Taking Cover When Disasters Far And Near Strike: Policyholders Should Look To Their Insurance Coverage

Sunday, April 3, 2011 - 01:00

Recent disasters in Japan and seasonal floods and fires in the United States again remind businesses that natural events can affect vital business operations. Businesses insure themselves to cover such losses. This article highlights several types of insurance that might cover such events and that are worthy of consideration when faced with a loss arising from a natural disaster.

Predictions About The Scope Of Insured Losses In Japan

News outlets are already reporting on the financial impact associated with the earthquake, tsunami, and flooding in Japan, and how such losses might affect insurance markets. The predictions are staggering. Swiss Re reports that "it expects claims of $1.2 billion on damages associated with the Japanese earthquake," in part because "the Japanese government provides earthquake insurance for individual['s] homes, and doesn't re-insure that risk abroad." http://businessinsider.com/swiss-re-japan-2011-3. Other analysts expect much higher insured losses, ranging from $25 billion to $35 billion. Id . For its part, AIG predicts losses of $700 million, but its president and chief executive concedes that the insurance industry is working "to quantify the complex impact of the devastation, a process that will take some time." http://www. sharecast.com/cgi-bin/sharecast/ story.cgi?story_id=4120375. Indeed, according to AIG, its own "total bill before any housing cost in Japan will be $1 [billion] once the Australian floods, the earthquake in New Zealand, Cyclone Yazi and floods in Brazil are allowed for." Id. Munich Re has "estimated that it will have to pay out [$2.1 billion] for claims resulting from Japan's devastating earthquake and tsunami, and dropped its 2011 earnings target." http://finance. yahoo.com/news/ Munich-Re-sees-21B-Japan-apf-1690390082.html?x=0&.v=2. At present, total losses are still hard to quantify, but two things seem certain: losses will be large and will have global consequences.

What Types Of Coverage May Apply?

1. Property Damage

When faced with a property loss, a traditional and common form of insurance to consider is that covering physical loss or damage to the property in question. A typical property insurance policy obligates the insurer as follows:

We [the insurer] will pay for direct physical loss of or damage to Covered Property at the premises described in the Declarations caused by or resulting from any Covered Cause of Loss.

Such a provision has a fair amount to unpack - such as the meaning of "direct physical loss or damage," "Covered Property," and "Covered Cause of Loss" - but the gist of the coverage is fairly clear. If a policyholder's building floods or its structure is impaired, and the policyholder has to spend money rebuilding, repairing, or replacing its damaged property, this insurance policy may offer some relief. Of course, property insurance policies are not without limits. Exclusions, deductibles, and self-insured retentions might apply - such as for earthquake or flood - but the "property damage" component of a first-party property policy is a very good first place to look when a property loss happens. Further, in the appropriate circumstances, "physical damage" may be equated with loss of use, function, or value, and policyholders and insurers should construe the term broadly and flexibly as common sense and the laws of various jurisdictions require.

2. Business Interruption

The purpose of business interruption insurance is to pay the lost profits and unavoidable continuing expenses caused by an interruption of the policyholder's business, which results from otherwise covered damage to property. Stated differently, business interruption insurance is designed to put the policyholder in the position it would be in but for the property damage. For example, if a policyholder's building is damaged and its operations must be suspended, any resulting decrease in the policyholder's stream of income normally generated from the damaged building (or, more accurately, the policyholder's activities at the building) might be covered under a business interruption insurance policy. Indeed, a typical policy will provide:

We [the insurer] will pay for the actual loss of Business Income you sustain due to the necessary suspension of your 'operations' during the 'period of restoration.' The suspension must be caused by direct physical loss of or damage to property. . . . The loss or damage must be caused by or a result from a Covered Cause of Loss.

According to this clause, and as mentioned above, business interruption insurance is tied to covered property damage - for business interruption coverage to apply, there must be "physical loss or damage" to property otherwise insured under the property damage component of the policy. In addition, a key to business interruption is the "period of restoration," which is the hypothetical time it would take to rebuild, repair, or replace the damaged property with "the exercise of due diligence and dispatch," or some other sufficiently amorphous term or phrase. Still, business interruption coverage is an invaluable source of insurance for policyholders to tap when disasters strike. Such policies should be reviewed closely in light of the lost profits that almost inevitably flow from damage to covered property of a business.

3. Extra Expense

Extra expense coverage is the flip side to business interruption. While business interruption insurance covers a policyholder's lost profits following a loss, extra expense coverage reimburses certain costs incurred by a policyholder to avoid or minimize its business interruption losses. For example, if after a flood a policyholder is unable to use a location, and must instead lease a replacement location or construct a temporary location while building a permanent replacement location, such expenditures may be recovered under extra expense coverage provisions.

Insurance policies are full of legal and insurance jargon, and an insurance policy's extra expense provisions are no exception. Businesses need to get their operations restarted as quickly as possible, but also must be mindful of the cost of doing so. After a devastating loss, which interrupts business and cash flow, getting operations up and running is both a physical and fiscal challenge. While being expeditious will certainly help to comply with an unreasonably and aggressively short "period of restoration," what might be counterintuitive to the business side of a policyholder is that insurance will sometimes actually pay extra to be expeditious. Extra expense is thus a crucial type of insurance to keep in mind when a catastrophe strikes.

4. Contingent Business Interruption

Although this is an important type of first-party property insurance in our globally linked economy, it might also be one of the least-well-known and poorest understood. Contingent business interruption insurance covers business interruption loss arising from damage to a "dependent" or "contingent" property, meaning the property of your suppliers and vendors, and buyers or sellers of your product. One standard form provides:

We [the insurers] will pay for the actual loss of Business Income you sustain due to the necessary "suspension" of your "operations" during the "period of restoration." The "suspension" must be caused by direct physical loss of or damage to "dependent property" at a premises described in the Schedule caused by or resulting from a Covered Cause of Loss.

In turn, the form defines "dependent property" as:

1. "Dependent property" means property operated by others whom you depend on to:

a. Deliver materials or services to you, or to others for your account (Contributing Locations)...;

b. Accept your products or services (Recipient Locations);

c. Manufacture products for delivery to your customers under contract of sale (Manufacturing Locations); or

d. Attract customers to your business (Leader Locations).

This insurance could prove vital for companies with assembly or supply links to companies in Japan. Should product availability be interrupted due to property damage at a supplier's facilities, then downstream businesses depending on those suppliers may have claims under their own policies for contingent business interruption losses resulting from those damaged dependent properties. Policyholders should review their policies carefully regarding contingent business interruption coverage, because not all policies have it, and frequently such coverage is subject to different and (much) lower limits of liability. For instance, note under the form quoted above that only losses resulting from damages sustained at properties "described in the schedule" would be insured. Those not scheduled could have lower limits or not be covered at all. Given the innumerable forms of insurance available in the market for first-party property claims, such distinctions must be examined very closely whenever a loss happens.

5. Contingent Extra Expense

This coverage pays for expenditures to minimize or avoid a contingent business interruption loss. For example, if a supplier cannot timely provide a component part needed for a policyholder's product, and the policyholder must instead buy the same part at a higher cost from a different supplier, that additional cost might be insured under extra expense coverage. This concept of paying for a replacement product to decrease a loss - what under the Uniform Commercial Code is known as "cover" ("by making in good faith and without unreasonable delay any reasonable purchase of or contract to purchase goods in substitution for those due from the seller") - is what contingent extra expense is meant to insure.

Other Issues To Think About

As with any potentially insured losses, questions will arise regarding the cause of the loss, whether the loss is excluded, what limit of liability is available for the loss, and whether there must be an allocation between covered and uncovered portions of a claim. For example, there will certainly be questions about causation and allocation in Japan, where arguments will be made that earthquakes, tsunamis, floods, and nuclear radiation may have played a part in losses.

Likewise, in business income and extra expense losses in particular, there are frequently thorny issues of valuation that might militate in favor of, if not require, the involvement of a forensic accountant to assist in quantifying a loss. Finally, insurance policies generally have many different conditions to coverage, and first-party property policies are no different. There are typical provisions requiring timely notice to the insurer and cooperation with its investigation. There also may be requirements relating to appraisals, proofs of loss, examinations under oath, and suit limitation clauses, to name just a few.

When a loss happens, probably the most important first step for any policyholder is to locate and analyze all insurance policies that might afford it coverage. Without understanding what types of insurance are available, a policyholder risks making a bad situation worse, especially if a policy has conditions that depend on doing and providing things to the insurance company within a certain and constrained time period. Moreover, policyholders should not be naïve, for while there are plenty of claims that are timely paid and for a fair price, if that loss is significant enough individually or in the aggregate, insurer resistance to the claim(s) in some manner nearly always is going to follow. A policyholder is best served by being prepared, thorough, and, even to some degree, cynical about the claims process, because absent such precautions a terrible loss could be unbearable if otherwise applicable insurance goes unused.

Sherilyn Pastor and Ira Gottlieb are Partners, and Nicholas M. Insua is a Senior Associate with McCarter & English, LLP's Insurance Coverage & General Litigation Group.Ms. Pastor is the Practice Group Leader and a member of the firm's Executive Committee. Mr. Gottlieb, Ms. Pastorand Mr. Insua counsel policyholders on a wide range of issues and have recovered billions of dollars, by settlement or judgment, on behalf of policyholder clients.

The views expressed in this article are those of the authors and do not necessarily reflect the views of McCarter & English or its clients.The article is for informational purposes only and is not offered as legal advice as to any particular matter. No reader should act on the basis of this article without seeking appropriate professional advice as to the particular facts and applicable law involved.

Please email the authors at spastor@mccarter.com, igottlieb@mccarter.com and ninsua@mccarter.com with questions about this article.