Fair dues

A recent ruling means that companies insured by insolvent insurance companies can now claim defence costs from the FSCS.

Following the ruling passed by the Administrative Court on 4 March in favour of Geologistics Limited v Financial Services Compensation Scheme (FSCS), corporate insureds of insolvent insurance companies are now able to recover their own defence costs from the FSCS.

Geologistics, holder of a compulsory policy with Independent Insurance, relied on the philosophy behind the Policyholders Protection Act 1975 (the act) to challenge the refusal of the FSCS to compensate it in respect of legal costs and expenses incurred in defending an employer's liability claim, which was heard in 1998.

Geologistics, represented by Davies Arnold Cooper (DAC), issued proceedings seeking a declaration of the proper interpretation of Section 6(5) of the act, believing itself to be entitled to compensation from the FSCS to cover the “full amount” of legal costs and expenses incurred prior to its insurer's liquidation.

The purpose of the act is to protect policyholders who would otherwise be prejudiced by the inability, through the insolvency or other financial difficulties of their insurance company, to meet their liabilities to indemnify the policyholder in respect of their insured liability.

It was the Geologistics case that, according to Section 6(4) of the act, the FSCS was obliged to pay Geologistics the full amount of Independent's liability under the terms of the compulsory policy held by the corporate. Since the terms of the policy encompassed indemnification against defence costs and third-party claimants' costs (as they invariably would do in any employer's liability insurance), as well as the damages payable to third-party claimants, the defence costs would fall within the ambit of the FSCS's obligation under Section 6(4).

The FSCS conceded that it was obliged to pay third-party claimants' costs. However, it argued that defence costs were excluded pursuant to Section 6(5) of the act: “Subsection (4) does not apply by reference to any liability of a company in liquidation under the terms of a policy to which this section applies arising otherwise that in respect of a liability of the policyholder which is a liability subject to compulsory insurance…”

Whether or not a policyholder's liability in respect of its own defence costs should be compensated by the FSCS is dependent upon whether the policyholder's liability for such costs constitutes a liability arising “in respect of” a liability of a policyholder that is subject to compulsory insurance. The essence of this case lies in the expression 'in respect of', as used in Section 6(5).

Geologistics contended that when Section 6(5) uses the words 'in respect of' the relevant liability, this can be translated as 'in connection with' or 'in relation to' the relevant liability, because this is the actual and ordinary meaning of the words.

The FSCS sought to draw a line in respect of the policyholders' liabilities that its is compelled to insure. It argued that this line should stop at third-party claimants' costs. The FSCS claimed that the defence costs of a policyholder in unsuccessfully resisting a compulsorily-insurable liability are “indirect” as opposed to “connected with”.

Mr Justice Davies considered this line to be artificial and unconvincing. The unsuccessful insured's liability for its solicitor's costs are connected “to the liability the insured is compelled to insure”.

In this particular case, the reality is that the insured has defended a case to the benefit of the insurance company itself, which will therefore benefit the FSCS too. It would be hard to believe that the intention of the act is to leave the insured to bear these costs. This interpretation of the act would lead to an undesirable result: Geologistics and other corporate policyholders would not receive the full benefit and protection of an insurance policy that they were required by law to take out.

Following Judge Davis's judgment, permission to appeal was granted following the FSCS request. A Notice of Appeal has recently been filed, with the appeal likely to be heard before the end of the current year.

Despite the clearness of Judge Davis's decision, the FSCS seems to be very confident that the Court of Appeal will uphold its appeal. Suzanne McCarthy, chief executive of the FSCS, recently commented: “It's important for this issue to be clarified as soon as possible. Part of our role is to ensure that the scheme doesn't make payments that may be unlawful.” (Insurance Day, 2 April 2003.)

Does this mean that if the appeal is unsuccessful, the FSCS has so far acted unlawfully in respect of the legal defence cost for corporate policyholders of compulsory insurance?

No doubt, this judgment will have a great impact on Independent's insureds and other recent insurance liquidations, which will be able to recover their fees from the FSCS. In the context of current concerns over the solvency margins of many insurers, the outcome of this test case is of great importance and will set the precedent by which future cases will be judged.

Gerald O'Mahoney is a partner and Ana Molinero a solicitor in the insurance department at Davies Arnold Cooper