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A Suitable Model
London & Bermuda Newsletter
The English Commercial Court has cut through the Gordian knot of the London Market excess of loss (LMX) spiral. The decision is extremely valuable for its careful analysis of the standard of proof that a reinsured must meet in making an outward claim.
Underlying Facts
The losses involved date back to events of 20 years ago.
In March 1989, Exxon Valdez ran aground in the Prince William Sound in Canada, occasioning pollution damage and consequent cleanup costs.
In August 1990, Iraqi troops took control of Kuwait International Airport. They captured 15 aircraft hulls and spares owned by Kuwait Airlines (KAC). In February 1991, coalition forces destroyed a hull owned by British Airways (BA), also at the airport, in the liberation of Kuwait.
Exxon – Market History
The Exxon claims were settled under three sections of Exxon’s Global Corporate Excess (GCE) policy – property damage ($303.5 million), marine liabilities ($414 million), and public and third party liabilities ($66 million). These were grouped together under the catastrophe code “89G”.
The market ceased settling losses between 1998 and 2000 on the basis that they were outside the scope of the property damage and public and third party liabilities sections of the GCE.
In 1998, the Court of Appeal held reinsurers had an arguable defence in relation to the property damage settlement. In 2005, the Court of Appeal held that neither the property damage nor third party liabilities sections of the policy covered the loss.
KAC – Market History
The KAC hull losses were settled at approximately $300 million. The BA losses were settled at $28 million and $15 million (hull and liability). The market ceased settling losses in 1996-1997 on the basis they were incorrectly aggregated. The English Commercial Court confirmed this in 2003.
In both cases, therefore, the market went into “lockdown” sometime between 1996 and 2000, with a vast (see below) wave of collection notices frozen in suspended animation.
The LMX ‘Spiral’ and Its Effects
The scale of these claims was magnified several times over by virtue of the infamous LMX “spiral”.
An ostensibly profitable business flourished, in the 1980s and early 1990s, among Lloyd’s syndicates and London companies buying and selling excess of loss (XL) protections of XL books, known as “XL on XL”. Reinsurers selling XL on XL themselves purchased XL protection, a process which was then repeated almost indefinitely and often reciprocally. This created a “complex intertwining network or mutual reinsurance, which has been described as the spiral.”
The problem arose upon the advent of claims. The iterative structure created the potential for the same underlying loss to return over and over again, each time eroding the participant’s excess limits even further. This process of magnification transformed the underlying KAC/Exxon losses into cumulative losses to the market in the region of $6 billion each.
Equitas Limited v R&Q Reinsurance Company (UK) Limited; Equitas Limited v Ace European Group Limited [2009] EWHC 2787 (Comm).
A little more than 10 years on, Equitas commenced proceedings in the English Commercial Court against outward reinsurers.
Contracts
The trial concerned 26 sample contracts, 14 “tainted” by KAC/BA, and 12 by Exxon. Most were “back-up” contracts, meaning that they did not respond until exhaustion of underlying aggregate limits. All included the following settlements clause: “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.”
Legal Issues
Previous authorities (treated as binding in this case) established that the settlements clause obliged the reinsured to prove that its inward settlement was of a loss falling within the terms and conditions of both the inward contract and the outward reinsurance.
Proving these two factors is a “matter of law”. Roughly, this means they are essential components of the reinsured’s case. If the reinsured cannot make out that – for example, an excess has been exhausted – its claim fails.
The reinsured fulfils the burden with evidence. If this makes it more likely than not that the limit has been blown by properly aggregated losses (for example), the burden is discharged.
The legal burden was significant in Equitas given the near certainty that underlying limits had been eroded at least in part by wrongly aggregated and irrecoverable losses. Did the reality that wrongly aggregated losses and irrecoverable amounts had been applied to breach the limits mean that Equitas’ claim must fail?
R&Q argued that the initial question of law – that the inward limit was blown by properly aggregated losses – begged an anterior question, whether the immediately antecedent contract in the spiral was exhausted by properly aggregated losses. This too, R&Q argued, was a “matter of law”, meaning that it stood to make or break Equitas’ case and Equitas had to prove it individually. The same was true of all preceding reinsurances down the chain until you reached the Exxon/KAC/BA losses themselves.
Equitas accepted that it couldn’t recover for wrongly aggregated or irrecoverable losses. Nevertheless, it said, contract-by-contract “regression” was unnecessary. Proving exhaustion of inward limits by correctly aggregated losses was an evidential matter. As such, it need only be established on the balance of probabilities and how was an open question. Equitas furnished evidence in the form of the output from an actuarial model which, it said, showed the sums syndicates would be entitled to if losses were properly aggregated up the spiral. This, it said, established, on the balance of probabilities, that the underlying limit was exhausted.
Decision
The judge held that it is an open question what kind of evidence is required to make out the legal burden of proof. Importantly, there is no legal principle that the reinsured must go back and re-present losses contract by contract, settle balances, and so on. That was one form of evidence, no doubt. And indeed it is the conventional form of evidence in the market. But it need not be the only one, and in extreme situations, Equitas was entitled to furnish the best evidence that it could lay its hands on.
The judge held that Equitas’ model allowed him to make a finding, on the balance of probabilities, as to the recoverable claims for each syndicate.
Comment
The circumstances of the spiral were highly material to this decision. The faulty losses constituted relatively small proportions of the losses aggregated. So the impact of each on aggregation was likely to be minimal and “the overwhelming majority of the sums paid by the syndicates” will have related to recoverable losses.
Adding in “magnification”, Equitas made a persuasive case that even after very substantial, sweeping discounts on the model results, the losses still breached the attachment points on the outward contracts.
R&Q’s case that these vast losses, only slightly “tainted” by faulty components, should be left to “lie crudely where they fall" therefore appeared a highly unappetizing one.
Practical Outcomes
Previous cases show that the reinsured can go behind a global settlement of insured and uninsured losses and furnish evidence apportioning the sum. Others show that the court will make a finding on the balance of probabilities how much of a multi-year divisible loss (e.g., recurrent vandalism) occurred within one policy year, and on that basis decide as a matter of law that an annual excess had been breached. Each of these requires the court to make a finding about what actually happened, and then using that determine a legal point concerning coverage. However, it may be that this is the first decision taking what would have happened – not what did happen – as the basis for a finding about whether a settlement is within the terms of cover.
On that basis, one might wonder whether this decision will have any relevance to future disputes concerning the recoverability of the incurred but not reported (IBNR) part of commutation settlements – a vexed issue unsettled in English reinsurance law. Possibly it will not. IBNR involves losses that have not yet occurred. This has been a sticking point because reinsurance claims presuppose a pre-existing loss imposed by law. A voluntarily assumed loss “created” by a commutation does not suffice. Future litigation may clarify.
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