UK: Cross Border Challenges In Reinsurance Contracts – Part 3

Last Updated: 18 March 2015
Article by Wayne Jones

The final instalment of our 3-Part series focussing on challenges arising from cross border reinsurance transactions in the Middle East, provides an analysis of the issues to emerge from the case review undertaken in Parts 1 and 2 of the series, and considers practical measures that re/insurers and brokers can take to avoid the potential pitfalls identified.

In Part 1 and Part 2 of this series, we reviewed two recent reinsurance cases to have come before the English courts, which have served to highlight the issues that can arise for cedants, reinsurers and brokers involved in cross-border reinsurance arrangements. The decision/s in 'Princess of the Stars'1 highlight the inherent risks in 'back to back' reinsurance placements; whilst the decision in Beazley v Al Ahleia2 illustrates the difficulties that can be encountered by reinsurers relying on claims co-operation and control clauses in reinsurance risks that are placed in a subscription market.

The key point which both judgments have in common is that they concern risks emanating from emerging markets which are substantially reinsured in the London market.  This is fairly standard practice for Middle East risks, where there is significant reliance on foreign reinsurance security underpinning the insurance of local risks.

In this final article of the series we will summarise some of the key issues to arise, and attempt to provide some practical steps to avoid these potential pitfalls.

Potential pitfalls and how to avoid them

A number of key potential pitfalls that arise from the cases reviewed include:

  1. Fronting issues

The prevalence of fronting, whereby a local cedant effectively 'fronts' for foreign reinsurers by underwriting the underlying risk on a 100% basis, and then substantially reinsuring the risk (sometimes up to 100%), still pervades the Middle East markets. This practice produces significant risk for:

  • the local cedant, who is responsible for 100% of the risk whether or not the reinsurance cover responds; and
  • reinsurer/s, who are reliant on the underwriting of the risk and handling of the claim by cedant in its local jurisdiction.

In the Princess of the Stars, the cedant faced the invidious position of being left without any reinsurance cover for a major loss which was still to be adjudicated by the local courts. In Beazley v Al Ahleia, following market reinsurers were likely to be bound by the actions of their cedant in compromising the claim with the lead reinsurer, without their knowledge or involvement, notwithstanding the reinsurance including a claims control clause.

The risks with fronting also arise where the cedant:

  • has an ongoing and wider relationship with the underlying insured, which is quite separate from the reinsurance placement of the risk in question; and
  • may in fact be owned by the underlying insured.

Both scenarios create conflicts of interest between the cedant and reinsurer, which need to be recognised and then carefully managed.

In order to avoid the difficulties that arise with fronting, it is incumbent on cedants and reinsurers to recognise and identify the issues that may be involved with fronting for foreign reinsurers, or participating in the reinsurance of a fronted risk, and ensuring the reinsurance documents reflect the position.

For cedants this may involve including provisions seeking to deal with any issues that occur as a result of a failure of reinsurance security by including terms that may include non-vitiation provisions, or remedies in the event of a failure of reinsurance security. Provisions that ensure that underlying and reinsurance wordings will be subject to the same interpretation are also vital.

For reinsurers, this will involve being aware of the cedant's position in retaining very little or no risk, understanding their relationship with the underlying insured, and ensuring the reinsurance contract contains adequate controls allowing reinsurers to conduct the investigation, adjustment and settlement of claims.

Where the same broker is involved on the underlying and reinsurance risks, as is often the case, it will be necessary to consider the potential for conflicts of interest to arise and to ensure that these potential conflicts are recognised and are adequately managed.

  1. Different legal systems applying to the direct and reinsurance placements

The default position in relation to Middle East risks, no matter what the policy wording might say, is that the underlying policy is almost always subject to local law and jurisdiction.  Even where a foreign law is selected, the policy will inevitably be interpreted in accordance with local law or a version thereof.

This local interpretation of the policy can be at odds with the manner in which the policy language is understood to operate internationally, and the manner in which it may be construed under the reinsurance policy, which is often governed by a foreign law (eg English law) and subject to the jurisdiction of a foreign court.  We explain further below that, in our view, the answer is not to require that both underlying and reinsurance wording be subject to the same local governing law and jurisdiction provisions: most local jurisdictions have little or no jurisprudence regarding reinsurance law, and often have relatively underdeveloped legal systems.

It is not uncommon for local courts in a local jurisdiction to interpret policy wordings in a manner which may not accord with international practice. This ought not to affect reinsurance placements placed on a 'back to back' basis where reinsurance policies are subject to English law and jurisdiction.  Over the last four decades, English law has accommodated differing interpretations of insurance wordings by local courts reinsured under 'back to back' reinsurance provisions, so that the reinsurance wording is construed in a manner that backs the underlying interpretation.

Notwithstanding the development of jurisprudence to deal with the position, the ruling in Princess of the Stars shows that it is still essential that the English court be supplied with sufficient evidence as to how a foreign court responsible for construing the underlying wording will interpret the underlying policy wording.  It appears in this case that the English court was persuaded that the law in the Philippines was likely to be the same as English law, which may not have been the case.  The remedy to counter this issue will be to ensure that 'back to back' wordings include a specific provision providing that the reinsurance policy will be construed in accordance with the interpretation of the underlying wording under local law.

A similar position appears to have been at the heart of the decision in the Beazley matter.  Here, the court was required to rule on the effect of a partial settlement that, on the face of it, was in breach of a claims control clause in the reinsurance policy.  The court in Beazley appeared to have received very little information on the nature of Kuwaiti proceedings on the underlying policy and the effect that any such partial settlement would have on the reminder of the underlying claim under Kuwait law.  Had the court appreciated that a settlement of even a small portion of the underlying claim would in all likelihood have been construed as an admission that the total claim was due, it is doubtful the court would have reached the decision it arrived at.

What is common to both cases is the fact that the English court did not appear to be fully briefed about the procedure and likely interpretation that would be given to both these issues under local law.  It is therefore incumbent on cedants and reinsurers in this position to obtain sound local legal advice in order to ensure that the court is given a full briefing on how the underlying policy wording is likely to interpreted under local law by the local courts.  It is also important that reinsurance wordings include specific provisions providing for the interpretation of the underlying wording to be binding on reinsurers.

  1. Failure to appreciate local law interpretations

The failure to understand the effect of the local law interpretation of the underlying policy wording appears to be a common thread in what led the English Court to reach the decisions it made in Beazley and Princess of the Stars.

In the Beazley decision, for instance, it does not appear that the judge was provided with sufficient information in relation to Kuwaiti law, that would enable him to appreciate that 'without prejudice' correspondence between parties is fully disclosable before the local courts, and that payment of any portion of a claim on the underlying policy is likely to be deemed to be an admission of liability under the original policy, and thus render the entire claim payable.

In the Princess of the Stars the English court appeared to accept that Philippine law and English law were likely to reach a similar conclusion in relation to the construction of a typhoon warranty, without the Philippine court having considered the issue.

It is imperative that those advising parties involved in Middle East reinsurance disputes, whether engaged in the local end or the London end of litigation understand and appreciate the position that applies under local law.

Whilst a number of market participants contend that, in the light of these anomalies, it would be preferable for both the underlying wording and the reinsurance wording to be subject to local law and jurisdiction, this is unlikely to provide a satisfactory solution for either party.  Many local jurisdictions (including the Middle East) will have a distinct lack of reinsurance jurisprudence, and the parties to the reinsurance contract cannot be guaranteed that the local court will be suitably equipped to deal with a genuine reinsurance coverage dispute.  From a cedant's perspective, whilst the prospect of litigating on 'home turf' may seem attractive, the reality of securing jurisdiction over a foreign reinsurer and the processes that would need to be followed to enforce a local judgment, may detract from the perceived advantages.

  1. Conflicts of interest

Middle East reinsurance placements are often subject to inherent conflicts of interest.  These can include:

  • the cedant having an entrenched existing relationship with the underlying insured;
  • the direct and reinsurance placements being handled by the same broker;
  • the cedant retaining little if any of the underlying risk and therefore having no 'skin in the game'; and
  • competing interests amongst subscribing reinsurers (as evidenced in the Beazley decision).

These inherent conflicts need not present insurmountable hurdles, as long as they are recognised and dealt with.  However, our experience in practice is that the parties to the reinsurance contract, and their brokers, rarely take any positive steps to recognise and deal with these inherent potential conflicts.

Some of the mechanisms that can be used by the parties to manage conflicts of interest include:

  • insisting on the independence of brokers involved in the direct and reinsurance placements;
  • requiring cedants' to warrant their 'net retention';
  • using express wording to recognise the reality of the fronting relationship; and
  • reviewing the basis on which reinsurers in a subscription market participate in adjusting a loss (it is becoming apparent from recent decisions that the London market General Underwriting Agreement may be deficient in this regard).
  1. Market wordings

Wordings used for Middle East risks have tended to be based on international standard wordings (e.g. LM7 for property risks; ICC Clauses for marine risks) which, although possibly tried and tested internationally, may be subject to different construction when translated into Arabic and considered by a local court.

There is a good case to be made for wordings that are to be used for Middle East risks to be reviewed in the context of local law and adapted accordingly. In the field of novel or relatively new risks to the market (e.g. in the area of Financial Lines or Cyber products) a good understanding of the local law and potential exposures is required in order to customise wordings for use in the Middle East.

Reinsurers cannot rely on how such wordings may be interpreted in an international context. From a cedant's point of view it is not sufficient simply to 'cut and paste' terms and wordings provided by reinsurers into a local policy.

The way forward

Given the extensive cross-border nature of the Middle East reinsurance industry, it is unlikely that any of the above issues will disappear from the market anytime soon.  It is incumbent on market participants to appreciate the issues that arise, and to take suitable steps to avoid the problems arising that have been the subject of the recent English court cases, in order to avoid similar issues cropping up in the future.

Footnotes

1 [2012] EWCA Civ 1341

2 [2012] EWCA Civ 1341

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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