Terrorism's impact upon privity of contract in Bermuda

The link between terrorism and the erosion of privity of contract in Bermuda is not immediately discernible. However, following the massive insurance and reinsurance payments for loss sustained during the 9/11 attack in New York the commercial and business environment in Bermuda has proved to be the catalyst for the erosion of privity of contract on island.

The rule of privity of contract is exemplified historically in the case of Tweddle v Atkinson [1861] 1 B&S 393 and in the well-known subsequent case of Midland Silicones Ltd v Scruttons Ltd [1961] 1 QB 106. The rule in common law has meant that a stranger to a contract cannot have the benefit of that contract even though it is made for his own benefit. This common law rule was ameliorated in England & Wales by the Contracts (Rights of Third Parties) Act 1999 and the rights of third parties have now been protected on island by the coming into force of the Contracts (Rights of Third Parties) Act 2016 (Bda) (the Act) on 28 March 2016.

The rule of privity of contract allows only a party to the contract to enforce the terms of that contract. Although this is an understandable rule in theory the privity of contract rule has caused many problems in practice. Despite their intentions contracting parties have been unable to confer enforceable rights to third parties which has been particularly problematic in Bermuda with regard to the reinsurance sector which constitutes the second largest re-insurance market in the world after New York.

Insureds are third parties to a reinsurance contract between a reinsurer and acceding insurer. One of the inherent problems in Bermuda has been that the privity of contract rule has meant that parties to a reinsurance contract were unable to protect policyholders in a situation where the insurer becomes insolvent. 

Following 9/11 there was a hardening of the market and traditional reinsurance cover became more difficult to obtain as many reinsurers introduced terrorism exclusion clauses. One of the responses to the hardening of the market was a proliferation of captive insurers being established in Bermuda.

Further, fronting arrangements increased whereby US and UK insurers sought to cede all or a significant part of the risk that they were carrying. Fronting describes a series of alternative risk transfer methods that share the following common elements:

  • The presence of a company (fronting company) that issues an insurance or reinsurance policy which is then completely or substantially ceded to a carrier (assuming carrier)
  • The assuming carrier is normally unlicensed or uncredited in the jurisdiction where the fronting company is licensed or accredited
  • The assuming carrier normally controls the underwriting and claims decision of the respective policy or policies

Fronting arrangements in Bermuda were particularly prevalent in respect of captive insurers where a company or group of companies considered that the creation of a “captive” insurance company which they own and control provided a method of obtaining insurance coverage for their operations in a more efficient and productive manner allowing them to participate in sharing underwriting profits and obtain access to the reinsurance markets which would be unavailable to the parent directly.

A captive can be defined as a special purpose insurance company which is created for insuring the risks of its parent company or associated corporation. In this type of alternative risk transfer method fronting is obviously a necessary service for the success of the captive insurer. The reason for this is that captives are normally offshore companies predominantly located in Bermuda which would not comply with statutory requirements for insurers onshore. A majority of captives lack the required licenses to transact the business of insurance. The captive operation therefore normally requires the existence of a fronting arrangement to enable the risk transfer mechanism to take place. The use of captives and fronting arrangements normally increases in times of hard market conditions and the hardening of the market creates a series of challenges for companies such as increased costs of risk management programmes, decreased coverage, changes in terms and conditions of coverage, reduced limits or capacity offered at renewal, and increased deductibles and retentions mandated by carriers.

The principal problem with a fronting arrangement and in respect of captive insurance is that the insured has no direct contractual relationship with the reinsurer which in respect of the majority of captives may hold 100 per cent of the risk assumed by the captive insurer. With no privity of contract an insured is in an invidious position if the insurer becomes insolvent. Even if the reinsurer holds 100 per cent of the risk there is no ability to enforce directly against the reinsurer. In order to avoid these problems the so-called “cut through clause” or “cut-through endorsement” was introduced in an attempt to allow an insured to have a direct right to the reinsurance proceeds in the event of the insurer’s insolvency. However, there has been great doubt as to whether such clauses are themselves enforceable or whether they fail due to the doctrine of privity of contract. The coming into force of the Act in Bermuda on 28 March 2016 removes the doubt as to the ability of insureds in the future in Bermuda to have a direct cause of action against the reinsurer if the reinsurance contract expressly so provides. Section 4 of the Act provides that a third party may in its own right enforce a term of a contract if the third party is expressly identified in the contract:

  • By name
  • As a member of a class; or
  • As answering a particular description

Importantly, the third party need not be in existence when the contract itself is entered into. Additionally, the contract must expressly provide in writing that a third party may enforce the terms of the contract. The Act itself obviously has potential impact outside of the insurance and reinsurance sectors. However, the size of the reinsurance market in Bermuda and the fact that historically circumvention of the privity of contract rules in the establishment of alternate risk transfer vehicles has been affected by the relatively cumbersome process of private act of Parliament means that the current Act is largely insurance and reinsurance driven. Section 4 of the Act which confers third party rights is more restrictively worded than the Contract’s Rights of Third Parties Act 1999 in England and Wales. In that Act section 1 provides that a person who is not a party to a contract (a “third party”) may in his own right enforce a term of the contract if (a) the contract expressly provides that he may, or (b) subject to subsection 2, the term purports to confer a benefit on him.

It is this phrase purporting to confer a benefit on him that has led to much litigation in England and Wales as to the applicability of the Act. The more restrictive wording of the 2016 Act in Bermuda means that we consider the impact of the Act to be less generally applicable as a third party must be expressly identified in the contract by name as a member of a class or answering a particular description and the contract must expressly provide in writing that the third party may enforce such term of the contract. Here we envisage that the relevant reinsurance contract will include an enforceable cut through clause that grants third party rights to future insureds as a member of a class or answering a particular description even if they are not in existence at the time of the execution of the contract. Section 9 of the Act sets out specific exceptions to the acquisition of third party rights and the Act does not apply to: 

  • A contract on a Bill of Exchange, promissory note or other negotiable instrument
  • Any contract binding on a company and its members under section 16 of the Companies Act 1981
  • A contract of employment against an employee
  • A contract for the carriage of goods by sea, road or air and associated letters of credit including respective Bills of Lading

However, just as there could have been no expectation that terrorism would explode the rule of privity of contract in Bermuda, it remains to be seen whether the Act will have a significant wider application beyond the insurance and reinsurance sectors which were the drivers behind its introduction - time as always will tell."