The English revolution: "follow the fortunes" after Lexington v. AGF and Wasa.

• Author: Harding, John T.

AS THE SUN was setting over the Thames on July 30, 2009, the last official day that the House of Lords served as Britain's highest court, (1) the Lords delivered their Opinions in the matter of Lexington Insurance Company v. AGF Insurance Limited and Wasa International Insurance Company Limited. (2) To say that the judgment in the Lexington case amounts to the "shot heard round the world" of reinsurance hardly does justice to the import of the decision and its practical implications for the interpretation and application of the "follow the fortunes" and "follow the settlements" clauses in commercial reinsurance contracts placed in the London market. While it may be a little late for the United Kingdom to now be declaring its independence from the vagaries of the American justice system, it appears that this is precisely what the House of Lords' Judgment attempts to accomplish.

Unlike those United States cases that have dealt with the application of these clauses to complex claim situations when a ceding company has attempted to manipulate the rules of allocation or number of occurrences to its advantage in presenting a claim for reimbursement to a reinsurer, (3) the House of Lords refused to bind reinsurers to a settlement entered into by the ceding company, despite the undisputed facts that (1) the Washington Supreme Court had finally determined Lexington's liability after a hotly contested trial and appeal, resulting in a judgment that was expected to be in excess of $180 million; and (2) all parties agreed that the settlement entered into by Lexington of this adjudicated liability was eminently reasonable, business-like and negotiated in good faith. Although the reinsurance certificate contained a "Full Reinsurance Clause," including a standard "follow the settlements" provision, the Lords determined that the reinsurers, AGF Reinsurance Limited ("AGF") and Wasa International Insurance Limited ("Wasa"), were not bound to pay the 2.5% share of the reinsurance slip that they had agreed to assume.

The opinions in Lexington attempt to dispel any notion that the Lords intended to water down the force and effect of the standard "follow the settlements" clause. Indeed, the decision was framed almost entirely as one focused on "choice of law" issues and the scope of what the reinsurers agreed when the reinsurance was placed in 1977. The Lords reasoned that since the intent of the parties (although not expressed anywhere in the reinsurance certificate or any other writing) was to have English law apply to the reinsurance contract, and since no English court would ever recognize the principle that a reinsurer who entered into a contract for a defined period of cover could be held to have agreed to provide coverage for liabilities arising out of damage that took place outside the period of cover, the reinsurers had no obligation to indemnify the ceding company for the liabilities imposed upon it by an American court. Because English law would not recognize the type of "all sums" approach to allocation embodied in the underlying judgment against Lexington, the reinsurer could correctly argue that the loss sustained by Lexington was not within the risk that the reinsurer agreed to accept--"follow the settlements" clause or not.

No matter how the Lords may have attempted to dress up their reasoning in the guise of "choice of law" or "scope of the reinsurance," the potentially enormous impact on the reinsurance market (particularly for ceding companies who believed that they were purchasing full "back to back" reinsurance) cannot be underestimated. Suddenly, direct companies whose liabilities are subject to the quixotic (and potentially unfair) rules of allocation adopted in some American courts, and who negotiate reasonable, good faith settlements in light of those rules, can longer rely upon the certainty of protection from their reinsurance contracts. As Shakespeare wrote, it is indeed a "brave new world" (4) for ceding companies and reinsurers alike, the consequences of which are certain to play out for a long time.

1. The Pre-Revolutionary Era:

   Fundamental Principles of "Follow the Settlements"

   As with any "revolution" in thought (legal or otherwise), the impact of the changes that flow from the decision in Lexington can only be understood within the framework of the cases that preceded the decision. Given the confidential nature of arbitrations, precisely how standard "follow the fortunes" and "follow the settlements" clauses have been applied to particular claims by panels remains speculative. However, to the extent that disputes between ceding companies and reinsurers concerning the scope and application of "follow the settlements" clauses have been the subject of reported court opinions, these cases had established a fairly uniform and workable set of rules that, if not entirely toppled by the decision in Lexington, must, at the very least, be regarded as uncertain in their future application.

   1. The Heart of Darkness

      The most influential case on the meaning of "follow the settlements" under English law is the decision of the Court of Appeal in The Insurance Co. of Africa v. Scor (U.K.) Reinsurance Co., Ltd. (5) Quite interestingly, the Court of Appeal articulated the fundamental rules governing the obligation of a reinsurer to follow a good faith settlement entered into by its ceding company in the context of an underlying claim that may well have been a fraudulent attempt by the policyholder to recover for a fire that was deliberately set. The Court of Appeal made two prominent holdings:

      1) the effect of a clause binding reinsurers to follow settlements of the insurers was that the reinsurers agreed to indemnify the insurers in the event that they settled a claim by their assured, i.e., when they disposed or bound themselves to dispose of a claim provided that the claim so recognized by them fell within the risks covered by the policy of reinsurance as a matter of law and provided also that in settling the claim the insurers had acted honestly and had taken all proper steps in making the settlement; and

      2) if insurers had so settled a claim, acting honestly and in proper and businesslike manner, then the fact that reinsurers might thereafter be able to prove that the claim of the assured was fraudulent did not of itself entitle reinsurers not to follow the settlement of the insurers; they must follow the settlement as they had contracted to do so.

      The Scor case arose out of a warehouse fire in Monrovia, Liberia at premises that were owned by the government, but were let to the Africa Trading Company ("ATC") for the storage of its goods. ATC had insured the contents of the premises with the Insurance Company of Africa ("ICA") in the amount of $3 million and the building for the sum of $500,000. ICA had refused the claimed loss, contending that the fire was deliberately set by one Mr. Ali, a mysterious figure who may have more in common with Mr. Kurtz from Conrad's Heart of Darkness than your typical policyholder making a claim for the lost contents of a building. Indeed, the opinion reads more like a post-Colonial novel than an insurance case, with anonymous witnesses sending letters to the reinsurer and the home office in London dispatching investigators in pith helmets to try to wrest a confession from the policyholder that the warehouse was filled with junk that could not possibly have had a value of $3 million.

      Notwithstanding its suspicions that the building had been torched to recover on the policy, ICA was never able to prove that this was the state of affairs. When ICA refused to pay the loss, ATC sued it in a local Liberian court and recovered a judgment in excess of $4 million. ICA then presented the claim to its reinsurer, Scor, who refused to pay under the reinsurance contract on the grounds that since the claim was fraudulent ICA were not legally liable to pay ATC the sums insured under their policy with ATC or the damages or costs awarded against them by the Liberian court. Scor took the dispute to trial, but failed to prove fraud and was held liable to pay the reinsurance claim. Scot sought an appeal on various grounds, including a request for a new trial on the basis that further evidence, which they alleged was not available at the time of the trial (primarily additional testimony from the previously anonymous witnesses who claimed that Mr. Ali confessed to setting the fire) would support a judgment in their favor. As the Court of Appeal summarized: "[Scot] is [in] the unsatisfactory position of suspecting fraud but being unable to prove it, like many another insurer or reinsurer...." (6)

      In rejecting Scor's claim that it could not be held liable to pay on the reinsurance under these circumstances, the Court of Appeal noted that the reinsurance contract contained what is referred to in the English reinsurance market as a "Full Reinsurance Clause," (7) which states:

      Being a Reinsurance of and warranted same ... terms and conditions as and to follow the settlements of the Insurance Company of Africa ... (8) The opinion reviewed the origins and history of the Full Reinsurance Clause, which originally included an additional key phrase "and to pay as might be paid thereon." This clause, determined to date back to at least the 1880's, was read literally to bind the reinsurer to pay without inquiry any claim that had been honestly paid by the direct insurer. In a case decided in 1895, the law introduced the additional qualification that there must be legal liability, proved or admitted, of the insurer to his assured, and the reinsurer was not liable to pay such an amount as the original insurer might choose to pay, whether liable or not. (9) Subsequent cases ascribed to this view, which limited the reinsurer's ability to contest the validity of the original loss so long as it was within the scope of the policy, (10) and based upon these authorities, Lord Justice Stephenson held:

      In this...