A recent decision from the House of Lords provides a rather interesting exegesis of English reinsurance law. In Lexington Insurance Co. v. AGF Insurance Lmt. [July 30, 2009] UKHL 40 (“Op.”), the House of Lords held that under English law a contract of proportional facultative reinsurance does not bind the reinsurer to the interpretation that is given to the primary liability policy by an American court. A copy of the decision is available here.   

The decision has its origins in a claim by Aluminum Company of America (“Alcoa”) and its subsidiary, Northwest Alloys, Inc. (“NWA”). Alcoa and NWA sought coverage from 167 CGL and property insurers for environmental remediation costs involving 35 facilities in 11 different states over a 32-year period. Lexington Insurance Company was one of Alcoa’s first-party property insurers who had provided Alcoa and NWA with “all risks differences in condition” coverage. 

In Aluminum Company of America v. Aetna Casualty & Surety Co., 998 P.2d 856 (Wash. 2000), the Washington Supreme Court, applying Pennsylvania law, held that under the respective insuring agreements of each liability policy “any physical loss or damage manifesting itself during the time a DIC policy was in effect was covered by the policy, including pollution damage starting before the policy inception.” 998 P.2d at 883. Ultimately, Lexington paid Alcoa and NWA $103 million.

Lexington insured Alcoa and NWA during the period from July 1, 1977 to July 1, 1980. Pursuant to a reinsurance slip, Lexington obtained proportional contributing facultative reinsurance from two London reinsurers, Wasa International Insurance Company Limited and HGF Insurance Limited. The reinsurance contract provided reinsurance for a 36-month period commencing on July 1, 1977 subject to the terms of the “original” reinsured policy. 

There was no dispute that the reinsurance slip was governed by English law and that the reference in the reinsurance slip to “&/or as original” incorporated “the relevant insurance provisions relating to the subject matter and risk” of the Lexington policy “into the reinsurance.” Op. ¶¶ 21, 31. 

The interpretative issue was whether the reinsurance contract not only incorporated the terms of the Lexington policy, but also incorporated any interpretative gloss given to those terms by an American court. That is, the issue was whether the reinsurance contract confined coverage to property damage occurring during the three-year reinsurance period or whether coverage extended more broadly to Lexington’s liability to Alcoa during the reinsurance period. The court held that because the reinsurance contract was governed by English law, the reinsurance coverage was confined to property damage occurring during the reinsurance period.

In his opinion, Lord Mance rejected Lexington’s argument that, because its policy was subject to American law and an American Service of Suit clause, the reinsuring agreement should be assigned the same interpretation as the Washington Supreme Court had assigned the primary policy’s insuring agreement. Lord Mance remarked that Lexington’s “verbal glass” is one that he “would not accept.” Op. ¶ 31. He reasoned  that “reinsurance slips are underwritten identifying the subject-matter insured . . . as the original insured’s property, rather than the insurer’s exposure, were liability under the original insurance.” Op. ¶ 33. “There is no basis or justification for courts to throw unnecessarily into doubt an accepted analysis with business significance.” Id.

Lord Mance remarked that “it is common ground that, if the present reinsurance slip, including such terms of the original as it incorporates, is to be construed accordingly to purely English law principles, it does not have a meaning or effect similar to that which the Washington Supreme Court gave to the insurance.” Op. ¶ 38. Rather, “the only property damage which the reinsurance, construed accordingly to purely English law principles, covers is property damage occurring during the three-year reinsurance period.” Id. He pointedly remarked that “this is under English law clear beyond argument upon its wording.” Id. The reinsurance slip “insures property against risk during a stated period.” Therefore, the parties’ “understanding must have been that any formal policy would be on terms consistent with those of any slip policy.” Id. “This construction of the slip also reflects the basic principle of English property insurance law, that the insurer is liable for a loss actually sustained from a period insured against the continuance of the risk.” Op.  ¶ 39. 

Lord Mance noted that the “insurance in this case was not against liability incurred or claims made.” Id. He remarked:

Viewing the reinsurance through purely English law eyes, it cannot therefore be construed as a contract to indemnify Alcoa in respect of all contamination of Alcoa sites, whenever caused or occurring, provided that part of such contamination manifested itself or was in being during the reinsurance period. That would involve reinsurers in an unpredictable exposure to which their own protections might not necessarily respond. It would mean that the same exposure would arise even if they had granted the reinsurance for a shorter period that the three-year period matching the original – since the original itself would, even if enforced for only one year have had effectively the same exposure as that for which the Washington Supreme Court held it answerable. Under the approach taken by the Washington Supreme Court, reinsurers must have incurred liability . . . as soon as they wrote the reinsurance.

Op.  ¶ 40. 

He found material that the reinsurance slip referenced the retention as “subject to excess of loss &/or Treaty R/I” which denoted that the slip provided excess of loss reinsurance:

In other words, it is fundamental that such a reinsurance will respond in  the one case to losses occurring during the reinsurance period, in the other to losses occurring during the period a policy is attaching during the reinsurance period. To treat excess of loss policies as covering losses through contamination occurring during any period, so long as some of the contamination occurred or existed during the reinsurance period, would be to change completely their nature and effect. The reference and the slip to excess of loss reinsurance underlines the difficulty about interpreting the terms of the reinsurance as covering the losses which the Washington Supreme Court had held to be recoverable under the insurance period.

Op.  ¶ 42. 

He rejected the proposition that “the parties must have contemplated that any claim under the insurance issued to Alcoa would, if contentious, be litigated and determined before the courts of one of the United States under the Service of Suit clause,” so that applying “conflicts rules . . . the state of Pennsylvania applied, on the basis that the insurance contract had its closest and most real connection with that State where Alcoa was incorporated and had its principal place of business.” Op.  ¶ 45. 

To the contrary, he concluded:

The reinsurance has a clear English law meaning. There was here no identifiable legal dictionary . . . still less a Pennsylvanian legal dictionary, which can be derived from the interaction or operation of the terms of the insurance and reinsurance and which could lead to any different interpretation of the reinsurance wording. For reasons I have already given, the reinsurance is an independent contract, with its own terms which fall to be construed under English law, and I see no basis for interpreting it as covering any liability which might subsequently be held to arise under the insurance in any State, whose law might, after disputes had arisen under it and other separate insurances, be applied by reference to factors extraneous to particular insurance to which alone the reinsurance related. It follows that there is no basis for construing the two contracts as back to back in the present situation.

Op.  ¶ 49. 

He emphatically remarked that the “consideration that Lexington probably did not reckon on the liability which it was held to have in America is not, by itself, a conclusive reason for passing that liability to reinsurers who were, on the face of it, also entitled to be confident that such liability could arise under the clear and basic terms of the English law contract into which they entered.” Op. ¶ 51.  

Lord Collins concurred. He felt compelled to note the importance of the reinsurance market to the United Kingdom, observing that “insurance is the country’s ‘largest invisible export,’ of which reinsurance forms a large part, and amounted to at least £ 1.2 billion in 2007 . . . .” Op.  ¶ 55. On this observation, he framed the issue in the appeal:

These appeals raise the question of the extent to which the coverage under a proportional facultative reinsurance contract is, or should be construed as being, co-extensive with the coverage under the insurance contract. The reinsurer takes a proportional share of the premium and bears the risk of the same share of any losses. Consequently, the starting point is that normally reinsurance of that kind is back-to-back with the insurance, and that the reinsurer and the original insurer enter into a bargain that if the insurer is liable under the insurance contract, the reinsurer will be liable to pay the proportion which it has agreed to reinsure. In the usual case, any loss within the coverage of the insurance will be within the coverage of the reinsurance. This is so, whether or not (as is often the case) the reinsurance is put in place before the insurance is put in place or written. It is not necessary to characterize the reinsurance policy as liability insurance to achieve this result, which is essentially a question of commercial intentions and expectations. Those commercial intentions and expectations should not be frustrated by allowing reinsurers to take on commercial and technical points based on the difference between the effect given to terms in the insurance and reinsurance under their respective governing laws.

Id. 

He noted that “in proportional facultative reinsurance the starting point for the construction of the reinsurance policy is that the scope and nature of the cover in the reinsurance is co-extensive with the cover in the insurance.” Op. ¶ 60. In this regard, the reinsurance contract covered “‘All Risks of Physical Loss or damage’ . . . in respect of loss and damage occurring between 1 July 1977 and 1 July 1980,” so that “this was reinsurance on the ‘loss occurring’ basis, under which a reinsurer is obliged to pay its share of the loss suffered by the reinsured, if it occurred during the period when the reinsurance contract was in force.” Op. ¶ 76. 

He further recognized that “it is elementary that an insurer under the original insurance takes the risk of changes in the law.” Op.  ¶ 110. Therefore, “the reinsurer [cannot] be heard to say that it rated the risk by reference to the then current scope of the original insured’s duties or by the scope of the insurer’s duty to indemnify the original insured, provided that the risk is within reinsurance.” Id. 

Nonetheless, “in the present case . . . there is no principal basis for treating the scope of the three-year reinsurance as the same as the insurance, which has been interpreted under the law of Pennsylvania not to include any ‘limitation as to time of the physical loss or damage to property.’” Op. ¶ 111. He characterized Lexington’s argument as “maintaining that, in the light of the decision of the Washington Supreme Court, if any damage occurred within any relevant policy period, of any duration, the relevant reinsurer would be liable for all of the damage, including damage occurring before inspection or after expiry.” Id. Thus understood, Lexington’s argument was, in his view, “wholly uncommercial and outside any reasonable commercial expectation of either party.” Id.

He observed that “in legal theory reinsurance is not liability insurance, and that in any event it would make no difference to the disposition of these appeals if it were.” Op. ¶ 114. Nonetheless, he remarked that “there is much to be said for the view that in commercial reality, reinsurance is liability insurance which provides cover for the reinsured in the event that the reinsured is liable to pay the original insured.” He was at pains, however, to caution that “the regulatory implications of departing from orthodox legal theory are considerable.” Id. ¶ 115.

He stated that it was “almost invariably . . . the case that losses for which the insurer has indemnified the original insured would be within the reinsurance even if losses are payable under a foreign law or a foreign judicial decision which takes a different view from English law of what losses are recoverable.” Op. ¶ 116. But he found this case distinguishable as “an unusual case in which the express (and entirely usual) terms of the reinsurance are clear.” Id. “This is not a case where the reinsurers are relying on a technicality to avoid payment.” Id. “There is . . . no principal basis for a conclusion” that “the parties must be taken to have meant that the reinsurance was to respond to all claims irrespective of when the damage occurred and irrespective of the period to which the loss is related.” Id.

Lord Phillips concurred. He observed that “it is unlikely that those who were party to the contract of reinsurance in 1977 can have anticipated that the interpretation of the wording common to the primary insurance and the reinsurance would differ so radically dependent on the law applied to its interpretation.” Op. ¶ 5. He thus agreed that “the ‘full reinsurance’ clause in this case, and ‘follow the settlements’ clauses in general, did not and do not have the effect of bringing within the cover of the policy of reinsurance risks that, on the true interpretation of the policy, would not otherwise be covered by it. Op.  ¶ 6. 

He did not foreclose the possibility that parties to a reinsurance contract could contract to reinsure the liability of the primary insurer:

The vital issue is . . . reduced to this. Did the parties to the reinsurance implicitly agree that whatever law might be applied to interpretation of the primary cover, and whatever result this might produce, would apply equally to the reinsurance? An affirmative answer to this question would, effectively, treat the contract of reinsurance as one to indemnify the primary insurer in respect of any liability sustained under the primary cover. There might . . . be much to be said for adopting this approach, and it is an approach that would be open to the market, by appropriate contractual terms, to follow. Those who, in 1977, were party to this reinsurance did not do so.

Id. ¶ 8.

In his concurring opinion, Lord Brown pointedly observed:

In all material respects, save one, the terms of the reinsurance contract mirrored those of the insurance contract. That one respect, central to the resolution of these appeals, was with regard to the applicable law respectively governing them. The insurance contract was subject to Pennsylvania law . . . the reinsurance contracts were subject to English law. Under Pennsylvania law . . . the fact that cover was expressly provided only for three years . . . was of no relevance in limiting the extent of the recoverable loss provided only that some physical damage became manifest during the three-year period. Plainly, however, that is not the position under English law. Under English law, nothing could be clearer than that a contract providing cover for loss and damage occurring only during a specified three-year period could not be construed as covering in addition damage occurring before (or, for that matter, after) that three-year period.

Id. ¶ 13.

In his view, “given the fundamental importance under English law of the temporal scope of a time policy, I find it impossible to construe the reinsurance contracts in the way contended for.”  Id. ¶ 15.