High Court slams massive fraud on reinsurance company
Judgment in Sphere Drake Insurance & Anr v Euro International Underwriting Ltd [2003] EWHC 1636 (Comm) was handed down by Mr Justice Thomas, sitting in the Commercial Court, on 8th July 2003, after a trial that had lasted from January to December 2003.
The judgment runs to several hundred pages and represents a highly detailed but forceful analysis of the issues and personalities involved. We attempt below to summarise some of the key findings and the possible consequences for the market.
Background
Euro International Underwriting Ltd ("EIU") were granted underwriting authority by Sphere Drake in early 1997. The Sphere Drake underwriter, Vic Broad, expected EIU to underwrite traditional personal accident business. In fact, they wrote a large volume of "workers' compensation carveout" reinsurance, a product developed in the late 1980s and 1990s, which enabled a large part of the exposure arising from US workers' compensation risks, traditionally written in the Property & Casualty market, to be underwritten instead by the Life and Personal Accident markets.
EIU was set up by two individuals, John Whitcombe and Chris Henton. The business giving rise to the dispute was underwritten by Mr Henton. Both Mr Whitcombe and Mr Henton were individual Defendants in the proceedings, as well as the company
Most of the business written by EIU was placed by Stirling Cooke Brown ("SCB"). SCB were a major broker in this area of the market. They were not only a broker but also had interests in underwriting agencies and licensed carriers who were involved in underwriting workers' compensation carveout (or other similar products) at a direct or first tier reinsurance level in the United States. Business from these companies and elsewhere was placed into the London reinsurance market, and with reinsures in Bermuda, the US and Canada, by SCB's reinsurance brokers. The driving force behind the reinsurance broking operation was Nick Brown. Mr Brown and another director of SCB, Jeff Butler, were individual Defendants in the proceedings.
In late 1998 Sphere Drake imposed a moratorium on EIU's underwriting. In 1999 it initiated proceedings against the companies and individuals who later became Defendants in these proceedings, and certain others, in New York. Those proceedings were dismissed on the basis that New York was not the appropriate forum, leading to the action in London.
The issues
Sphere Drake alleged that EIU and SCB had dishonestly colluded to defraud them in a number of ways:
- The underwriting. EIU wrote contracts with huge exposures, often including unlimited reinstatements, with little or no information or, when information was available, that information demonstrated a high likelihood of substantial losses.
- The terminology "gross loss-making business" was adopted in the trial to define business that was almost certain to make losses, but which was underwritten with the intention of recovering those losses from retrocessionaires. The Defendants accepted that many of the risks could only be accepted on that basis. Sometimes there were many tiers of reinsurance and losses were circulating round the market in spirals, with ever-diminishing premium. Sphere Drake said they did not know this was being done in their name, and that it was, in essence, a dishonest practice, because it could only be sustained by capacity somewhere in the chain being ignorant as to the liabilities they were likely to pick up.
- Sphere Drake were misled as to the business being written. As well as the general nature of the business, there were examples of attempts to manipulate the period of contracts to fit within the authority when in truth EIU was not permitted to write the contracts, dishonest devices being adopted to overcome contractual restrictions and assuming massive additional risks when a moratorium to cease underwriting had been imposed.
- There were also a number of ancillary allegations of fraudulent misrepresentations about the personnel involved in EIU and their history in the market.
EIU and SCB did not always agree with one another in their defences, and on occasions alleged that they were lied to by one another, but on the whole their defences coincided: They said that the placing and writing of risks "below the burn" were a normal and legitimate incident of a soft market, that passing losses on to reinsurers was acceptable because reinsurers were "in the know", and that spirals were a naturally occurring and not improper feature of the market. It was alleged that Sphere Drake's own underwriter, Vic Broad, knew the business that was being written and had not been misled.
The decision
Thomas J accepted virtually all of Sphere Drake's case, and was damning in his criticism of EIU, SCB, the individual Defendants and certain other individuals who had been involved in the business, some of whom appeared as witnesses during the trial.
The Judge agreed that the gross loss making business with which the trial was concerned was improperly underwritten, that EIU were dishonest to have written it, that EIU colluded with SCB in a whole series of ways and has become subservient to SCB's interests. The structure of the business was intended to advance SCB's interest and to generate commissions. Such business could only be written by those in the know because others were likely to be misled.
EIU recklessly endangered Sphere Drake's capital because they did not always have outwards reinsurance in place, and when they did losses could spiral back to Sphere Drake, and there were substantial solvency, cashflow and legal risks in seeking to rely on reinsurance recoveries.
Sphere Drake had been serially misled as to the nature of the business being underwritten and a number of other matters. However, Sphere Drake's underwriter, Vic Broad, had been grossly negligent for failing to supervise the binder properly.
Thomas J found that Nick Brown was the architect of the scheme and guilty of "singular dishonesty". Jeff Butler dishonestly assisted him. Chris Henton was dishonest in his underwriting. John Whitcombe, although the least culpable of the four, had been party to misleading Sphere Drake and had acted dishonestly in a number of regards. As well as having been dishonest at the time, all of the individual Defendants were untruthful in giving evidence.
As well as misleading Sphere Drake, the DTI had been misled in an attempt by Whitcombe, Henton and others to establish an insurance company, and SCB had been dishonest in their prospectus for an IPO on NASDAQ.
Consequences
1. For Sphere Drake
Sphere Drake have not obtained any pecuniary remedy from the trial, other than an entitlement to costs. It does not necessarily follow that Sphere Drake will be entitled to rescind the contracts that were underwritten by EIU. That will need to be determined in separate arbitration proceedings with those cedants. The judgment will, however, form the basis of Sphere Drake's arguments against those cedants.
2. For the workers' compensation carveout market
As part of his judgment, Thomas J makes findings as to the spirals that existed in earlier years, 1993 to 1996, which he concludes were deliberately created by SCB. This is likely to have a major impact on the many disputes that already exist in relation to those years.
Others with involvements for 1997 and 1998 will also be directly affected.
3. For the reinsurance and retrocession markets generally
Although scathing in his criticism of the type of business before him, Thomas J is careful to draw the parameters of what he considers to be improper. His judgment will not prevent prudent and even extensive purchase of retrocession in other sectors of the market. Nor does it mean that writing a risk knowing that it may well make a loss is improper. The features of the sector of the market with which the Judge was concerned, that made it so unusual, included the virtual certainty of heavy frequency losses, very low excess points, unlimited reinstatements, substantial underpricing, lack of information and tight, deliberate created spirals. Those are features that could arise in other sectors of the market in soft market conditions, but they will be unusual.
4. For underwriting agents and principals
The case highlights the massive damage that can be done in a very short period of time if an agent fails to act in his principal's best interests. This case is an extreme, but underwriting agencies, MGUs and binding authorities have historically given rise to many problems. Agents need to recognise the importance of acting in their principals' best interest at all times, and principals need to carefully supervise agencies to whom they entrust their pens.
5. For regulators
No direct criticisms of regulators are made in the judgment, save in relation to a failure by Lloyd's to make documents available for the trial, but questions may need to be asked about how a high-profile Lloyd's broker was able to base its business for many years on a structure that has been found to have been improper.
Conclusions
This is one of the most important reinsurance cases decided in the UK Courts. It is uncompromising in its findings of dishonesty against underwrites and brokers, including one of the highest profile brokers of the 1990s. The industry needs to be alert to avoid similar corrupting of market forces in the future.
For further information, please contact Andrew Symons at andrew.symons@cms-cmck.com or on +44 (0)20 7367 3044 or Neil Beighton at neil.beighton@cms-cmck.com or on +44 (0)20 7367 3017.
