Pay to be Paid rule – An Anachronism?

This article will consider the effect of the “Pay to be Paid” rule found in the Rules of the P&I Clubs and whether the protection granted to the Clubs in case of insolvency of the Member survives after the implementation of the Insurance Act 2015.

1. The cover provided by P&I Clubs (Mutual), although described, as liability insurance, is in fact indemnity insurance. This is because the Clubs have a “Pay to be Paid” Rule and which makes it incumbent on their members to first make payment to the claimants to discharge their liabilities and subsequently seek reimbursement subject to the terms of the entry (See Rule 5 A of the UK P&I 2016 Rules which provide “Unless the Directors in their discretion otherwise decide, it is a condition precedent of an Owner’s right to recover from the funds of the Association in respect of any liabilities, costs or expenses that he shall first have discharged or paid the same out of funds belonging to him unconditionally and not by way of loan or otherwise”). While the wordings of this Rule may vary between the various P&I Clubs, the gist of this Rule is that the Member must have a liability to pay a claim and which they must first settle with their claimants so as to entitle them to seek a reimbursement under the cover provided by the Club. There are however exceptions to the general rule that the member’s liability must have been first discharged, one of them being the Omnibus Rule (see Rule 38 of the UK P&I Rules 2016 which states “The Directors shall meet as often as they may consider necessary for the settlement of claims which shall be paid by the Association as the Directors may determine in accordance with these Rules and the Directors shall have power from time to time to authorise the Managers, without prior reference to the Directors, to effect payment of claims of such types and up to such sums as the Directors may determine. No Director shall act as such in the settlement of any claim in which he is interested”).
2. The P&I Club’s Rules invariably incorporate English Law and Practice (see Rule 42 of the UK P& Rules 2016 which states “Law of Contract :Any contract of insurance howsoever made between the Association and an Owner and these Rules shall be governed by and construed in accordance with English law”). Accordingly, the English Marine Insurance Act 1906, The UK Third Parties (Right against Insurers) Act 2010 (which repealed the 1930 Act) and the Insurance Act 2015 (which amended certain provisions of the Marine Insurance Act 1906) apply to the contract.

   We consider the relevant sections of each of these acts below:

   1. S 85 of the English Marine Insurance Act 1906 deals with Mutual Insurance and states:

      ”Modification of Act in case of mutual insurance:
      (1) Where two or more persons mutually agree to insure each other against marine losses there is said to be a mutual insurance.
      (2) The provisions of this Act relating to the premium do not apply to mutual insurance, but a guarantee, or such other arrangement as may be agreed upon, may be substituted for the premium.
      (3) The provisions of this Act, in so far as they may be modified by the agreement of the parties, may in the case of mutual insurance be modified by the terms of the policies issued by the association, or by the rules and regulations of the association.
      (4) Subject to the exceptions mentioned in this section, the provisions of this Act apply to a mutual insurance.”

   2. The UK Third Parties (Right against Insurers) Act 2010 came into force on 01st Aug 2016. This Act modernizes and simplifies the earlier Third Parties (Rights against Insurers) Act 1930 (which has been repealed). The 2010 act allows third parties to bring proceedings directly against insurers when the insured is liable to the third party but has become insolvent. The third party need no longer “establish” the insured’s liability to it first (as was required under the 1930 act). The result is that the third party is able to litigate the substantive claim against the insured in tandem with an action against the insurers so that they (Insurers) pay any damages awarded.

      S 9(5) of the 2010 act states “The transferred rights are not subject to a condition requiring the prior discharge by the insured of the insured’s liability to the third party” i.e. it bars any condition precedent to liability such as the “pay to be paid” rule.

      S 9(6) of the 2010 Act then goes on to state “In the case of a contract of marine insurance, subsection (5) applies only to the extent that the liability of the insured is a liability in respect of death or personal injury” i.e. the preceding sub-section would only apply if there was a liabllity for death or personal injury (gives effect to the dicta of The Fanti and The Padre Island and which is discussed in 3a below).

   3. The Insurance act 2015: The UK Insurance Act 2015 came into force on 12th August 2016 to reform the prevailing UK legislation on Marine Insurance. It applies by default to all commercial insurance policies. The Act amends key sections of the Marine Insurance Act 1906. In particular, S 11 of the Insurance Act 2015 deals with the effect of warranties and condition precedent to liability. The wordings of S 11 are given below:

      Terms not relevant to the actual loss:  
      (1) This section applies to a term (express or implied) of a contract of insurance, other than a term defining the risk as a whole, if compliance with it would tend to reduce the risk of one or more of the following—
      (a)loss of a particular kind,
      (b)loss at a particular location,
      (c)loss at a particular time.
      (2) If a loss occurs, and the term has not been complied with, the insurer may not rely on the non-compliance to exclude, limit or discharge its liability under the contract for the loss if the insured satisfies subsection (3).
      (3) The insured satisfies this subsection if it shows that the non-compliance with the term could not have increased the risk of the loss which actually occurred in the circumstances in which it occurred.
      (4)This section may apply in addition to section 10.

      The effect of the S 11(3) of Insurance Act 2015 is that if the Condition Precedent to Liability clause has no bearing to the actual risks, then the Insurer would be unable to rely on them say to exclude liability.

3. Validity of “Pay to be Paid” Rule:
   1. The validity of this clause was tested in the English Courts (The Fanti and The Padre Island) when the 1930 Act was in place. The HOL ruled that the words “Pay to be Paid” meant what they said and a member ship-owner had no right to be indemnified unless and until it had made payment to the third party. This outcome resulted in the third party unable to pursue directly against the P&I Clubs (which we submit was the intent of the 1930 Act) when the member was insolvent. In effect, insolvency of a member protected the P&I Clubs from any claims from third parties. It however appears that in this case, a concession appears to have been made that the P&I Clubs would not enforce the “Pay to be Paid” provision in claims for personal injury or death. The 2010 Act has, by S 9(5) and 9(6), legislated that the bite of the “Pay to be Paid” rules remain except for personal injury and death claims.
   2. With respect to the Hull and Machinery Policies, the most common wordings used are the Institute Time Clauses 1/10/83. Clause 8.1 of the Running Down Clause (Collision Liabilities) states as below:

      8.1 The Underwriters agree to Indemnify the Assured for three -fourths of any sum or sums paid by the Assured to any other person or persons by reason of the Assured becoming legally liable by way of damages for … (words underlined by us for emphasis)

      Invariably, Owners cover ³/₄ of the RDC with the Hull Insurers and the balance ¹/₄ with their P&I Insurers. It is also not uncommon for Owners to seek ⁴/₄ cover either with their Hull Insurers or their P&I Insurers. Most of the Hull Insurers are commercial Insurers – however, some of the cover is provided on a mutual basis (e.g. Norwegian Hull Club). Given the wordings of the RDC Clause, it is submitted should a third party pursue for recovery directly against the Insurers, say due to the Insolvency of the Owners, they would be caught with the requirement “paid by the Assured” (see the Canadian Federal Court of Appeal Judgement in Conohan v. The Co-Operators, 2002 F.C.A. which considered the wordings similar to a “Pay to be Paid” Rule).

      The English Courts however have not allowed development of this argument for Commercial Insurers. The English Commercial Court in Ventouris v Mountain (The Italia Express) (No 2) [1992] 2 Lloyd’s Rep 281 (this was a case on War Risks Insurance) stated that “the purpose of the “Pay to be Paid” rule was to meet the special needs of a mutual insurance scheme in a member’s association or club; such a rule was in appropriate in the non-club environment of a commercial insurance contract. 

   3. The “Pay as may be Paid” Rule in Reinsurance Contract: Both the 1930 and the 2010 Third Parties (Rights against Insurers) Act do not apply for Reinsurance contracts. This being the case, there is no statutory “protection” for insolvency available to a party pursuing the reinsurers under these Acts. The English Courts have considered the meaning of “Pay as may be Paid” and maintained “it would be both unjust and discordant with commercial good sense, if by reason of the accident of a reassured becoming insolvent, the reinsurers (who had accepted premiums) should go free from liability under the reinsurance policies in respect of claim for which they would unquestionably have been liable had the reassured remained solvent.”

      In Charter Reinsurance Company Ltd v Patrick Feltrim Fagan (1996), the English House of Lords held that the (reinsurance) contract had to be construed as a whole. Under the contract, the sum became payable when the insurance claim itself became payable and not only when it was actually paid out. It therefore appears that the English Courts have been generous in giving a wide interpretation of the wordings to facilitate recovery against a reinsurer when the reassured was insolvent.

4. Further comments:
   1. One of the arguments for the “Pay to be Paid” Rule is that this rule is used by P&I Associations and which are strictly not Insurance Companies but are run by the pooling of risks by the Owners. While protection may have been relevant in the last century, P&I Clubs now have sizeable reserves and provide cover, some of which are compulsory in nature.  Additionally, some P&I Insurers provide Fixed Premium Entry (similar to Commercial Insurers). If protection is deemed necessary, then it is submitted, that it should be given to both P&I and Commercial Insurers (who may also provide similar P&I cover).
   2. Some jurisdictions have dealt with the application of “Pay to be Paid” by denying its application and thereby allowing third-parties to directly pursue the P&I Insurers for recovery. Should the English Courts continue to maintain the same position of the “Pay to be Paid” rule, third parties would prefer to initiate actions in jurisdictions which do not give effect to this rule.
   3. The wordings of “Pay to be Paid” and “Pay as may be Paid” rules are similar. However, English courts have given different interpretations. The “Pay as may be Paid” rules are mainly with respect with the reinsured pursuing the reinsurer (and not a third party as in the case of “Pay to be Paid” rule). Dicta in Re Eddystone Insurance Co Ltd., ex parte Western Insurance Company Ltd (1892) which was expressly approved by the Court of Appeal in Re Law Guarantee Trust and Accident Society (1914) and also came up in Home and Overseas Insurance Co Ltd v Mentor Insurance Co (UK) Ltd (1988) tends to suggest that the effect of the clause would be similar even if the liquidators were to pursue the counterparty.

   4. Section 11 of the Insurance Act 2015 provides that “condition precedent to liability” is of no effect if the breach did not result in an increase in the risk. The “Pay to be Paid” Rule only comes into effect once the liability of the member has been established. This being the case, the payment or non-payment of the Owners would generally have no bearing to the risk. It is therefore submitted that the wordings of the Insurance Act 2015 would catch the “Pay to be Paid” Rule rendering it null and void. 
5. Conclusion:
   1. It remains to be seen if the English Courts continue to provide protection to P&I Clubs from pursuit by third parties and thus giving effect to the “Pay to be Paid” rules, particularly with the provisions of the Insurance Act 2015 which tends to override “Conditions Precedent” which have no bearing to the risks.
   2. With respect to commercial insurance, the English Courts had earlier denied the application of similar “Pay to be Paid”wordings. Given the blurring of the differences between the P&I and Commercial Insurers, should the English Courts wish to continue with the protection afforded earlier, it would be appropriate for them to consider their application with commerical insurers so as to ensure parity.