A GUIDE TO REINSURANCE LAW CHAPTER 6 FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

1st Edition, 2007

Chapter 6

FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

WHY NOT CHARACTERISE THE OBLIGATION AS A DEBTRATHER THAN A CONTRACTUAL
OBLIGATION?
One other way of attempting to enforce payment from a reinsurer was argued before the Supreme Court of New South Wales in
Odyssey Re (Bermuda) Ltd v. Reinsurance Australia Corp Ltd (12 April 2001) to the effect that an amount payable to it under a
reinsurance policy placed with ReAC was a debt. There are considerable advantages in having a claim characterised as a debt. First, a
claimant can normally obtain judgment for a debt with a minimum of supporting evidence. Secondly, once the claimant proves the
existence of the debt, the onus of proof shifts to the defendant, who must prove that the debt has been paid or is not payable. Thirdly,
a person claiming for debt does not normally need to comply with the rules requiring mitigation of loss. These rules apply to a breach
of contract. Finally, the claimant of a debt is able to take advantage of the statutory demand procedure available in most jurisdictions.
In Odyssey Re the reinsured sought to take advantage of the last of these factors by issuing a statutory demand for payment by
ReAC. The effect of such a demand is that if the recipient is unable to prove there is a genuine dispute regarding the amount payable,
the recipient must either pay or face the prospect of being wound up. Not surprisingly, ReAC opposed the statutory demand on a
number of grounds. One of its arguments was that the amount claimed by the reinsured was not a debt, so the statutory demand
procedure was not available. ReAC had to contend with the fact that the reinsurance agreement contained a form of follow the
settlements clause which provided that the reinsureds loss settlements shall be binding upon the reinsurers and payable by them
upon reasonable evidence of the amount paid being given by the reinsured, which according to Odyssey resulted in ReACs
obligations under the agreement taking the form of a debt. It has long been settled that a claim under a contract of insurance is not a
debt, but instead is a claim for damages for breach of contract. The one exception to this rule is in the case of valued policies, where
the amount payable is a specific liquidated sum. Justice Windeyer of the New South Wales Supreme Court accepted this position, but
noted that this raised the question whether the same principle applied to a contract of reinsurance. He found that the same approach
did apply to the reinsurance in this case, his principal reason being that payment by the reinsured does not trigger an automatic
obligation on the reinsurer to pay. The existence of an agreement to arbitrate in the reinsurance agreement also indicated that the
reinsurance obligation was not a debt.

EXTRA-CONTRACTUAL LIABILITY

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It is possible that a reinsured could be liable to the insured in excess of its specified limit of contractual liability. For example, a
reinsured may fail to settle the loss promptly in breach of an express term to do so, such as the 60-day time for payment within ICA v.
SCOR (see above). Equally there may be a breach of the duty of utmost good faith owed by the reinsured to the insured, and this
would apply to the position prior to the formation of the contract as well as to the limited duty of good faith applicable once the
contract has been concluded. There could also be liability on the grounds of a wilful failure to reach agreement with the insured, or in
respect of a voluntary assumption of responsibility which gives rise to liability upon breach. It is certainly the case that in the absence
of any specific clause covering such additional liability, the reinsurer would not be liable. Thus in ICA v. SCOR (see above) there was
effectively a punitive element of US$600,000 payable by the reinsured to the insured, as general damages. This sum was not
payable by the reinsurer because it fell in excess of the reinsurance policy limit, and an open-ended liability was not what either party
had intended upon entering into the contract of reinsurance. The Court of Appeal also said that to imply such a term would be
inconsistent with the claims co-operation clause, although it is of course uncertain as to what the position would be where no such
overriding claims co-operation clause existed. Further, ICA v. SCOR does not determine whether a follow the settlements clause
which is unaffected by any claims co-operation requirement obliges the reinsurer to make such excess liabilities, provided that its
total liability remains within the limits fixed by the reinsurance contract. There is no English authority on any aspect of the
extra-contractual obligations clause, although it is thought that a follow the fortunes clause may impose a higher degree of liability
upon the reinsurer, particularly in respect of the reinsureds extra-contractual payments, than a standard follow the settlements clause.
See, however, Gan Insurance Co. Ltd v. Tai Ping Insurance Company Ltd below.
It is certainly the case that, following Lancashire County Council v. Municipal Mutual Insurance Limited [1995] L.R.L.R. 293, it is
not contrary to public policy for insurance to cover both compensatory awards and awards of exemplary damages against the insured,
and such liabilities can be passed by the reinsured to the reinsurer provided there is a sufficiently clear contractual obligation to do so.
Only where there is an element of moral culpability deceit, fraud, dishonesty or recklessnesscould the insurer refuse to pay, or
the reinsurer to indemnify.
One other aspect that has yet to be judicially explored is the liability of the reinsurer to indemnify the reinsured in situations where
the reinsured has been required by the court to pay more to the insured under section 51 of the Supreme Court Act 1981, where the
losing party to legal proceedings has been the reinsured in all but name, and five criteria have been satisfied, e.g. the reinsured funded
and conducted the litigation, and the defence failed in its entirety. In the absence of any implied term post-Baker v. Black Sea (see
below) it is unlikely that reinsurers would be liable for extra-contractual third party legal costs.

COSTS
Robert Merkin

A GUIDE TO REINSURANCE LAW CHAPTER 6 FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

1st Edition, 2007

In the absence of clear provision for the reinsureds costs in the contract of reinsurance, the position used to be capable of division
into two parts. These are as follows.

Where the costs and claim together do not exceed the policy limit
In British Dominions General Insurance Co v. Duder [1915] 2 K.B. 394 the Court of Appeal held that the cost of reaching a
settlement could be recovered from the reinsurer, who had to pay 66% of the reinsureds costs, the reinsured having settled with the
insured for 66% of its liability. The original cover was for 20,500, and the reinsurance was only for 2,500. The reinsurer therefore
paid 1,000, i.e. 66% of 2,500, equivalent to its proportion of liability under the reinsurance.
In contrast the court refused to award the costs of the reinsured in proving that he was not liable to the insured in Scottish
Metropolitan Assurance Co v. Groom (1924) 20 Lloyds Rep. 44. The reinsured incurred costs in establishing that it was not liable at
all to the insured but had it merely paid the claim, there was a likelihood that it would not have been able to establish that it was under
any legal liability to do so, which would have precluded a valid claim being made on the reinsurance. Thus if the reinsured were
unable to recover from the reinsurer the claim paid to the insured, why should it be entitled to claim the costs of establishing that the
claim should not be paid? The reinsured in both cases reduced the reinsurers potential liability, but in Duder the reinsured was
clearly liable to the insured. Today the issue to some extent revolves around the construction of settlement in the relevant clause of
the reinsurance contract; it seems reasonable that the reinsured should recover his costs where the aggregate does not exceed the
policy limit, a possibility reviewed by Stephenson L.J. in ICA v. SCOR in construing settlements as including all sums reasonably
paid in the normal course of disposing of the assureds claim (ibid., p. 53), provided these costs relate to the original claim and not to
a dispute involving the reinsurance policy.

Where the costs and claim together exceed the policy limit
The initial problem is that a reinsurer who specifies his maximum liability should not be forced to pay any greater sum. This was the
position in ICA v. SCOR. Leggatt J. at first instance implied a term into the contract that the reinsurer would reimburse all expenses
incurred by its refusal to authorise payment to the reinsured. In the Court of Appeal Stephenson L.J. agreed, pushing the term to
include all costs voluntarily incurred in establishing liability. Robert Goff and Fox L.JJ. disagreed, on the basis that the maximum
liability had been agreed and was inviolate, the implied term was inconsistent with the original agreement, and the claims
co-operation clause enabled the reinsurer to refuse to authorise a settlement without becoming liable for the consequences of such
refusal. Such an implied term was not necessary to provide business efficacy to the contract, and the reinsured therefore did not
recover his costs of $58,000, although the final result seems to be more one of public policy than pure legal analysis. Although ICA v.
SCOR confirms the sanctity of the limit of cover, in fact its other main effect does no more than establish the rule that a reinsurer who
is entitled to refuse its consent to a settlement will not be liable for the consequences of so doing.

Colin Baker v. Black Sea and Baltic General Insurance Co. Limited [1998] Lloyds Rep. IR 327
A short answer to some of the problems posed by these cases was given in Colin Baker v. Black Sea and Baltic General Insurance Co. Limited, in
which a Lloyds syndicate ceded risks under a proportional reinsurance treaty and went to the House of Lords on an issue as to whether or not the
cedant was entitled to recover a proportion of the costs incurred in investigating, settling or defending claims made by their insured on the basis that
proportional reinsurance requires the reinsurer to share the same underwriting fortunes as the reinsured as to risk and premium, and therefore it was
unreasonable and not intended that the cedant would bear all the costs having effectively received only a portion of the premium, paying the balance
over to the reinsurer. The cedants case was made on three grounds. First, that the reinsurer was liable under the follow the settlements clause in the
reinsurance policy, an allegation rejected by Millett L.J. on the basis that A follow the settlements clause does not extend cover but operates to
prevent the reinsurer from reopening a settlement or other disposal of a claim which is within the cover. The argument was that the presence of a
follow the settlements clause required the reinsured to defend claims in which liability was disputed with a consequential indemnity from the reinsurer
for the costs of so doing, but on the majority judgments of the Court of Appeal in ICA v. SCOR it was clear that the clause was not to be construed as a
request to defend. The follow the settlements argument which was validated by the dissenting judgment of Stephenson L.J. in ICA v. SCOR now
would appear to have run out of steam, subject to any extension to which it may judicially be granted folowing the comments of Mance L.J. in Gan
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(below).
The second argument put forward by the cedant was that the reinsurer was effectively a partner or joint venturer and the costs incurred by the reinsured
were for their mutual benefit. A term as to its proportionate payment was therefore required to give the contract business efficacy or to give effect to
the presumed intention of the parties. This view was disposed of on the grounds that a proportional reinsurance treaty does not have the character of a
partnership; further, any costs incurred by the reinsured are as principal in its own right and not as agent for the reinsurer.
The third ground that a term could be implied by way of custom or usage was held by the House of Lords to have incomplete evidence in the lower
courts and this aspect was remitted to the Commercial Court for fresh determination, but the matter settled after the decision of the House of Lords.

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A GUIDE TO REINSURANCE LAW CHAPTER 6 FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

1st Edition, 2007

It is still open to a cedant to show that there is a custom to the effect that the costs should be shared, but it will be a custom that is difficult to prove.
The reinsured did not seek to recover any part of their overheads or fixed costs, and the only costs in issue were the variable costs specific to the
particular claim, e.g. legal expenses in defending the claim, but not the cost of the salaries of the claims manager who would be employed anyway,
even though they were dealing with the claim in question. The syndicate also confined its application for costs to proportional reinsurance and it was
never suggested that the reinsurer should be liable for costs in non-proportional reinsurance in the absence of any express provision to that effect.
Can the actions of the reinsurer give rise to liability where they not only prevent the reinsured from reaching an agreement with the insured, but also
give rise to a liability of the reinsured which is in excess of the reinsurance limit of indemnity? In ICA v. SCOR additional damages of $600,000 were
payable by the reinsured because the reinsurer would not approve any settlement and would not divulge the information which may have assisted the
reinsured to refute the claim or reach a compromise.
Robert Goff L.J. said that the effect of the claims co-operation clause was that if a settlement is made without the approval of the reinsurer, it cannot
be relied upon as a settlement authorised by the policy, and so cannot constitute a settlement which the reinsurers are bound to follow under the follow
the settlements clause (ibid., p. 332). It is therefore clear that the presence of the claims co-operation clause was an overriding consideration in respect
of extra-contractual payments. This clause has been refined since SCOR, in Gan Insurance Co. Ltd v. Tai Ping Insurance Co. Ltd (No. 2) [2001] 2 All
E.R. (Comm) 299 (see also Chapter 7) where the Court of Appeal held that a provision in a reinsurance treaty that the reinsurers were to approve any
settlement was subject to qualification. Mance L.J. explained that such qualification does not arise from any principles or considerations special to the
law of insurance. It arises from the nature and purpose of the relevant contractual provision. He went on: it is possible to envisage circumstances
in which reinsurers refusal or approval could take place for reasons extraneous to the claim and prejudice insurers.
However, whether the courts will imply such a term will depend on the facts. Although it may be easier to imply such a term than one whereby consent
is not to be unreasonably withheld (despite the finding of Longmore J. of an implied term that the reinsurer would not unreasonably withhold consent)
the Court of Appeal thought the term to be implied was that the withholding of approval should take place in good faith after consideration of and on
the basis of the facts giving rise to the particular claim, and not with reference to considerations wholly extraneous to the subject matter of the
particular reinsurance or arbitrarily.
Mance L.J. went on to add that if any further implication were to be made it would be along the lines that the reinsurer will not withhold approval
arbitrarily, or will not do so in circumstances so extreme that no reasonable company in its position could possibly withhold approval. This will not
ordinarily add materially to the requirement that the reinsurer should form a genuine view as to the appropriateness of settlement or compromise
without taking into account considerations extraneous to the subject matter of the reinsurance.

GAN Insurance Co. Ltd v. Tai Ping Insurance Co. Ltd (No. 2)
In GAN Insurance Co. Ltd v. Tai Ping Insurance Co. Ltd (No. 2) the Court of Appeal looked at the claims control clause (which had been revised after
ICA v. SCOR to make each aspect a condition precedent). The Commercial Court had been asked to consider whether a term should be implied into the
reinsurance contract to the effect that reinsurers would not withhold their approval to a settlement unless it had reasonable grounds for doing so, even
where the claims control clause was a condition precedent. It said that the right of a reinsurer to refuse to approve a settlement without reasonable
grounds for so doing would defeat the purpose of the reinsurance, and that such a term that the reinsurers would not unreasonably withhold its consent
would be implied. To force the reinsured to litigate his liability with the insured in every case is uncommercial and unbusinesslike, and unlikely to
have been the intention of the parties.

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The Court of Appeal started from the premise that the parties are free to contract on whatever basis they wished and applied the traditional tests of
implicationnecessity for business efficacy, and the obvious but unexpressed intention of the parties. Mance L.J. pointed out that the necessity for the
reinsured to obtain a judgment against itself in order to claim against its reinsurer provided stringent protection to the reinsurer, which could not have
been intended by the parties without some qualification, which in his view was that the reinsurers right to withhold approval to a settlement should be
exercised in good faith after consideration of the facts giving rise to the claim and without consideration of matters wholly extraneous to the subject
matter of the reinsurance. The reinsurer must not withhold approval arbitrarily or in circumstances so extreme that no reasonable reinsurer could
possibly withhold approval. It must consider the underlying claim as a whole without regard to its own sectional exposure as a reinsurer, and would
therefore have to disregard its ability to influence the reinsureds approach to another claim, particularly because a reinsurance contract creates a

Robert Merkin

A GUIDE TO REINSURANCE LAW CHAPTER 6 FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

1st Edition, 2007

community of interest between insurer and reinsurer, namely that of determining how best to deal with the original claim. Thus, a reinsurer must not
use its right to refuse approval as an attempt to influence the reinsured in relation to a matter arising under another quite separate reinsurance; as an
attempt to harm the reinsured as a competitor or in the eyes of a local regulator; simply to delay payment for as long as possible despite it being clear
that the claim will have to be paid; or to force the reinsured to litigate in the hope that some defence to the underlying claim might emerge during the
action. The decision was not unanimous and was one which sought to give guidance rather than order the declaration in the terms sought by the
reinsured, who lost the case.
The Court of Appeal in Paragon Finance plc v. Nash [2001] EWCA Civ 1466 considered that a lender will not exercise his discretion in a way that
no reasonable lender acting reasonably would do. However, it added that it is unlikely that a lender who was acting in that way would not also be
acting either dishonestly, for an improper purpose, capriciously or arbitrarily.
The courts are increasingly willing to imply terms limiting a partys contractual discretion, formulated in terms either that any relevant approval or
consent is not to be unreasonably withheld, or, more likely, that any such approval or consent is to be exercised in good faith after consideration of and
on the basis of the facts giving rise to the particular claim and not with reference to considerations wholly extraneous to the subject matter of the
particular contract or arbitrarily.
Thus it still seems to be arguable, subject to the impact which the courts may still give to the limit of indemnity set out in the reinsurance contract
(which would mean overturning the majority decision in ICA v. SCOR), that if the reinsurer breaks its obligation not to act capriciously or
unreasonably or act in accordance with its sectional interests, then arguably it should be liable in damages for the consequences of such breach. If the
insurer has to incur additional costs in proving that the underlying claim should be paid, which are directly attributable to the consequences of the
unreasonable attitude of the reinsurer, then there would appear to be no good reason why reinsurers should not pay.
There is one other method by which a reinsurer could technically be liable for costs incurred by the reinsured in unsuccessfully defending a claim by
the insured. This arises out of section 51 of the Supreme Court Act 1981 which enables a court to award costs against any person, whether or not that
person is party to the litigation or a third party. Such a situation would only arise in the event that the reinsured had become insolvent but had incurred
liability to the insured for the insureds legal costs in establishing the liability of the reinsured to it. Since 1996 there has been a spate of cases on this
point, most notably Murphy v. Youngs Brewery [1996] L.R.L.R. 60, TGA Chapman Limited v. Christopher [1998] 1 All E.R. 873, Pendennis
Shipyard Limited v. Magrathea (Pendennis) Limited [1998] 1 Lloyds Rep. 315, Gloucester Health Authority v. Torpy [1999] Lloyds Rep. IR 203,
Citibank NA v. Excess Insurance Co. Limited [1999] Lloyds Rep. IR 122, Cormack & Cormack v. Excess Insurance Co. Limited [2002] Lloyds Rep.
IR 938, Bristol & West Plc v. Bahdresa [1999] Lloyds Rep. IR 138 and Monkton Court Limited v. Perry Prowse (Insurance Services) Limited [2002]
Lloyds Rep. IR 408. The issue has not yet arisen in a reinsurance context but no doubt will do so upon the insolvency of a reinsured with liabilities to
the insured for the insureds costs.

COMMUTATIONS: IS A REINSURER LEGALLY OBLIGED TO PAY THE COMMUTED SUM TO THE

REINSURED?
The main issue to be considered in connection with this question is whether the claims proposed to be commuted between insurer
and reinsurer constitute loss settlements for the purposes of the reinsurers retrocession.
The provisions of the retrocession are obviously relevant to the question under discussion and these should contain an Ultimate Net
Loss Clause, Notice of Loss Clause and a Reinsurance Clause.

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Notwithstanding the retrocessionaires burden of proving that the settlement was not made honestly and in a businesslike fashion, a
commutation arrangement is inherently likely to be more exposed to objection by a retrocessionaire than is the compromise of a
single quantified claim. This will be particularly the case when outstanding and IBNR claims are a substantial element of any
commutation. It will be important for a reinsured (or retrocedant) to be able, if required, to justify why he has agreed to a particular
commutation figure and how this was calculated. The fact that a retrocedant did not obtain expert actuarial advice will probably be
evidence of an unbusinesslike settlement.
The argument likely to be made by the retrocessionaire is that such claims are not recoverable because they are not losses. It
would be suggested that the IBNR claims have been artificially crystallised as losses and quantified only for the purposes of the
commutation. The retrocessionaire could contend that the outstanding and IBNR reserves may never in fact become claims at all and
even if they do they may not be properly recoverable under the outwards treaties.
Although there has, to date, been no English court decision which gives authoritative guidance about the question whether
quantified IBNR claims are recoverable under an excess of loss treaty, some limited assistance may be gleaned from In Re A
Company No. 0013734 of 1991 [1992] 2 Lloyds Rep. 415. The case arose from an application by an unidentified
insurance/reinsurance company to strike out a winding-up petition which was presented by Cambridge Re (not in liquidation,

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A GUIDE TO REINSURANCE LAW CHAPTER 6 FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

1st Edition, 2007

although ordered to be wound up in Bermuda in May 1985). One of the principal difficulties faced by liquidators of reinsurance
companies is that the winding-up of such companies can take many years because the need to run-off the portfolio of business written
by the insolvent company. In a novel and imaginative response to this problem, the liquidators of Cambridge Re applied to the
Bermudian court to obtain its approval to actuarial valuations of contingent claims and claims of uncertain value. These actuarial
valuations were approved by the court. The reinsurance company submitted, however, that the order of the Bermudian court was not
binding on it as the valuations were not loss settlements under the reinsurance agreement concerned.
This case was heard by a deputy judge, Mr Roger Kaye QC, who made the following interesting observations about the question
under discussion:
It seems to me that there is a serious and complex argument of construction as to whether, in the particular circumstance of the case, the valuation
pursuant to the Bermudian court order could be a loss settlement as suggested. As I have explained above, the reference in Article 15 to loss
settlements seems at first blush to presuppose that an actual loss has arisen and been settled by agreement between the assured and the insurer and not
to relate to an actuarial valuation of contingent claims or claims of uncertain value, still less in the context of an order permitting a valuation which
was principally made and expressly made binding for the purposes of the litigation only and which fixed the liabilities of the Petitioner primarily with
a view to dividend and the timing of proofs. On the other hand, I have considerable sympathy with the liquidators. Their argument has the undoubted
merit of good common sense and is in keeping with the views [expressed in the previous cases]. It may well be that the consequential effect is that it
also serves to fix the underlying liability for the purposes of claims by the Petitioner against reinsurers. It may well be that many reinsurers did not
challenge the order. It may be that the company would not be able to or would not wish to challenge the actuarial methodology In my judgement,
however, the hearing of an interlocutory application to strike out a Winding-Up Petition and the hearing of the Winding-Up Petition itself is not the
appropriate forum for resolving what could be an important and serious matter of fact and law affecting the insurance and reinsurance market as a
whole.

There are certainly indications in the above observations that English courts would be sympathetic to argument that valuations of
IBNR claims approved by a court should be considered to be loss settlements under excess of loss treaties. However, these
observations should be viewed with considerable caution in connection with this particular case because:
(a) The deputy judge expressly declined to express any concluded view about the application of the loss settlement
provision to the actuarial valuation of the IBNR reserves. In Re a Company is, therefore, not authority for the proposition
that IBNR claims, even if they are quantified, are loss settlements under excess of loss treaties.
(b) The English courts have generally been sympathetic to arguments that reinsurers should not be allowed to evade their
legal liabilities because their reinsureds are insolvent.
(c) The fact that actuarial valuations had been approved by the Bermudian court was a further special factor favouring a
broad interpretation of loss settlement in the above decision.

CAN THE INSURED CLAIM AGAINST THE REINSURER IFTHE REINSURED FAILS TO PAY HIS
CLAIM, OR BECOMESINSOLVENT?
The insured has no contractual link with the reinsurer and the contract between the reinsurer and reinsured is of no concern of his,
unless it contains a cut-through clause.
A cut-through clause can often be found either as an indorsement on the insurance policy or more formally contained as a clause in
the body of the contract of reinsurance. Such clauses are usually agreed for the purposes of marketing by the insurer to the insured of
the fact that there should be sufficient security behind the insurer should any insolvency occur, or alternatively where the insured is
anxious about the continuing ability of its insurer to meet claims. A third party, i.e. the insured, will have the right to enforce a
contractual term either:

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(a) if the contract expressly provides for this to happen; or

(b) if the term in question confers a benefit on the third party, unless it is clear, on a true construction of the contract, that this
was not intended.
The insured third party then has the same rights to enforce the contract as if he were one of the original signatories. This means that
such a right is subject to the reinsurance contracts terms and conditions, so, for example, if it provides that rights arising under it will
only be enforceable within a certain time limit, the insured will be bound by this. A third party seeking to enforce its rights can take
advantage of all the remedies available to a person bringing a claim for breach of contract, but the normal rules of law, including
those relating to causation, remoteness and mitigation, apply equally to the third partys claim. It constitutes either a priority payment
arrangement in circumstances where it is intended that the insured can have the benefit of any reinsurance receivables due to the
reinsurer and in priority to other creditors, or a direct payment arrangement in circumstances where the insured is entitled to hold the
reinsurer secondarily responsible to meet its claims. Unfortunately in situations where the insurer becomes insolvent, such
expectations are false. Although a cut-through clause would clearly satisfy both limbs of the test under the Contracts (Rights of Third
Parties) Act 1999, it is a cardinal principle of English insurance law that all creditors of an insolvent company should receive equal
treatment of the limited funds available to the liquidator of that company on a pro rata basis.

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A GUIDE TO REINSURANCE LAW CHAPTER 6 FOLLOW THE SETTLEMENTS ANDFOLLOW THE FORTUNES

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The House of Lords made this clear in British Eagle International Airlines Limited v. Compagnie Nationale Air France [1985] 1
W.L.R. 758, in which a clearing agreement provided for multi-lateral netting off but was held void in respect of the provision for
payment of debts which conflicted with the pari passu insolvency principle. All claims stand alone and cannot be affected by any
agreement to net off. Thus the liquidator was able to recover sums which had not been netted off prior to the presentation of a
winding-up petition against the broker, even though the [insured] had authorised the operation for the movement of funds through the
central accounting system which utilised netting off.
Cut-through clauses are intended to ensure that the insured is paid in priority to other creditors. Unfortunately, however, this
principle is subject also to an overriding objective of public policy to achieve equitable treatment of creditors of insolvent companies,
and it simply was not acceptable that an insolvent debtor (the reinsured) could contract out of this principle to the benefit of one of its
creditors.
Further, the problems outlined above in relation to attempts by the insured to allege that a trust has been set up in its favour will
also apply. English courts look at attempts to allege that trusts exist in favour of one creditor very carefully in situations involving
insolvency. One other option would be for the contract of insurance to provide for an assignment by the insurer to the insured of the
right to be paid any reinsurance monies payable to the reinsured, but such an assignment may give rise to the need to register the
security. If the appropriate registration formalities are not fully complied with, the security would be unenforceable against other
creditors of the insurer in the event of its insolvency.
More recently in Nemgia v. AGF Holdings [1997] 2 B.C.L.C. 191, Nemgia, an insurer, sold parts of its business to AGF who also
reinsured other business (which Nemgia retained). AGF acquired the goodwill of Nemgias policyholders and negotiated and agreed
claims direct with the policyholders, although AGF actually paid the claims on behalf of Nemgia. Nemgia went into liquidation and it
was feared that the liquidator would require AGF to pay to Nemgia all sums due after the commencement of the liquidation, payable
under the reinsurance agreement, which would then have been available to meet the claims of other creditors. Further, Nemgia
policyholders might not renew with AGF and so AGF agreed to pay the Nemgia policyholders direct in return for an assignment from
them of their claim against Nemgia. AGF thereby prevented claims being filed against Nemgia and Nemgia, having suffered no loss,
was unable to claim on the reinsurance policy against AGF.
The court held that this Direct Payment Arrangement did not cause Nemgia any actionable loss and was neutral to its insolvent
state. The decision (although decided on narrow contract issues) therefore reveals how the indemnity nature of the contract between
an insurer and reinsurer may bolster the insureds ability to obtain an effective cut-through by this means. The insolvent estate is
relieved simultaneously of both the benefit of the reinsurance receivable and the burden of the relevant insurance liability. No privity
of contract arises although this and other cut-through mechanisms may give rise to other legal and regulatory issues, particularly as
regards solvency margins and insolvency.
Such direct payment arrangements may be relatively straightforward to engineer in facultative transactions but will be much more
difficult to negotiate in the context of excess or non-proportional treaty reinsurance.

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The Contracts (Rights of Third Parties) Act 1999 is unlikely to be enforced by the courts in favour of those creditors of an
insolvent insurer (despite their foresight in attempting to protect their position) because to do so would be to destroy the pari passu
rule, a primary tenet of insolvency law and itself the product of public policy: fairness to and equality to all. It will be for the courts to
reconcile the interaction of the third party rights made enforceable by the Act and the principle of pari passu distribution in
insolvency. Cut-through clauses would appear to be unobjectionable in situations that do not involve insolvency, but they become of
limited value in these circumstances.

Robert Merkin