Note: the decision in this case at first instance has now been overruled by the Court of Appeal in a judgment dated 29 February 2008. Click here to access the note on the Court of Appeal judgment. 

DMC Category Rating: Confirmed

This case note is based on an Article in the May 2007 Edition of the ‘Re(insurance) Bulletin’, published by the Insurance & Reinsurance team at the international firm of lawyers, DLA Piper. DLA Piper is an International Contributor to this website.

Facts
Lexington insured Alcoa for three years from 1 July 1977 for loss or damage to property arising from environmental pollution subject to a limit of liability of US$20,000,000 any one occurrence, where "occurrence" was defined as "any one loss(es), disaster(s), or casualty(ies) arising out of one event or common cause".

Lexington purchased a facultative reinsurance covering the same period in respect of all risks of physical loss or damage, subject again to a per occurrence limit of US$20,000,000. Wasa and AGF subscribed to this reinsurance, which was placed in the London market and which, in accordance with English common law principles, was subject to English law. There was no formal contract and the terms of the reinsurance were set out in the slip.

The reinsurance provided as follows:
"to pay or to make good to the reinsured all such loss as aforesaid as may happen to the subject matter of this reinsurance, or any part thereof during the continuance of this policy; and being a reinsurance of and warranted same gross rate, terms and conditions as and to follow the settlements of the Company."

In the early 1990s the US Environmental Protection Agency required Alcoa to clean up pollution and contamination at US manufacturing sites. Alcoa subsequently sued insurers who hadprovided cover to it during the period 1956 to 1985. The Washington Superior Court found that there was a reasonable basis on which to allocate to each policy year the costs related to the property damage that occurred during that policy year.

The Judge found that the property damage at each relevant site could be measured and quantified and that remedial costs for each policy year could reasonably and appropriately be equated to the damage that occurred during that year. Moreover, the progress of the contamination was more or less steady over all the years and it was therefore reasonable to divide the total damage (and the consequent costs) by the number of years that the contamination had taken to reach its current state.

On that basis, insurers would be liable for the individual years for which they provided insurance up to their policy limits and subject to any other applicable terms. Alternatively, if the property damage was indivisible as between years, the damage should be allocated on a pro rata basis.

In May 2004, the Supreme Court overturned this decision and held that insurers were jointly and severally liable to Alcoa for all property damage, including damage which had occurred before the policies incepted. This finding was based on the broad wording of the insurance policy which, as the court pointed out, did not exclude physical loss or damage that may have begun spreading before inception of the policy, and which provided for a broad definition of "occurrence". In addition, the policy did not make any provision for pro rating of coverage.

Lexington eventually agreed to pay Alcoa US$103,140,500 and sought recovery of that settlement amount plus legal fees from reinsurers. Wasa and AGF sought declarations that they were not liable.

Follow the settlements
A follow the settlements clause of the kind here is intended to give effect to the balance between the practical need for a reinsurer to be bound to follow underlying settlements and the reinsurer's position not being jeopardised by an agreement over which it has no control. 

Under the current law, a reinsurer is not obliged to indemnify the reinsured unless the loss falls within the scope of the insurance cover and within the scope of the reinsurance cover. This is the case even where the insurance and the reinsurance are largely back-to-back.

Where there is a follow settlements clause, however, the reinsured does not have to prove that a loss actually fell within the scope of the insurance but that he acted honestly and took all proper and business-like steps in settling the claim (as Lexington did in this case).

The point in dispute was whether the claim fell within the scope of the reinsurance as a matter of law. This primarily revolved around the period clause in the reinsurance and whether the scope of the reinsurance cover should be construed so as to be the same as the cover provided by the insurance.

Judgment
On the "follow the settlements" issue, the court held that the period clause in the reinsurance (a time policy) was of fundamental importance and should not be disregarded simply because the insurance and the reinsurance were largely back-to-back and the reinsurance contained a follow settlements clause.

Reinsurers had agreed to reinsure Lexington in relation to property damage occurring between 1 July 1977 and 1 July 1980 (that is, "during the continuance of this policy") and not in relation to damage occurring before or after that time. Here, the settlement had been agreed in the context of a US decision (based on a US law interpretation of the insurance policy) that found insurers jointly and severally liable for losses occurring over the full period of more than forty years and not just the three year period covered by the reinsurance. As a result, it included claims that did not fall within the scope of the reinsurance and so reinsurers were not obliged to follow that settlement.

The costs of defending Alcoa's claim
Following the decision in Baker v Black Sea & Baltic [1998] 1 WLR 974 (House of Lords), the court found that, in the absence of an express term to that effect, there was no obligation on reinsurers to meet the legal costs incurred by the reinsured in defending claims brought by the original insured. That applied with even greater force in this case, where the contract in question was non- proportional, than in the case of a proportional cover, where there was an element of partnership between reinsured and reinsurer (although even that would not give rise to an implied obligation on the reinsurer to meet the reinsured's legal defence costs).

Comment
Whilst the decision may be welcomed by reinsurers, Lexington will no doubt be disappointed that they have been unable to recover from their reinsurers under a contract that was intended to be back-to-back.

In order for insurers to ensure recovery from reinsurers, they can take steps both at the stage of purchase of the reinsurance and at the stage of settlement of the underlying claims. In the first case, if the two contracts are 100% back-to-back, including express choice of law provisions, and the reinsurance contains a follow settlements clause, it should be difficult for reinsurers to resist a reasonable settlement. It may also be prudent for insurers to involve reinsurers in the settlement process or at least, to ensure that any settlement agreement can be clearly broken down so that the part that may be recoverable from a particular reinsurer is readily identifiable.

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