London Market - December 2009

Facultative policies, coverage period, back-to-back cover, governing law

Equitas v R & Q Reinsurance Company (UK) Limited
On 11 November 2009, the long awaited decision in Equitas v R&Q Reinsurance [2009] was handed down by Mr Justice Gross, provoking much speculation as to its effect on the London Market Excess of Loss spiral (“LMX spiral”).

Background
By way of background, the notorious LMX spiral arose because many syndicates at Lloyd’s which wrote excess of loss cover took out excess of loss cover themselves.  Their reinsurers in turn took out their own excess of loss cover.  As a result, there was a group of syndicates and companies which created a complex intertwining network of mutual reinsurance.  In the event of a loss triggering the excess covers, claims were repeatedly made in respect of the loss as it circulated in the spiral, impacting on successive layers of reinsurances.

Two notorious losses which resulted in claims going through the LMX spiral was the Exxon Valdez disaster in 1989 and the invasion of Kuwait in 1990.  Both incidents gave rise to claims which were presented to and paid by insurers and reinsurers within the LMX spiral on certain mistaken assumptions:

(a)     In the case of Exxon Valdez, claims were paid at the initial stages that included elements of cover which were later ruled irrecoverable in subsequent litigation (in particular, King v Brandywine Reinsurance Co [2005]). 

(b)    In the Kuwait losses, losses were claimed and paid on the aggregation of a single event with no differentiation made between the losses arising from Kuwait Airways Corporation aircraft and British Airways aircraft stranded at Kuwait airport.  Scott v Copenhagen Re CO (UK) Ltd [2003] subsequently ruled that the losses should not have been aggregated in this fashion because they did not arise out of the same event.

The dispute between Equitas and R & Q arose from claims by Equitas relating to these two losses under various excess of loss retrocessions underwritten by R&Q.  The retrocessions were excess of an attachment point on an each and every loss basis and by reference to the reinsured’s Ultimate Net Loss.  The contracts were either “back up” cover or with a significant element of such cover.  As such,   the wrong aggregation/payment of irrecoverable losses had an impact on (a) the true amount of Exxon Valdez/Kuwait losses that Equitas were entitled to recover under these retrocessions; and (b) the recovery of other separate reinsured losses where there was no question that they fell within the terms of the reinsurance but where questions arose as to whether the underlying layers were properly exhausted.

Issues
The question before the court was the burden of proof that Equitas had to discharge.  In particular, whether Equitas could recover under the retrocessions without replicating the LMX spiral at each level to take into account the wrongly aggregated and irrecoverable elements in circumstances where it was accepted this would be impossible to do.

R & Q argued that Equitas need to show how properly aggregated and recoverable loses would flow through the spiral, irrespective of impossibility or impracticality.  Equitas on the other hand took the position that they were entitled to prove their loss by using actuarial modelling.

Settlements wording
The relevant settlement clauses in the contracts were either:

“It is a condition precedent to liability under this contract that settlement by the reassured shall be in accordance with the terms and conditions of the original policies or contract” (the Joint Excess of Loss Committee (“JELC”) wording);

or

“All loss settlements by the Reassured including compromise settlements and the establishment of Funds for the settlement of losses shall be binding upon the Reinsurers, providing such settlements are within the terms and conditions of the original policies and/or contracts … and within the terms and conditions of this Reinsurance” (the “Settlements Clause”).

The Settlements Clause was considered previously in Hill v Mercantile [1996] where the court described it as containing a “dual proviso” with the first proviso being the requirement that “such settlements are within the terms and conditions of the original policies and/or contracts” and the second proviso that the settlements are “within the terms and conditions of this Reinsurance”.  It was not in dispute that the JELC wording was the equivalent of the first proviso.

Judgment
The court decided that there was no requirement that Equitas must prove a loss at each underlying level of the LMX spiral.

The starting point taken by the court was the distinction between questions of law on the one hand and questions of fact or evidence on the other.   It found that as a matter of law, Equitas must meet the requirements of the dual proviso to a standard of balance of probabilities.  However, there was nothing in Hill v Mercantile that decided how Equitas must do so – that is a matter of fact or evidence.

In coming to this conclusion, the court decided that the reference to “original policies or contracts” in the first proviso was to the inwards policies or contracts and is not taken as referring to the/all of the intermediate or underlying contracts.  Further, it was one thing to say that the loss must fall within the cover of the inwards policy but another to require proof of liability under each and every underlying contract.  These are issues of fact and not law.

Having said that, the court recognised that there may be factual situations where it may be possible and appropriate to re-construct the layers of the LMX spiral, and that the above conclusions were subject to contractual provision or market practice to the contrary. 

That aside, it was clear that a claimant was left to take its own decision on how to prove its claim and was not bound in all cases to prove a loss at each underlying level in the chain.

In considering market practice, Mr Justice Goss found that because the situation before him was unprecedented, there was only limited assistance that market practice can provide.  However, what assistance there was favoured Equitas’ case and in particular, the use of collection notes by the market to recover losses rather than requiring strict proof of loss.

The court went on to assess the actuarial modelling put forward.  Although Mr Justice Gross described actuarial modelling as “complex, expensive (and) imperfect”, he was persuaded that the models were capable of establishing the properly recoverable minimum losses having regard to the applicable burden and standard of proof.  This was subject to a discount factor applied of 25% for Exxon Valdez losses and 13.5% for the Kuwait losses.

Comment
This action was regarded very much as a test case with the court describing the LMX market as having reached a state of “lock down.”  As such, the court was conscious of its obligation to find “an acceptable legal and sensible commercial solution” in circumstances where the market has failed to do so. 

The expectation is that this judgment will now un-freeze claims caught in the LMX spiral.  At the same time, as the court recognised, the facts behind the dispute between Equitas and R & Q are unprecedented and it is therefore difficult to say what practical impact it would have in reality.