd's syndicates approved the settlement and paid Generali their proportion of the claim without dispute, but the ILU reinsurers challenged the claim. The court, therefore, had to decide on the true meaning and effect of the follow the settlements clause.

Issues
Generali's primary argument was that the clause, and in particular the words "without question" precluded reinsurers from challenging any settlement made under the underlying policy, except settlements made ex gratia or without prejudice or made in bad faith. Because of the clause, reinsurers could not question whether the loss fell within the terms of the underlying policy or the reinsurance, or whether Generali had taken all proper and businesslike steps in making the settlement.

Reinsurers argued that the proper construction of the clause meant that they were not liable to provide indemnity unless the loss fell within the risks covered by the underlying policy and by the reinsurance as a matter of law, and unless the underlying insurers acted in good faith and took all proper and businesslike steps in making the settlement. Generali, therefore, had to prove that the loss gave rise to an actual liability under the terms of both the insurance and the reinsurance.

Judgment
In the judge's view, neither interpretation was correct.

If there is no "follow the settlements" clause in a reinsurance contract, then the insurer/reinsured must show that the loss falls within the cover of the underlying policy and within the cover created by the reinsurance. The parties are, however, free to agree on ways of proving whether these requirements are satisfied (Hill v Mercantile and General Reinsurance Co Plc [1996] 1 WLR 1239).

As a result, various forms of follow the settlements clause have been devised to relieve insurers of the obligation to prove that the loss falls within the cover of the underlying policy.

But the fact that a reinsurance contract contains a follow the settlements clause does not mean that reinsurers have relinquished all right to challenge a settlement. There are two important provisos – firstly, that the claim recognised by the insurers has to fall within the risk covered by the contract of reinsurance as a matter of law and, secondly, that insurers should act honestly and have taken all proper and businesslike steps in making the settlement (Insurance Company of Africa v Scor (UK) Reinsurance Company Limited [1985] 1 Lloyd's Rep 312).

Consequently, the fact that the insurance and reinsurance are back-to-back and subject to the same terms and conditions does not necessarily mean that reinsurers will be bound to indemnify the insurers even if there is a follow the settlements clause. Insurers may, for instance, have waived a breach of warranty or condition precedent in the underlying cover. That warranty or condition would still exist in the reinsurance cover and insurers would not be able to satisfy the first proviso – that the claim recognised by insurers fell within the terms of the reinsurance as a matter of law. Similarly, if insurers settled a claim that clearly fell outside the cover of the insurance, they would not be able to demonstrate that the claim fell within the risk covered by back-to-back reinsurance (Hiscox v Outhwaite (No. 3) [1991] 2 Lloyd's Rep 524).

The situation would be different if there was some doubt as to whether the claim was covered by the underlying insurance and insurers, having considered the position, decided that it was covered, and settled on that basis. In those circumstances, back-to-back reinsurers would be bound because the claim "as recognised" by insurers would fall within the risk covered by the reinsurance. Otherwise, reinsurers would be able to re-open coverage issues in the underlying cover and the whole purpose of the follow the settlements clause would be defeated.

Under the terms of the clause, reinsurers had agreed to follow without challenge Generali's settlements, except those falling within the two identified categories (ex gratia and without prejudice). Provided Generali could show that the claim as recognised by it fell within the terms of the reinsurance cover as a matter of law, and that it had acted in good faith and in a businesslike manner, reinsurers would be bound by the Pirelli settlement. The words "without question" did not describe or qualify what reinsurers had agreed to follow, but rather the manner in which they were required to do so.

As regards the words "pay as may be paid thereon", this bound reinsurers to the amount of the claim settled by insurers, subject to the same provisos as the follow the settlements clause (Insurance Company of Africa v Scor (UK) Reinsurance Company Limited [1985] 1 Lloyd's Rep 312).

The judge also took the view that, in the circumstances of this case, it made no difference that Generali was not the original insurer, since 100% of the risk had been passed on under identical terms and Generali had dealt with the claim directly from the start.

Reinsurers argued that, if insurers had settled the underlying claim when they were not, in fact, liable under the policy, the payment would be ex gratia and so fall within the specific exception in the follow the settlements clause. The judge disagreed. Ex gratia settlements are those made on the basis that there is no liability to indemnify (and without prejudice settlements are those made on the basis that there is no admission of any liability to indemnify). But if a claim is settled on the basis of an arguable liability to indemnify and that liability is, by the settlement itself, admitted or compromised, the settlement cannot be an ex gratia settlement.