Cross-border challenges for Middle East reinsurance coverage and claims issues

Reinsurance arrangements in the Middle East often involve cross-border transactions, with the cedant based locally, and the reinsurer located in one of the traditional reinsurance centres of London, Munich, Zurich or Paris.

This can give rise to challenges when interpreting wordings and handling difficult coverage issues and claims.  Although historically, English law has offered a relatively clear and stable basis for determining coverage issues and interpreting wordings, a number of recent English cases have created concerns for both cedants and reinsurers.  In the first part of a three-part series of article, we review the basis for the concerns, and specific issues regarding incorporating warranties into reinsurance contracts that are intended to operate on a back to back basis.

Local law challenges

The Middle East presents a number of challenges when dealing with the inter-relationship between, on the one hand, underlying insurance wordings and how those are interpreted in the local courts and, on the other hand, how reinsurance wordings with international reinsurers are viewed and applied.  There is a general lack of jurisprudence at any level in the local courts in most Middle East jurisdictions. There are also very few laws or regulations specifically relating to reinsurance in these jurisdictions.  As a result, although any local litigation between underlying insured and cedant will be subject to local law and local courts, resolving any issues that arise in relation to the reinsurance coverage is rarely likely to be dealt with in a competent and understandable manner by the local courts.  Most reinsurance practitioners (at both cedant and reinsurer level) will shy away from having to litigate in the local courts.

Historically, English law and the English courts have developed a useful body of jurisprudence that has sought to interpret and give effect to the commercial intention of the relationship between local cedant and reinsurer.  There is a long line of English cases (beginning with Vesta v. Butcher in 1973) which takes into account the difference in interpretation of clauses such as warranties in local insurance contracts, and how those are to be interpreted in a reinsurance context, to give effect to the back-to-back intention in the re/insurance contracts.  For this reason, the inclusion of English law and jurisdiction clauses in reinsurance contracts has been seen as a good choice to assist with any disputes that arise in a reinsurance context.  It has generally been regarded that the English courts will look to respect and to give effect to the commercial relationship between cedant and reinsurer.

However, a recent decision by the English court has challenged this traditional belief, and will require cedants and their brokers to make sure that the wordings used at the underlying and reinsurance contracts take into account the realities of the local law position, and are clear as to the intentions of the parties, in order to achieve their commercial intention.

"Princess of the Stars"

In the most recent “Princess of the Stars” appeal (August 2014)1 , the Court of Appeal upheld the underlying decision of Mr Justice Field handed down in 20122 , that allowed reinsurers to obtain a declaratory order that they were not liable to claims arising from their reinsurance of Oriental’s exposure to a Philippines ferry disaster that took place in June 2008.  The ‘Princess of the Stars’ ferry had set sail from Manila on a short scheduled trip to a nearby island, but sailed into the eye of Typhoon Frank, capsized and sank.  Only 32 of the 851 people on board survived.  Both the insurance and reinsurance contracts contained a ‘typhoon warranty’ in very similar terms, which provided that ‘violation of this warranty shall render this policy void’.

The pre-emptive action by reinsurers before the English courts took place before there had been any determination of the cover for the loss in the Philippines.   The underlying policy wording incorporated wording that was said to be subject to English law, and the reinsurance contract contained a ‘follow settlements’ clause.  Oriental argued that any interpretation of the warranty in the reinsurance policy would need to take into account the manner in which the underlying policy, and specifically the typhoon warranty, was interpreted before the Philippine courts.   On that basis, Oriental argued at first instance that reinsurers’ action was premature, and should be stayed pending determination of the coverage position in the Philippines.  It would only be in the light of that position having been determined that the interpretation of the warranty in the reinsurance policy could be determined.  The English court disagreed, which decision was upheld by an earlier Appeal Court decision3, although the Court of Appeal, recognizing the position this put Oriental in, did so "with little enthusiasm".

The most recent Court of Appeal decision concerned a review of the judge's decision as to whether the court was entitled to interpret the terms of the warranty in the reinsurance policy independently.  This decision was upheld.  The Court also held that it was capable of construing the warranty in the reinsurance policy in accordance with English law, and that there was no material difference between English law and Philippine law with respect to policy interpretation or the effect of a breach of warranty.  In the English court's view, the two clauses should be construed identically. It is not clear exactly what evidence as to Philippine law and procedure was produced to the court.

In the light of the above, the Court of Appeal upheld the decision of Mr Justice Field that reinsurers were entitled to bring the action for declaratory relief prior to any determination by the Philippine courts, and were entitled to an order that reinsurers were not obliged to indemnify Oriental for the losses that fell to be covered as a result of the ferry disaster.

Implications for local cedants

The decision has resulted in Oriental, as the 100% local insurer in the Philippines, being left to fight its corner on the warranty issue, without reinsurance support.  Should the Philippine court take a different view on the warranty issue, and hold that Oriental's policy does respond, it will be left to Oriental to foot the bill without any reinsurance cover.  An invidious position for Oriental, indeed!

The problems that arose in this case could potentially have been addressed by:

  1. More care being taken when incorporating an express warranty as a standalone provision in a reinsurance contract that was clearly intended to operate on a back-to-back basis.
  2. Clear evidence of exactly how the underlying warranty was likely to be interpreted under Philippines law before a Philippines court.

The issues highlighted above are likely to apply in a Middle east setting as well.  It appears, on the basis of this judgment, that absent careful attention being paid to reinsurance wordings and without properly highlighting the local jurisdiction issues, local cedants will be vulnerable to pre-emptive actions by reinsurers being taken seeking to avoid liability for claims that might well prove to be payable in the local jurisdiction.

Compliance with Claims Control Clauses: the 'reinsurance pizza'

In March 2013, the English Commercial Court handed down a judgment on a case involving the reinsurance of a risk in Kuwait, which is typical of the type of re/insurance arrangements that are put in place on a daily basis in the region.  The Court's decision in Beazley and others v Al Ahleia and others  is a fascinating read for anyone involved in reinsurance business in the region.

The original policy involved a Construction All Risks and Third Party Liability policy issued to Kuwait Oil Company (incorporating Kuwait Petroleum Company) to cover risks associated with the construction of 15 new crude oil storage tanks as part of an onshore crude export facility.

The original risk was underwritten by a consortium of Kuwaiti insurers, led by Al Ahleia with a 35% share.  Facultative insurance to the order of 89.5% was placed with the London market on a subscription basis, led by AIG (20%) and Beazley, pursuant to the usual General Underwriting Agreement for subscription risks.  Of special note was that AON were brokers on the direct and reinsurance policies. The reinsurance policy contained a Claims Control Clause that required compliance with the clause as a condition precedent to liability.  The reinsurance policy also contained a follow settlements clause.

Partial settlement of the re/insurance claim

Notice of alleged damage to Tank 84 was given under the re/insurance policies in March 2007.  The loss was quantified at US$28m. Adjusters were appointed and cover for the claim was initially declined on grounds of a design defect that was excluded under the London Engineering Group Exclusion 2 (LEG2).  Reinsurers were at first united in this stance until, in May 2009 when the KOC account came up for tender, AON contacted AIG to see whether AIG would be prepared to take a fresh look at the claim.  Unbeknown to the rest of the market, and as part of a bid to secure renewal of the KOC insurance tender, AON and AIG arranged for a further engineering report to be undertaken.  In December 2009, AON and AIG agreed with KPC that AIG would settle its 20% share of the loss based on a reduced 100% loss figure of US$19m.  Al Ahleia were informed of this development, and duly produced release and discharge forms for AIG's share, along with the local Kuwaiti insurers' share of the loss. It was only after these developments that Beazley and the following reinsurers were informed of the deal that had been struck.

Beazley and the following market notified Al Ahleia that the arrangements that had taken place without their involvement were in breach of the Claims Control Clause and therefore declined cover for the loss.  In the meantime, KPC commenced proceedings against Al Ahleia in Kuwait, relying on documents (a number of which were marked 'without prejudice') for the remainder of the claim.  Beazley and the following market initiated proceedings in London seeking a declaration they were not liable as a result of the breach, by Al Ahleia of the Claims Control Clause in the reinsurance contract.

Decision of the English Commercial Court

Various representatives of Al Ahleia and the London market reinsurers gave evidence at trial, with the notable exception of AON, who the judge remarked, based on their dual role of being the original and reinsurance brokers on the risk, were "placed in a difficult if not impossible position". Some evidence of the Kuwait proceedings was put before the court, although the judge remarked that "the precise nature of these proceedings remains somewhat unclear", and confessed that "I have found the debate in relation to the [underlying claim in the Kuwait proceedings] confusing partly because I am not sure whether the documents I have been shown in relation to the Kuwaiti proceedings are complete and partly because I am not sure that the translations are accurate".

In proceeding to hold that the Claims Control Clause had not been breached, Mr Justice Eder referred to the following factors as the basis for his decision:

  1. Discussions and without prejudice documentation produced between KPC and Al Ahleia, including documentation forwarded to AON confirming Al Ahleia's agreement to the proposed settlement of AIG's and the Kuwaiti insurers' shares did not breach the rights of reinsurers to "control all negotiations, adjustments, and settlements" pursuant to the Claims Control Clause;
  2. The settlement that was reached did not constitute a 'settlement' under the reinsurance to which the terms of the Claims Control Clause, because "in accordance with business common sense … [Al Ahleia] should, if they so wish, be entitled to settle, compromise or admit liability under the Insurance Policy at least if such settlement, compromise or admission is not in respect of or in connection with any loss or losses that might give rise to a claim under the Reinsurance Contract …". The judge held that settlement of AIG's 20% share was also not such a settlement.
  3. The settlement was made "without prejudice" in circumstances where "the effect of a without prejudice settlement as a matter of Kuwaiti law would be far from certain".
  4. There was no admission of liability by Al Ahleia, because the documentation produced amounted to "at best simply an offer to pay money".

The decision has not been appealed and is thus final.  The English Court's decision, in our view, represents a significant setback to following market reinsurers seeking to rely on the cedant's responsibility to involve its reinsurer in the negotiation of a loss. Although no ruling was made on Al Ahleia's arguments that the settlement agreed by AIG was akin to comparing its settlement to a slice of a pizza, with the rest of 'the pizza' continuing to remain open for individual negotiation, the judge's ruling has in effect confirmed this view of the basis on which individual 'slices' of a reinsurance contract might be negotiated and settled, independent of the rest of the contract.

Implications for the Middle East market

The decision in the case leaves following market reinsurers in a very difficult position where one of their number breaks ranks and seeks to cut a deal with the underlying insured in order to settle its liability.

The problems that arose in this case could conceivably have been avoided by:

  1. Avoiding the position where the broker is involved in placing both the direct insurance policy and the reinsurance placement, which of itself gives rise to a significant conflict of interest that became readily apparent in this matter as the adjustment of the claim progressed.
  2. More attention being paid to producing contractual documentation which properly delineates and scopes out the role of the local insurer/s in risks which are heavily reinsured by the international reinsurance markets.
  3. Those advising the local insurer and the reinsurance market being able to show that a settlement of any part of the loss by the local insurer would be regarded under local law as an admission of liability, and that the risk could never be 'sliced up' under local law.
  4. The duties and responsibilities required of the leaders (AIG and Beazley) on the reinsurance risk be further clarified and scoped out, which may be a reason to review the basis on which the General Underwriting Agreement is used in the London Market.

As we have indicated above, the circumstances which gave rise to the issues which fell to be considered by the English Court are by no means abnormal: reinsurance placements are effected in this manner in the Middle East region on a regular basis.  The participants in these placements (brokers, local insurers and reinsurers) need to recognise the nature of the contractual arrangements that are put in place, in order to appreciate their particular position (and possibly exposure) as a result of their participation, and then take steps to safeguard themselves effectively against the types of problems that arose in the Tank 84 case.

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.

2. 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.

3. 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.

4. 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).

5. 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.