A UK High Court Judge has ruled that Equitas, (Berkshire Hathaway's run-off vehicle), may recover reinsurance losses based on modelled calculations of the LMX Brandywine spiral, setting an important legal precedent.
In the dispute between Equitas and R&Q Reinsurance (formerly Brandywine), the issues concern the recovery of indemnity (under retrocession contracts) in respect of the costs originating from the Exxon Valdez oil spill and Kuwait Airways/British Airways' loss of aircraft during the first Gulf war. Through the magnifying effects of the LMX spiral, each loss had given rise to payments in excess of US$6 billion by the time the market stopped paying.
The main issue was whether Mr Justice Gross would accept Equitas' application of actuarial modelling techniques to the spiral to determine those proportions of the liabilities properly falling to R&Q. Equitas argued that its recoverable losses were in fact capable of being proved and that it had succeeded in proving them to a standard of the balance of probabilities through the use of actuarial modelling. R&Q's case was that Equitas was entitled to recover nothing at all. Unless Equitas could prove that the sums claimed were properly due, contract by contract, the losses must lie where they fall.
Mr Justice Gross concluded that it was not a requirement of law that Equitas must prove a loss at each underlying level of the LMX spiral. It is a question of fact or evidence. The issue was therefore whether the modelled output permits conclusions to be drawn with confidence and to the requisite standard of proof as to the recoverable losses for each syndicate.
In ruling, he held that "the models are both capable of making the transition from the general to the particular and do go on to provide a reasonable representation of reality". He said that the models assist in doing practical justice in this case – which was an emphatically preferable solution to just letting losses lie where they fall.
In conclusion, therefore, he was satisfied that the models provided an acceptable route to establishing the properly recoverable minimum losses sustained, having regard to the applicable burden and standard of proof.
This unprecedented decision may have far-reaching effects as LMX market participants have been waiting for a decisive ruling. The general consensus is that the ruling may restart the unwinding of the infamous LMX spiral. In fact, Justice Gross said in his judgment that he hopes the spiral would be "kick-started" by his ruling.
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Full Article
A UK High Court Judge has ruled that Equitas, (Berkshire Hathaway's run-off vehicle), may recover reinsurance losses based on modelled calculations of the LMX Brandywine spiral, setting an important legal precedent.
Background
In the dispute between Equitas and R&Q Reinsurance (formerly Brandywine), the issues concern the recovery of indemnity (under retrocessional reinsurance contracts) in respect of the costs originating from the Exxon Valdez oil spill and Kuwait Airways loss of aircraft during the first Gulf war. Through the magnifying effects of the LMX spiral, each loss had given rise to payments in excess of US$6 billion by the time the market stopped paying.
Twenty-six test contracts were examined at the trial: 14 related to the Kuwait Airways losses and 12 to Exxon Valdez. R&Q's case was that Equitas must present (or in many cases, represent) its claims, appropriately stripped of the irrecoverable British Airways and Exxon Valdez losses and adjusted to take account of the effect of the United Nations Compensation Commission (UNCC) refunds paid to Equitas on behalf of Iraq. Equitas agreed in theory that this adjustment should and will take place; the real question was how - and whether it is even possible. Equitas asserted that the adjustments can be made by way of complex actuarial modelling.
Issues
The main issue was whether Mr Justice Gross would accept Equitas' application of the actuarial modelling techniques to the spiral to determine those proportions of the liabilities properly falling to R&Q.
The effects of the spiral had wrongly aggregated certain losses and included irrecoverable losses. Equitas acknowledged that the spiral's effects make the losses impossible to quantify by any conventional method and sought to rely instead on projected figures obtained from its modelling. Equitas argued that its recoverable losses were in fact capable of being proved and that it had suceeded in proving them to a standard of the balance of probabilities through the use of actuarial modelling. In effect, allowing appropriate discounts to strip out the wrongly aggregated or irrecoverable elements, so leaving a minimum recoverable amount properly due under each of the reinsurance contracts.
R&Q's case was that Equitas was entitled to recover nothing at all. Unless Equitas could prove that the sums claimed are properly due, contract by contract, the losses must lie where they fall. Estimating and guesswork would not do. In principle, the losses of individual syndicates cannot be proved by a generalised actuarial model and further, the Equitas model itself is flawed and does not achieve its purpose.
Decision
- Legal Analysis
R&Q's initial "knock-out blow" was their argument that under the settlements clause, Equitas needed to re-present correctly aggregated losses upwards through the spiral – it must show how properly aggregated and recoverable losses would flow through the spiral. Equitas was not entitled to proceed by way of a short-cut working backwards from wrongly aggregated losses. In such an unprecedented situation, market practice could not provide a solution. In any event, whatever the characteristics of the market, parties were entitled to rely upon and enforce the contractual terms. Equitas could not satisfy this burden and would therefore "fall at the first hurdle".
Equitas denied it bore any such burden, and stated it was not required to undergo a process of regression involving proof of loss at every underlying stage of the spiral. The reinsurance was shaped by the market which furnished a "universal background" which involved proof of loss is a particular manner – by way of collection notes and not involving the identification of every underlying cedent, contract and proof of liability of each individual cedent in order to prove a loss.
Mr Justice Gross said he had no real hesitation in preferring the case advanced by Equitas. The key distinction lay between questions of law on one hand and questions of fact or evidence on the other. Case law did not prove, either expressly nor implicitly, that the only way a settlement clause could be satisfied was if Equitas can re-present correctly aggregated losses upwards through the spiral. Doubtless, there could have been a contractual provision covering how Equitas was entitled or bound to prove what it must prove, but the settlements clause here did not do that.
It was agreed that the present situation is unprecedented, which necessarily means that there is a limit to the assistance that can be provided by market practice – either way. However, Mr Justice Gross found that subject to this, market practice favours the Equitas case: the market has invariably relied on collection notes rather than insisting on strict proof of loss.
Mr Justice Gross concluded that it was not a requirement of law that Equitas must prove a loss at each underlying level of the LMX spiral. It is a question of fact or evidence. Equiras therefore did not fall at the first hurdle on account of its inability to reconstruct the LMX spiral.
- Actuarial Modelling
Equitas sought to utilise actuarial modelling; R&Q objected in both principle and in detail, that the models were incapable of discharging the burden of proof resting upon Equitas. R&Q submitted that the question was not whether the models were "reasonable" but whether they proved that individual attachment points had been reached. Equitas stated that it was correct that the models did not seek to create the actual spiral; but that did not matter because the models provided reasonable representations of the relevant features of the spiral for the purposes which mattered. The models drew significantly on actual data and produced results representative of those of actual syndicates (including the relevant syndicates).
Mr Justice Gross held that he could not accept R&Q's objection to the use of models as a matter of principle. Equitas must be free to deploy such evidence as it chooses to satisfy the burden of proof resting on it;he could see no proper logical or principled objection to the use of the models here.
With regard to the objection of a matter of detail, Mr Justice Gross regarded the issue to be whether the modelled output permits conclusions to be drawn with confidence and to the requisite standard of prood as to the recoverable losses for each syndicate. He concluded, that on a balance of probabilities, subject only to consideration of the detailed grounds of challenge to the models (which we do not go into here), he was satisfied that the modelled input did permit conclusions to be drawn with confidence and to the requisite standard of prood as to the recoverable losses for each syndicate. In short, the models, which started with real or actual data finish with answers which are representative of the actual position.
- UNCC Refunds
This related to the UNCC refunds not yet processed through the spiral, relating to the Kuwait Airways claims. Mr Justice Gross did not accept R&Q's criticism that these had not yet been modelled and said he was anxious that everything that can be done to ensure these were processed once the spiral is "kickstarted" by this judgment. He was confident that the matter would be fairly and justly dealt with by the incorporation of appropriate undertakings in the declaratory relief to be granted to Equitas in accordance with his judgment.
Conclusion
Mr Justice Gross considered R&Q's objections in respect of the models – ranging from the objection both as matter of law and more widely that actuarial modelling could not be utilised at all to establish the Equitas models, to detailed criticisms of the models in question. He accepted that actuarial modelling is "complex, expensive, imperfect" and that it was "plainly necessary to proceed with caution".
However, he said that he was persuaded that "the models are both capable of making the transition from the general to the particular and do go on to provide a reasonable representation of reality". He said that the models assist in doing practical justice in this case – which was an emphatically preferable solution to just letting losses lie where they fall.
In conclusion, therefore, he was satisfied that the models provided an acceptable route to establishing the properly recoverable minimum losses sustained, having regard to the applicable burden and standard of proof.
Impact for the Insurance Market
Equitas' use of an actuarial model to calculate substantial insurance payouts against the respective losses was a test case for four arbitrations. These represented more than 4,000 LMX spiral-related claims that have been stayed pending its outcome, resulting in the market being in "lockdown".
This decision could therefore have far-reaching effects indeed as LMX participants have been waiting for a decisive ruling. The general consensus is that the ruling may restart the unwinding of the infamous LMX spiral. In fact, Justice Gross said in his judgment that he hopes the spiral would be "kick-started" by his ruling.
Further reading: Equitas Limited v R&Q Reinsurance Company (UK) Limited AND Equitas Limited v ACE European Group Limited [2009] EWHC 2787.
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 11/11/2009.
