Basics of business interruption insurance: The ins and outs of tricky coverage

HEADNOTE

It's important to know and interpret policy language, exclusions and coverages in order to state a valid claim under this insurance

Business interruption insurance is "`designed to do for the business what

the business would have done for itself had no loss occurred."1 Thus, this coverage provides a vehicle to recoup earnings lost as a result of an occurrence of a covered risk that interrupts the insured's business operations.2 The coverage may be purchased as an endorsement to a property insurance policy or as a separate insurance policy. The coverage form typically provides insurance against loss of earnings and also may cover other costs, including payroll, rent, insurance premiums, utility bills and taxes. Business interruption insurance typically requires proof of covered physical loss to specified property, causing actual interruption of business with resulting monetary loss.

SCOPE OF COVERAGE

A. Insuring Provision

A typical business interruption insuring provision reads:

This policy insures against loss resulting directly from necessary interruption of business caused by damage to or destruction of real or personal property, by the perils) insured against, during the term of this policy, on premises occupied by the Insured and situated as herein described.3

B. Covered Causes of Loss

Because coverage for consequential economic losses is generally added to a commercial property policy by way of endorsement, coverage is usually "closely tied to the underlying property damage coverage. That is, the endorsement usually covers business interruptions that result from physical loss or damage to covered property from a covered peril."4 Thus, the language of the business interruption endorsement must be read in light of the underlying property damage coverage and the enumerated causes of loss to determine whether a particular interruption will trigger coverage.

The mere fact that there has been a business interruption is not sufficient to trigger coverage under a business interruption endorsement. The interruption must have been caused by a covered cause of loss. On this point, Red Bird Egg Farms Inc. v. Pennsylvania Manufacturers Indemnity Co.,5 a Fourth Circuit case, is instructive. In that case, a lightning strike somewhere outside Red Bird's property caused an interruption in the power supply to its facility. Later that same day, the utility company restored single-phase power to Red Bird's facility, instead of the usual threephase power. The introduction of singlephase power burned out the motors in approximately a hundred ventilation fans, causing permanent damage to the fan motors. Without proper ventilation, more than 500,000 chickens perished.

Red Bird submitted a claim to its insurer for the loss of the birds, debris removal and business interruption. The insurer denied the claim for business interruption, relying on an exclusionary provision that stated that there was no coverage for:

Any loss caused directly or indirectly by the failure of power or other utility service supplied to the described premises, however caused, if the failure occurs outside of a covered building. But if the failure of power or other utility service results in a covered cause of loss, we will pay for the loss resulting from that covered cause of loss.

Red Bird argued that the exclusion contained in the property coverage was not applicable to its loss, because the introduction of single-phase power was not an "interruption" in utility service and could best be characterized as the introduction of too much power for the fan motors. The court rejected this argument because the policy excluded interruption losses caused by a "failure of power or other utility service" and did not speak in terms of "interruptions" in utility service.

Red Bird further argued that the failure of electrical service resulted in a fire (a covered cause of loss) that, in turn, damaged the fan motors and triggered the business interruption coverage. But the singlephase current merely caused overheating without the presence of flames that melted the insulation of the wires in the motors. Thus, the fan motor damage was not caused by a covered cause of loss.

The Fourth Circuit held that the business interruption losses suffered by Red Bird occurred as a result of "failure of power or other utility service," and sustained the insurer's denial of coverage.

Similarly, in Meritcare Inc. v. St. Paul Mercury Insurance Co.,6 a Third Circuit case applying Pennsylvania law, the operator of a nursing home closed its facility for more than two months because the roof was structurally unsound. The operator's insurance policy provided property damage and business interruption coverage that read, in relevant part:

We'll insure covered property against the risk of direct physical loss or damage involving collapse of a building or any part of a building...7

Although it was undisputed that the roof of the structure did not cave in, the plaintiff argued that the collapse provision was triggered when the structural integrity of the nursing home was seriously impaired. The insurer further noted that the term "collapse" was not defined in the policy and was capable of several meanings.

The Third Circuit, however, stated that the terms of the insurance contract were to be given their plain, ordinary meaning,8 and that Pennsylvania case law previously held that collapse meant "to fall together or fall in."9 Since a collapse did not occur, the plaintiff was not entitled to recovery of its losses under the business interruption insurance.

An insurer also prevailed in its denial of a business interruption claim in Protection Mutual Insurance Co. v. Mitsubishi Silicon America Corp.10 In that case, the insured operated a manufacturing plant in Salem, Oregon. Owing to a flood, the city closed its waste water treatment facility, and the insured was forced to shut down most of its operations for two days because it could not discharge waste water into the sewer system. It sought reimbursement of its business interruption losses caused by the loss of utility service.

In interpreting the insurance contract, the Oregon Court of Appeals noted that its over-all design, which is typical of most business insurance policies, consisted of a general statement of coverage that was both limited and expanded by other provisions. Thus, the court said its interpretative task turned "less on the meaning of the individual parts or the specific words and more on the meaning of the parts combined." The parties agreed that the policy provided coverage for business interruption losses, losses due to interruption of utility services and flood-related losses. The dispute centered on whether those endorsements, in combination, covered business interruption losses caused by a loss of utility service caused by flood damage at the utility site.

The base coverage of the policy insured "against all risks of physical loss or damage" to the insured's property, except as specifically excluded. The base coverage incorporated "Property Damage Form 3000," which specifically excluded losses caused by "lack of incoming electricity, fuel, water, gas, steam or refrigerant caused by an occurrence off the locations described in this policy unless specifically endorsed herein." A series of endorsements were added to the base coverage, including a "Service Interruption Endorsement (Time Element)," which extended protection for "the actual loss sustained caused directly by the interruption of the specified incoming services during a period of service interruption." This endorsement contained specific exclusionary language specifying that the provision did not insure against "loss or damage caused by the interruption of incoming services caused by ... flood, unless otherwise specifically provided elsewhere in this policy with a service interruption time element limit of liability for flood."

Therefore, the policy provisions demonstrated that coverage was not extended for business interruption caused when utility service was halted due to flooding at the utility site. A further endorsement (a service interruption time element limit of liability for flood) was required to insure against this loss.

In arguing that the policy included such an endorsement, the insured pointed to the "flood endorsement" covering "physical loss or damage caused by or resulting from flood waters." (Emphasis added.) Specifically, the insured contended that the "limits of liability" clause in the flood endorsement, which stated, "If this policy includes time element coverage, the foregoing limits shall be the maximum amount collectible under this endorsement," restored the coverage in the flood exclusion of the service interruption endorsement (time element).

The court disagreed. It reasoned that the flood endorsement provided coverage only for property damage and loss caused by flood, not business interruption. Moreover, it held, the "limits of liability" clause in the flood endorsement was not a coverage provision and did not expand the scope of flood coverage. Rather, the cross-reference to business interruption contained in the "limits of liability" clause ensured that "any covered business interruption due to flooding [was] indemnified to the extent of the liability limit applicable to [the business interruption endorsement], if any, rather than to the extent of the flood endorsement liability limits."

Since the policy did not contain an endorsement insuring against business interruptions caused by loss of utility service caused by flood damage at the utility site, there was no coverage for the business interruption claim.11

C. Multiple Causes of Loss

It is not uncommon for a loss to have multiple causes, some of which are covered and some of which are not. This was the situation in Fajardo Shopping Center S.E. v. Sun Alliance Insurance Co.,12 in which the insured sought recovery for business interruption resulting from hurricane damage to its shopping center. Such losses were a covered peril under the policy, but it excluded from coverage losses caused by "faulty design, specifications, workmanship, construction, or materials if a peril excluded by this policy contributed to the loss at any time." The insurer denied the claim because its inspector concluded that the partial collapse of the roof was caused by faulty design and construction.

The First Circuit noted that where covered and excluded perils concurrently cause an interruption in business, the insured is entitled to recovery if the covered peril is the efficient cause of the damage, because " `the efficient cause-the one that sets others in motion-is the cause to which the loss is to be attributed."13 Since all the experts in the case agreed that there was a danger of collapse of the roof after the hurricane that did not exist prior to the storm, the court held that the hurricane was the efficient cause of the roof collapse.

D. Covered Premises

As is apparent from the insuring provision, business interruption coverage typically covers only loss at the covered premises. In Monumental Paving & Excavating Inc. v. Pennsylvania Manufacturers' Association Insurance Co.,14 fire destroyed one of the insured's buildings. The business income coverage form issued by PMA provided that it would "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 at the premises described in the declarations." (Emphasis added.) The insured argued that the only premise described in the declarations was premise 001, including all of its buildings at the location.

The declarations listed "Prem No. 001 Bldg No. 001 BUSINESS INCOME INCLUDING EXTRA $50,000 EXPENSE OPTION III RENTAL VALUE CONSTRUCTION: JOINTED MASONRY." The designation of premises schedule, however, listed premises 001, consisting of buildings 001-004, and premises 002. Thus, the Fourth Circuit concluded, the policy insured two premises, and only building 001 at premises 001, constructed of jointed masonry, was insured under the business interruption coverage. Since the building destroyed by fire was building 002, a frame building at premises 001, the court held that the insured was not entitled to business interruption coverage.

In Lakes' Byron Store Inc. v. AutoOwners Insurance Co.,15 the insured, a hunting lodge operator, lost electrical power for eight days because of a snow and ice storm, and it submitted a claim for business interruption losses. A policy exclusion stated that the insurer would not be liable for loss caused directly or indirectly by power failure "if the failure occurs away from the described premises." The plaintiff argued that the exclusion did not apply because the storm knocked down power lines on unadjoining lands leased for hunting purposes, and thus the failure of electrical service occurred on the insured's premises.

The South Dakota Supreme Court found that the unambiguous phrase "away from the described premises" must be given its plain, ordinary meaning, namely "not on the premises that are described in the contract of the insured." The insured premises were limited to Lot 1 in the insurance contract, which included the hunting lodge and 8.5 acres of land, and did not include the lands used for hunting purposes. Since none of the power lines located on Lot 1 were damaged, the power failure occurred away from the insured premises, and the exclusion precluded coverage.

COVERAGE LIMITS

A. Limits of Liability Provision

A typical insurance policy limit of liability provision might read:

In the event of such damage or destruction this company shall be liable for the ACTUAL LOSS SUSTAINED by the insured resulting directly from such interruption of business, but not exceeding the reduction in gross earnings less charges and expenses which do not necessarily continue during the interruption of business, for only such length of time as would be required with the exercise of due diligence and dispatch to rebuild, repair or replace such part of the property herein described as has been damaged or destroyed, commencing with the date of such damage or destruction and not limited by the date of expiration of this policy. Due consideration shall be given to the continuation of normal charges and expenses, including payroll expense, to the extent necessary to resume operations of the Insured with the same quality of service which existed immediately preceding the loss.16

B. Valuing Business Interruption Claim

Typically, the value of business interruption claims is established through business records or other proof of the net loss to a business during the period of interruption. Courts are sensitive, however, to the need to assure that the insured is not unduly enriched as a result of the loss. Thus, for example, a company that is operating at a loss prior to the interruption may not be in a position to recover under a business interruption policy.17 Similarly, if there is no evidence that the interruption actually caused lost production capacity or other loss, the insured will not be entitled to any recovery.18

In Lyon Metal Products LLC v. Protection Mutual Insurance Co.,19 the Illinois Appellate Court held that a business interruption policy required that the compensation paid to the insured for damaged inventory under its property damage coverage had to be deducted from the amount of actual loss sustained as defined by the business interruption endorsement. The business interruption endorsement provided that "this policy is extended to cover the actual loss sustained by the insured during a period of interruption directly resulting from the physical loss or damage of the type insured against by this policy."

"Actual loss sustained" was defined in the endorsement:

In the event the insured is wholly or partially prevented from producing goods or from continuing business operations or services and is unable: (a) to make up lost production within a reasonable period of time (not to be limited to the period during which production is interrupted), or (b) to continue business operations or services, all through the use of any property or service owned or controlled by the insured... then this company shall be liable, subject to all other conditions of this policy not inconsistent herewith, for the actual loss sustained of the following items during the period of interruption: (A) NET PROFIT, ... (B) FIXED CHARGES .20

The court concluded that the portion of the definition of actual loss sustained italicized above imposed a duty on the insured to use any of its property, including damaged inventory, to continue business operations. Since the insurer is liable only for the actual loss sustained in net profit and the fixed charges that would have been earned had no interruption occurred, the court continued, if there is enough inventory to meet the projected sales for the period of interruption, there is no loss of earnings.

Concluding that the purpose of business interruption insurance is to cover a loss of earnings due to a loss of production, not just a loss of production, the court held that the insured would receive a windfall profit, in contravention of Illinois public policy, if it were permitted to recover for damaged inventory, lost production and expenses incurred in replenishing inventory.

Sublimits also can cause interesting issues in valuing business interruption claims. In Altru Health System v. American Protection Insurance Co.,21 the insured was forced by a state health department to evacuate its hospital because of flooding. The insured submitted a claim in excess of $5 million for property damage and business interruption losses, but the insurer argued that its total liability was limited by the policy's $1.5 million sublimit for flood losses.

The policyholder's business interruption losses were not caused by flood damage to the hospital, but by the health department's mandatory evacuation order. Therefore, the business interruption claim was filed under the "interruption by civil authority" clause that insured against

the actual loss sustained by the insured, resulting directly from an interruption of business as covered hereunder, during the length of time, not exceeding 2 consecutive weeks, when as a direct result of damage to or destruction of property within 1,000 feet of the premises herein described by the perils) insured against, access to such described premises is specifically prohibited by order of civil authority.

The Eighth Circuit looked to two other provisions in deciding whether the insurer's liability for all claims arising from the flood was limited to the $1.5 million sublimit in the flood endorsement. The preamble of the policy provided, "All liability for loss or expense under this policy for any one occurrence shall not exceed the smallest of . . . any applicable sublimits of liability entered elsewhere in the policy." Since the $1.5 million limitation in the flood endorsement was a sublimit of liability, the question was whether that limitation was applicable to the "interruption by civil authority" paragraph.

The second critical provision contained in the flood endorsement provided that "all claims for loss, damage or expense arising out of any one flood occurrence shall be adjusted as one claim." Therefore, the court found that the insured's claim was subject to the $1.5 million flood sublimit because the business interruption losses arose from the flood.

MISCELLANEOUS PROVISIONS

A. Other Insurance

In Hardrives Paving and Construction Co. v. Hartford Steam Boiler Inspection and Insurance Co.,22 the Ohio Court of Appeals held that an "other insurance" exclusion contained in a business interruption endorsement was context specific, meaning that an insurer may deny a claim only for interruption losses if the insured has other business interruption insurance provided by a separate company. The policy in Hardrives provided that the insurer would not pay for damage to property resulting from "lightning, if coverage for that cause of loss is provided by another policy of insurance." The business interruption endorsement incorporated by reference all of the exclusions contained in the property coverage, including the lightning exclusion.

The policyholder carried a second property damage policy issued by another insurer covering damage caused by lightning. The first insurer argued that the lightning exclusion in its business interruption endorsement was "triggered by virtue of the fact that lightning was explicitly referenced as a covered cause of loss in the [other property insurance policy]."

The court concluded that on being incorporated into the business interruption endorsement, the term "coverage" in the lightning exclusion no longer referred to physical damage to covered property but to losses associated with an interruption in operations. The insured was entitled to recovery under its business interruption coverage, the court held, because it did not maintain interruption insurance with another insurer that covered damage caused by lightening.

B. Appraisal Rights

In Jupiter Aluminum Corp. v. Home Insurance Co.,23 the business interruption policy contained an appraisal provision stating:

If the insured and the company fail to agree as to the amount of the loss, each shall, on the written demand of either, . . . select a competent and disinterested appraiser.... The appraisers shall first select a competent and disinterested umpire. ... The appraisers shall then appraise the loss in accordance with the insurance conditions, stating separately the amount of loss, and failing to agree, shall submit their differences to the umpire. An award in writing of any two (2) shall determine the amount of loss.

Since the parties could not agree on the amount of the insured's business interruption losses, Jupiter requested an appraisal in accordance with the terms of the coverage. Both appraisers met with the umpire after conducting independent appraisals. The umpire, whose own calculations of the loss were lower than that of both appraisers, asked the appraiser for the insurance company to select from one of his three amounts. The insurer's appraiser selected the highest of the umpire's calculations, and both the umpire and insurer's appraiser signed the award. The appraiser for the insured, Jupiter, refused to sign the award.

Jupiter contended that it was not bound by the appraisal because the policy did not state that the procedure was binding and it did not agree to a binding appraisal. Under governing Indiana law, however, a voluntary appraisal is binding unless a party can demonstrate that the appraisal was infected with unfairness or injustice. Thus, the Seventh Circuit held, Jupiter was bound to the umpire's award, even though the policy did not state that the appraisal process was binding.

C. Limitation of Suit Provisions

In Bowersox Truck Sales and Service Inc. v. Harco National Insurance Co.,24 a commercial property insurance policy, which also covered business interruption loss, stated, "No one may bring a legal action ... under this coverage part unless: . . . [t]he action is brought within 2 years after the date on which the direct physical loss or damage occurred." On March 4-5, 1994, the policyholder's roof collapsed. The parties failed to agree on whether the building could be repaired, and the insured eventually sued for its replacement costs and business interruption losses. On August 31, 1995, the parties agreed on the claim for replacement costs, but the settlement reserved the insured's right to pursue its claim for business interruption.

The insured's counsel then sent a letter to the insurer outlining a proposal to adjust the business interruption claim. The substance of the letter notified the insurer that it was likely that the insured would not be able to begin construction on a replacement building until the spring of 1996. In the ensuing exchange of correspondence, the insurer never advised the policyholder that the two year limitations period began to run on the date the building collapsed. The policyholder ultimately filed suit in 1997. At trial, the insurer argued that the claim for business interruption losses was barred by the contractually mandated two-year limitations period.

The "business income coverage form" stated that the insurer would "pay for the actual loss of business income you sustain due to the necessary suspension of your 'operations' during the `period of restoration."' The "period of restoration" was defined as "the period of time that a. Begins with the date of direct physical loss or damage... ; and b. Ends on the date when the property ... should be repaired, rebuilt, or replaced with reasonable speed and similar quality."

The Third Circuit stated that if the insurer was correct in its assertion that any suit must be brought within two years of the date the property was damaged, then such a claim would be impossible to bring when the reconstruction is not completed within that time frame. "Such a reading would render Harco's coverage illusory in situations like the one before us now," the court added.

The policy also provided that the two-- year limitation period was subject to a provision called "Additional Conditions in Commercial Property Coverage Forms." This language included the definitions and conditions of coverage pertaining to business income and the period of restoration. Alternatively, the limitations clause stated, "No one may bring a legal action against us under this coverage part." (Emphasis added.)

Since the insured's claim for business interruption loss arose under a different "part" of the policy, which did not include a similar time bar, the court held, as a matter of law, that the two-year limitations period did not apply to the insured's claim for business interruption coverage.

CONCLUSION

In evaluating any insurance claim, it is important to review both the facts of the underlying loss and the details of the insurance coverage. The nature of business interruption insurance, which is often written as an endorsement to a policy and is thus dependent on other provisions in the policy, makes a careful evaluation of the entire insurance agreement even more important.

FOOTNOTE

1. Protection Mut. Ins. Co. v. Mitsubishi Silicon Am. Corp., 992 P.2d 481 (Or.App. 1999), review denied, 6 P.3d 1100 (Or. 2000), quoting A&S Corp. v. Centennial Ins. Co., 242 F.Supp. 584, 589 (N.D. 111. 1965).

2. Lyon Metal Prod. L.L.C. v. Protection Mut. Ins., 747 N.E.2d 495, 505 (Ill.App. 2001).

3. INSURING REAL PROPERTY 3.02 (Matthew Bender & Co., 2001).

4. Protection Mut., 992 P.2d at 481.

FOOTNOTE

5. 2001 WL 878321 (4th Cir.) (unpublished opinion).

6. 166 F.3d 214(3d Cir. 1999). 7. Id. at 224 (emphasis added).

8. Id. at 224, citing Skelly v. Fid. & Cas. Co., 169 A. 78, 79 (Pa. 1933).

9. 166 F.3d at 224, quoting Dominick v. Statesman Ins. Co., 692 A.2d 188, 192 (Pa.Super. 1997), alloc. denied, 723 A.2d 671 (Pa. 1998).

10. 992 P.2d 479 (Or.App. 1999), review denied, 6 P.3d 1100 (Or. 2000).

FOOTNOTE

11. Id. at 486.

12. 167 F. 3d 1 (1st Cir. 1999).

FOOTNOTE

13. Id. at 8, quoting Allstate Ins. Co. v. Smith, 929 F.2d 447, 451 (9th Cir. 1991).

14. 176 F.3d 794 (4th Cir. 1999). 15. 589 N.W.2d 608 (S.D. 1999).

FOOTNOTE

16. INSURING REAL PROPERTY, supra note 3, at 3.02.

17. See, e.g., Continental Ins. Co. v. DNE Corp., 834 S.W.2d 930, 934 (Tenn. 1992).

18. See, e.g., Fold-Pak Corp. v. Liberty Mut. Ins. Co., 784 F.Supp. 49, 54 (N.D. N.Y. 1992).

19. 747 N.E.2d 495 (III.App. 2001). 20. Id. at 504 (emphasis added).

FOOTNOTE

21. 238 F.3d 961 (8th Cir. 2001).

22. 738 N.E.2d 463 (Ohio App. 2000). 23. 225 F.3d 868 (7th Cir. 2000).

FOOTNOTE

24. 209 F.3d 273 (3d Cir. 2000).

AUTHOR_AFFILIATION

IADC member Paul M. Hummer is a partner in the Philadelphia office of Saul Ewing LLP, where he is chair of the firm's insurance and reinsurance practice and concentrates his practice on complex litigation involving insurers, reinsurers and others in the insurance industry. He received his B.A. degree with highest honors from the University of California at Santa Barbara in 1980 and his J.D. from Hastings College of the Law, where he was a member of the law review, in 1984. He is an adjunct professor at the Temple University Fox School of Business.